Laguna II Equip Electrico

ST1 – P C – 08
Combined Materials Pack
ActEd Study Materials: 2008 Examinations
Subject ST1
Contents
Study Guide for the 2008 exams

Course Notes
Question and Answer Bank
Series X Assignments*
*Note: The Series X Assignment Solutions should also be supplied

with this pack unless you chose not to receive them with your study material.
If you think that any pages are missing from this pack, please contact ActEd’s admin team
by email at ActEd@bpp.com or by phone on 01235 550005.
How to use the Combined Materials Pack
Guidance on how and when to use the Combined Materials Pack is set out
in the Study Guide for the 2008 exams.
Important: Copyright Agreement
This study material is copyright and is sold for the exclusive use of the purchaser. You
may not hire out, lend, give out, sell, store or transmit electronically or photocopy any
part of it. You must take care of your material to ensure that it is not used or
copied by anybody else. By opening this pack you agree to these conditions.
The Actuarial Education Company © IFE: 2008 Examinations

All study material produced by ActEd is copyright and is sold
for the exclusive use of the purchaser. The copyright is owned
by Institute and Faculty Education Limited, a subsidiary of
the Faculty and Institute of Actuaries.
You may not hire out, lend, give out, sell, store or transmit
electronically or photocopy any part of the study material.
You must take care of your study material to ensure that it is

not used or copied by anybody else.
Legal action will be taken if these terms are infringed. In

addition, we may seek to take disciplinary action through the
profession or through your employer.
These conditions remain in force after you have finished using

the course.
© IFE: 2008 Examinations The Actuarial Education Company

ST1: Study Guide Page 1
2008 Study Guide
Subject ST1
Introduction
This Study Guide contains all the information that you will need before starting to study
Subject ST1 for the 2008 exams. Please read this Study Guide carefully before
reading the Course Notes, even if you have studied for some actuarial exams before.
The study guide includes:
• information about the course structure and how it links to the tutorials
• information about how the notes are written
• advice on how to study efficiently and prepare for the exam
• a summary of the Assignment and Mock Exam deadlines
• details of what to do if you have a query
• the full Syllabus.
Contents:
Section 1 The Subject ST1 course structure Page 2

Section 2 The course Page 3
Section 3 ActEd study support Page 5
Section 4 Information from the profession Page 12
Section 5 Study skills Page 15
Section 6 Frequently asked questions Page 19
Section 7 Syllabus Page 21
Section 8 Summary of useful information Page 27
Section 9 File tabs Page 31

Page 2 ST1: Study Guide
1 The Subject ST1 course structure

There are six parts to the Subject ST1 course. This should help you plan your progress
across the study session. The parts cover related topics and are broken down into
chapters. The following table shows how the parts, the chapters and the syllabus items
relate to each other. The end column shows how the chapters relate to the days of the
regular tutorials.
No of Syllabus Tutorials
Part Chapter Title
pages objectives 3 full days
1 H&C insurance products – income protection 55 (b)
2 H&C insurance products – critical illness 28 (b)
3 H&C insurance products – long-term care 40 (b)
4 H&C insurance products – PMI & related 28 (b)
1 products
5 Product design and stakeholder interests (1) 48 (c)
6 Product design and stakeholder interests (2) 43 (c) 1
7 The general business environment (1) 30 (d)
9 State healthcare provision 22 (e)
10 Assumptions (1) 55 (f),(k)
11 Assumptions (2) 40 (k)
2 12 Assumptions (3) 20 (k)
13 Models (1) 24 (j)
14 Pricing (1) 27 (f),(j)
15 Pricing (2) 53 (f),(j)
16 Pricing (3) – Group risk assessments 18 (f)
17 Costs of options 27 (f) 2
3 18 Pricing (4) – other considerations 21 (f)
19 Models (2) 15 (j)
21 Reserving 38 (l),(m)
4
22 Investment 35 (n)
23 Nature of risks (1) 29 (g)
5 25 Nature of risks (3) 14 (g)
3
26 Reinsurance 52 (h)
27 Other risk management techniques 39 (i)
28 Monitoring and feedback into the control 51 (o)
6 cycle
29 Glossary 34 (a) 2

2 The Course
The Course consists of Course Notes, a Question and Answer Bank and Series X
Assignments. Collectively, these are referred to as the Combined Materials Pack
(CMP).
2.1 Course notes
Each chapter of the Course Notes includes the Syllabus, a chapter summary and, where
appropriate, a page of important formulae or definitions.
The Syllabus for Subject ST1 has been written by the profession to state the
requirements of the examiners. The relevant individual Syllabus Objectives are
included at the start of each course chapter and a complete copy of the Syllabus is
included in Section 7 of this Study Guide. We recommend that you use the Syllabus as
an important part of your study. The Syllabus is supplemented by Core Reading, which
has also been written by the profession. The purpose of Core Reading is to give the
examiners, tutors and students a clear, shared understanding of the depth and breadth of
treatment required by the Syllabus. In examinations students are expected to
demonstrate their understanding of the concepts in Core Reading. Examiners have the
Core Reading available when setting papers.
Core Reading deals with each Syllabus objective. However, the Core Reading in
isolation is not ideal to pass the exam. Core Reading is supplemented by tuition material
that has been written by ActEd to help you prepare for the exam. The Subject ST1
Course Notes include the Core Reading in full, integrated throughout the course. Here
is an excerpt from some ActEd Course Notes to show you how to identify Core Reading
and the ActEd material. Core Reading is shown in this bold font.
Note that in the example given above, the index will fall if the actual share price goes
below the theoretical ex-rights share price. Again, this is consistent with what would
happen to an underlying portfolio.
This is
After allowing for chain-linking, the formula for the investment index then ActEd
becomes: text
This is Core
∑ Ni ,t Pi ,t Reading
I (t ) = i
B(t )
where N i ,t is the number of shares issued for the ith constituent at time t;
B(t ) is the base value, or divisor, at time t.

You should not simply try to memorise the Core Reading (or, for that matter, the tuition
material). Rather, you should understand the principles stated in the Core Reading and
developed in the tuition material.
2.2 Question and Answer Bank
The Question and Answer Bank provides a comprehensive and balanced bank of
questions with solutions and comments, which will be helpful as part of your preparation
for the Subject ST1 exam. Some students like to attempt the questions from the relevant
part of the Question and Answer Bank before attempting the corresponding assignment.
Others use the Question and Answer Bank at the revision stage. Our advice is to try out
various approaches and pick the one that best suits you.
The Question and Answer Bank is divided into seven parts. The first six parts of the
Question and Answer Bank include a range of short and long questions to test your
understanding of the corresponding part of the Course Notes. Part 7 of the Question and
Answer Bank consists of 100 marks of exam-style questions. You may wish to use this as
part of your revision closer to the examinations.
2.3 Assignments
The six Series X Assignments (X1 to X6) cover the material in Parts 1 to 6 respectively.
Assignments X1 to X3 are 80-mark tests and should take you two and a half hours to
complete. Assignments X4 to X6 are 100–mark tests and should take you three hours to
complete. The actual Subject ST1 examination will have a total of 100 marks.
If you order Series X Marking at the same time as you order the assignments, you can
choose whether or not to receive a copy of the solutions in advance – see the back of the
order form for details. If you choose not to receive the solutions with the study
material, we will send the assignment solutions to you when we mark your script (or
following the deadline date if you don’t submit the assignment).

3 ActEd study support

This section lists the study support available from ActEd for Subject ST1.
3.1 Combined Materials Pack
The Combined Materials Pack (CMP) comprises the Course Notes, the Question and
Answer Bank and the Series X Assignments, as already described.
3.2 Series Y Assignments
The Series Y Assignments comprise three 100-mark assignments (Y1, Y2 & Y3), each
covering the whole course. Series Y is suitable for retakers who have previously used
the Series X Assignments and for first-time sitters who want additional question
practice.
3.3 Mock Exam
Two 100-mark mock exam papers are available for students as a realistic test of their
exam preparation – Mock Exam 2007 and Mock Exam 2008. Both are issued with full
marking schedules and are available with or without marking.
Mock Exam 2008 is completely new. Mock Exam 2007 is also still available for
students wanting extra practice. It has been updated to reflect any changes to the
Syllabus and Core Reading over the last year.

3.4 ActEd Solutions with Exam Technique (ASET)
The ActEd Solutions with Exam Technique (ASET) contains ActEd’s solutions to the:
• Subject ST1 exams from April 2005 to September 2007 ie six papers
plus comment and explanation. In particular it will highlight how questions might have
been analysed and interpreted so as to produce a good solution with a wide range of
relevant points. This will be valuable in approaching questions in subsequent
examinations.
A “Mini-ASET” will also be available (from July 2008) covering the April 2008 Exam
only.
In addition, a discount is available if you have already purchased a full ASET in a

previous year and wish to purchase this year’s full ASET in the same subject. Please
email ActEd@bpp.com for details.
3.5 CMP upgrade
The CMP Upgrade lists all significant changes to the Core Reading and ActEd material
so that you can manually amend your 2007 study material to make it suitable for study
for the 2008 exams. The Upgrade includes replacement pages and additional pages
where appropriate. If a large proportion of the material has changed significantly,
making it inappropriate to include all changes, the upgrade will still explain what has
changed and if necessary recommend that students purchase a replacement CMP or
Course Notes at a significantly reduced price. The CMP Upgrades can be downloaded
free of charge from our website at www.ActEd.co.uk.
3.6 Marking
You can have your attempts at Assignments or Mock Exams marked using Series
Marking, Mock Exam marking or Marking Vouchers. These are described below.
Marking is not included with the CMP and you need to order it separately.
On every assignment or mock exam that you submit for marking, you must write your
ActEd Student Number clearly in the box on the cover sheet. Your ActEd Student
Number is printed on all personal correspondence from ActEd. This is not the same as
your ARN (Actuarial Reference Number), which is used by the profession. By filling in
your ActEd Student Number, you will help us to process and return your script more
quickly. If you do not supply this information, your script may be delayed.

When completing an assignment which you are having marked, please also remember
the following guidelines:
• Leave plenty of space for markers to write their comments – the less room
you leave, the fewer helpful comments the marker will be able to add.
• Photocopy your assignment before posting it to ActEd – we’ll be happy to
mark your copy if your original script should get lost in the post.
• Only use current versions of assignments. Do not submit any assignments
from the 2007 exam session. We will return old versions of assignments
unmarked.
• Identify how much you completed in the recommended time – this will help
the marker to advise you on your chances of passing the exam. Do not stop
after the allotted allocation of time however. Use the marker to get feedback
on all questions, even if the assignment takes you longer to complete than the
time allocated.
• Grade and comment on your previous assignment marker (where applicable)
– this helps us to improve the quality of future marking.
Series Marking and Mock Exam marking
You may buy marking for a specified series of assignments (eg Subject ST1 Series X) or
Mock Exam Marking for a specified subject (eg Subject ST1). By submitting your scripts
in line with our published recommended submission dates, you will make steady progress
through the course. We also publish a set of final deadline dates – if you miss the final
deadline date for an assignment or mock exam, your script will not be marked.
Recommended submission dates and final deadline dates are set out on the summary
pages at the end of this document. Once you have booked Series Marking or Mock Exam
Marking, you will not be able to defer the marking to a future study period.
If you order Series X Marking at the same time as you order the assignments, you can
choose whether or not to receive a copy of the solutions in advance – see the back of the
order form for details. If you choose not to receive the solutions in advance, we will
send the assignment solutions to you when we mark your script (or following the
deadline date if you don’t submit the assignment).

Marking Vouchers
If you would prefer not to be restricted to deadlines during the session, or a particular
series of assignments in any one study session, you may buy Marking Vouchers instead.
Each Marking Voucher gives the holder the right to submit an attempt at any assignment
or mock exam for marking at any time, irrespective of the individual assignment
deadlines, study session, subject or person. Marking Vouchers are valid for four years
from the date of purchase. Expired Marking Vouchers cannot be refunded.
Important information
Although you may submit your script with a Marking Voucher at any time, you will need
to adhere to the explicit marking voucher deadline dates to ensure that your script is
returned before the date of the exam. The deadline dates are given near the end of this
study guide.
If you live outside the UK you must ensure that your last script reaches the ActEd office
earlier than this to allow the extra time needed to return your marked script.
Submission dates and deadlines
Your preparation for the exam should be based on a programme of sustained study over
the whole session. If you are having your attempts at the assignments marked by ActEd,
you should submit your scripts regularly throughout the session.
If you are attempting the assignments or mock exams you should aim to submit scripts
according to the schedule of recommended dates set out in the summary at the end of this
document. This will help you to pace your study throughout the session and leave an
adequate amount of time for revision and question practice. Scripts submitted after the
deadline date will not be marked. It is your responsibility to ensure that scripts are
posted in good time.
Important information
The recommended deadline dates are realistic targets for the majority of students. Your
scripts will be returned more quickly if you submit them well before the final deadline
dates.

3.7 Tutorials
ActEd tutorials are specifically designed to develop the knowledge that you will acquire
from the course material into the higher level understanding that is needed to pass the
exam. We expect students to have read the relevant part of the Course Notes before
attending the tutorial so that the group can spend time on exam questions and discussion
to develop understanding rather than basic bookwork.
ActEd run a range of different tutorials at various locations. Full details are set out in
ActEd’s Tuition Bulletin, which is sent regularly to all students based in the UK, Eire
and South Africa and is also available from the ActEd website at www.ActEd.co.uk.
Regular and Block Tutorials
You can choose one of the following types of tutorial:

• Regular Tutorials (three full days) spread over the session.
• A Block Tutorial (three consecutive days) held 2 to 8 weeks before the exam.
The Regular Tutorials provide an even progression through the course. Block Tutorials
cover the whole course.
Revision Days
Revision Days, where available, are intensive one-day tutorials in the final run-up to the
exam. They are particularly suitable for first-time sitters who attended Regular
Tutorials and would like to spend a day close to the exam focusing on the course or
retakers who have already attended ActEd tutorials. Revision Days give students the
opportunity to practise interpreting and answering past exam questions and to raise any
outstanding queries with an ActEd tutor. These courses are most suitable for students
who have attended Regular Tutorials or a Block Tutorial in the same subject.
Details of how to apply for ActEd’s tutorials are set out in our Tuition Bulletin,

3.8 Queries and feedback
From time to time you may come across something in the study material that is unclear
to you. The easiest way to solve such problems is often through discussion with friends,
colleagues and peers – they will probably have had similar experiences whilst studying.
If there’s no-one at work to talk to then use ActEd’s discussion forum at
www.ActEd.co.uk/forums (or use the link from our home page at www.ActEd.co.uk).
Our online forum is dedicated to actuarial students so that you can get help from fellow
students on any aspect of your studies from technical issues to study advice. You could
also use it to get ideas for revision or for further reading around the subject that you are
studying. ActEd Tutors will visit the site from time to time to ensure that you are not
being led astray and we also post other frequently asked questions from students on the
forum as they arise.
If you are still stuck, then you can send queries by email to ST1@bpp.com or by fax to
01235 550085 (but we recommend that you try the forum first). We will endeavour to
contact you as soon as possible after receiving your query but you should be aware that
it may take some time to reply to queries, particularly when tutors are away from the
office running tutorials. At the busiest teaching times of year, it may take us more than
a week to get back to you.
However, please note that we only provide this additional email support to students who
have purchased materials directly from ActEd in the UK, South Africa or Australia. If
you have obtained your materials from a 3rd party, eg the Institute of Actuaries or the
Actuarial Society of India then we are unable to help (unless your query relates to an
error in our materials).
If you have many queries on the course material, you should raise them at a tutorial or
book a personal tuition session with an ActEd Tutor. Information about personal tuition
is set out in our current brochure. Please email ActEd@bpp.com for more details.
Each year ActEd Tutors work hard to improve the quality of the study material and to
ensure that the courses are as clear as possible and free from errors. We are always
happy to receive feedback from students, particularly details concerning any errors,
contradictions or unclear statements in the courses. If you have any comments on this
course please email them to ST1@bpp.com or fax them to 01235 550085.
The ActEd Tutors also work with the profession to suggest developments and
improvements to the Syllabus and Core Reading. If you have any comments or
concerns about the Syllabus or Core Reading, these can be passed on via ActEd.
Alternatively, you can address them directly to the Profession’s Examination Team at
Napier House, 4 Worcester Street, Oxford, OX1 2AW or by email to
examinations@actuaries.org.uk.

3.9 The ActEd website
The ActEd website at www.ActEd.co.uk contains much useful information on all

aspects of ActEd’s products and services, including:
• copies of the Study Guide in every subject
• the current Student Brochure and application forms
• the latest version of the Tuition Bulletin, including details of finalisation dates
and all new courses
• details of how to organise tutorials at a convenient location for you
• a link to the ActEd discussion forum
• details of any minor corrections to the study material
• advice on study and a blank personal study plan
• details of recommended assignment submission dates and deadline dates.

4 Information from the profession
4.1 The Profession’s Copyright
All of the course material is copyright. The copyright belongs to Institute and Faculty
Education Ltd, a subsidiary of the Faculty of Actuaries and the Institute of Actuaries.
The material is sold to you for your own exclusive use. You may not hire out, lend,
give, sell, transmit electronically, store electronically or photocopy any part of it. You
must take care of your material to ensure it is not used or copied by anyone at any time.
Legal action will be taken if these terms are infringed. In addition, we may seek to take
disciplinary action through the profession or through your employer.
These conditions remain in force after you have finished using the course.
4.2 Changes to the Syllabus and Core Reading
The Syllabus and Core Reading are updated as at 31 May each year. The exams in
April and September 2008 will be based on the Syllabus and Core Reading as at 31 May
2007.
We recommend that you always use the up-to-date Core Reading to prepare for the
exams.
4.3 Core Reading accreditation
The Faculty and Institute of Actuaries would like to thank the numerous people who
have helped in the development of the material contained in this Core Reading.
4.4 Past exam papers
You can download some past papers and reports from the profession’s website at
www.actuaries.org.uk.

4.5 The profession’s libraries and website
All students are entitled to use the profession’s libraries in Edinburgh, London and
Oxford. The following services are offered:
Loans
You can borrow books by post if you do not live or work near one of the libraries. The
libraries have multiple copies of many popular titles.
Photocopies
The library staff can post photocopies to you. The cost is 20p per sheet (£5.00 postage
and packing added for destinations outside the UK).
Enquiries
The library staff will always help with enquiries. They will try to obtain items not held
in stock and can advise on access to other libraries. They compile lists of references on
specialist topics on request.
Study facilities
All three libraries have comfortable quiet study space. Past exam papers, examiners’
reports, ActEd Course Notes and Core Reading are all available for reference.
Website
You can search the library catalogue on the website and order items online. Many
catalogue records include links to full text documents for downloading. You can also
access the Publications Shop and order items for purchase. The website is a free
information resource for the latest thinking from the profession. You will find briefing
statements, press releases, responses to consultations, CMI reports, conference papers,
sessional meeting papers and the latest news.
The actuarial education section contains practical information such as exam dates, past
papers and reports, syllabuses, the Student Handbook, guidance on study and exam
techniques and the lists of suggested additional reading.

Bookmark these pages:
Information for students:

www.actuaries.org.uk/link/education/education.xml
Library services:
www.actuaries.org.uk/link/maintained/resource_centre/library.html
Order publications:
www.actuaries.org.uk/link/maintained/resource_centre/resource.html
4.6 Calculators
The following advice has been issued by the profession. However we strongly
recommend that you check on the profession’s website for the latest details.
With effect from the 2008 examinations copies of actuarial tables, including a list of
standard formulae, will be available to candidates in the examination room. Candidates
may use electronic calculators in all the examinations subject to the following
conditions:
• Candidates must provide their own calculators.

• The following calculators are permitted:
• Casio FX85ES
• Hewlett Packard HP9S
• Hewlett Packard HP 12C Platinum
• Sharp EL531WB
• Texas Instruments BA II Plus
• Texas Instruments TI-30XIIB
• Any stored data and/or stored program facilities must be cleared before the
calculator is taken to the examination room.
• No extra time will be allowed for candidates who do not use calculators or
whose calculators break down in the course of the examination.

5 Study skills
5.1 The ST Subject exams
It is important to recognise that the ST Subject exams are very different from the
CT Subject exams in both the nature of the material covered and the skills being
examined.
Both the Core Reading and the exam papers themselves are generally much less
numerical and more “wordy” than the typical CT subject. The exam will primarily
require you to explain a particular point in words and sentences, rather than to
manipulate formulae. Numerical questions typically account for only a small part of
each exam paper. If you haven’t sat this type of exam for some time, you need to start
practising again now. Many students find that it takes time to adjust to the different
style of the ST Subject exam questions. As ever, practice is the key to success.
The aim of the exams is to test your ability to apply your knowledge and understanding
of the key principles described in the Core Reading to specific situations presented to
you in the form of exam questions. Therefore your aim should be to identify and
understand the key principles, and then to practise applying them. You will also need a
good knowledge of the Core Reading to score well and quickly on any bookwork
questions.
We recommend that you prepare for the exam by practising a large number of exam-
style questions under exam conditions. This will:
• help you to develop the necessary knowledge and understanding of the key
principles described in the Core Reading
• highlight exactly which are the key principles that crop up time and time again
in many different contexts and questions
• help you to practise the specific skills that you will need to pass the exam.
There are many sources of exam-style questions. You can use the specimen paper, the
Question and Answer Bank, assignments and the mock exam.

5.2 Overall study plan
We suggest that you develop a realistic study plan, building in time for relaxation and
allowing some time for contingencies. Be aware of busy times at work, when you may
not be able to take as much study leave as you would like. Once you have set your plan,
be determined to stick to it. You don’t have to be too prescriptive at this stage about
what precisely you do on each study day. The main thing is to be clear that you will
cover all the important activities in an appropriate manner and leave plenty of time for
revision and question practice.
Aim to manage your study so as to allow plenty of time for the concepts you meet in
this course to “bed down” in your mind. Most successful students will probably aim to
complete the course at least a month before the exam, thereby leaving a sufficient
amount of time for revision. By finishing the course as quickly as possible, you will
have a much clearer view of the big picture. It will also allow you to structure your
revision so that you can concentrate on the important and difficult areas of the course.
A sample ST subject study plan is available on our website at www.ActEd.co.uk. It

includes details of useful dates, including assignment deadlines and tutorial finalisation
dates.
5.3 Study sessions
Only do activities that will increase your chance of passing. Try to avoid including
activities for the sake of it and don’t spend time reviewing material that you already
understand. You will only improve your chances of passing the exam by getting on top
of the material that you currently find difficult.
Ideally, each study session should have a specific purpose and be based on a specific
task, eg “Finish reading Chapter 3 and attempt Questions 1.4, 1.7 and 1.12 from the
Question and Answer Bank”, as opposed to a specific amount of time, eg “Three hours
studying the material in Chapter 3”.
Try to study somewhere quiet and free from distractions (eg a library or a desk at home
dedicated to study). Find out when you operate at your peak, and endeavour to study at
those times of the day. This might be between 8am and 10am or could be in the
evening. Take short breaks during your study to remain focused – it’s definitely time
for a short break if you find that your brain is tired and that your concentration has
started to drift from the information in front of you.

5.4 Order of study
We suggest that you work through each of the chapters in turn. To get the maximum
benefit from each chapter you should proceed in the following order:
1. Read the Syllabus Objectives. These are set out in the box on Page 1 of each
chapter.
2. Read the Chapter Summary at the end of each chapter. This will give you a useful
overview of the material that you are about to study and help you to appreciate the
context of the ideas that you meet.
3. Study the Course Notes in detail, annotating them and possibly making your own
notes. Try the self-assessment questions as you come to them. Our suggested
solutions are at the end of each chapter. As you study, pay particular attention to
the listing of the Syllabus Objectives and to the Core Reading.
4. Read the Chapter Summary again carefully. If there are any ideas that you can’t
remember covering in the Course Notes, read the relevant section of the notes
again to refresh your memory.
You may like to attempt some questions from the Question and Answer Bank when you
have completed a part of the course. It’s a good idea to annotate the questions with
details of when you attempted each one. This makes it easier to ensure that you try all of
the questions as part of your revision without repeating any that you got right first time.
Once you’ve read the relevant part of the notes, tried a selection of questions from the
Question and Answer Bank (and attended a tutorial, if appropriate), you should attempt
the corresponding assignment. If you submit your assignment for marking, spend some
time looking through it carefully when it is returned. It can seem a bit depressing to
analyse the errors you made, but you will increase your chances of passing the exam by
learning from your mistakes. The markers will try their best to provide practical
comments to help you to improve.
It’s a fact that people are more likely to remember something if they review it from time
to time. So, do look over the chapters you have studied so far from time to time. It is
useful to re-read the Chapter Summaries or to try the self-assessment questions again a
few days after reading the chapter itself.
To be really prepared for the exam, you should not only know and understand the Core
Reading but also be aware of what the examiners will expect. Your revision programme
should include plenty of question practice so that you are aware of the typical style,
content and marking structure of exam questions. You should attempt as many questions
as you can from the Question and Answer Bank and past exam papers.

5.5 Active study
Here are some techniques that may help you to study actively.
1. Don’t believe everything you read! Good students tend to question everything
that they read. They will ask “why, how, what for, when?” when confronted
with a new concept, and they will apply their own judgement. This contrasts
with those who unquestioningly believe what they are told, learn it thoroughly,
and reproduce it (unquestioningly?) in response to exam questions.
2. Another useful technique as you read the Course Notes is to think of possible
questions that the examiners could ask. This will help you to understand the
examiners’ point of view and should mean that there are fewer nasty surprises in
the exam room! Use the Syllabus to help you make up questions.
3. Annotate your notes with your own ideas and questions. This will make you
study more actively and will help when you come to review and revise the
material. Do not simply copy out the notes without thinking about the issues.
4. Attempt the questions in the notes as you work through the course. Write down
your answer before you check against the solution.
5. Attempt other questions and assignments on a similar basis, ie write down your
answer before looking at the solution provided. Attempting the assignments
under exam conditions has some particular benefits:
• It forces you to think and act in a way that is similar to how you will
behave in the exam.
• When you have your assignments marked it is much more useful if the
marker’s comments can show you how to improve your performance
under exam conditions than your performance when you have access to the
notes and are under no time pressure.
• The knowledge that you are going to do an assignment under exam
conditions and then submit it (however good or bad) for marking can act as
a powerful incentive to make you study each part as well as possible.
• It is also quicker than trying to write perfect answers.
6. Sit a mock exam 4 to 6 weeks before the real exam to identify your weaknesses
and work to improve them. You could use the mock exam written by ActEd or a
past exam paper.

6 Frequently asked questions

Q: What knowledge of earlier subjects should I have?
A: The Course Notes have been written assuming that you have already studied, or
been exempted from, Subjects CT1–CT8.
The key area that you will need in studying Subject ST1 is:
• a basic knowledge and understanding of stochastic models, survival
models and multi-state models and their financial applications as
described in Subjects CT4 and CT5.
It will also be useful to have a knowledge and understanding of:

• some of the statistical methods covered in Subject CT6, particularly those
used for rating and experience
• investment management and the characteristics of the major asset types,
as covered (mainly) in Subject CA1.
Q: I have studied Subject ST2 or ST3. Will this help?
A: It may help you a little but we don’t recommend that you alter your study
methods. Read the course as you would any other. You may be familiar with
some parts of the Notes, especially if you have studied ST2. This will enable
you to work through these more quickly so that you can spend more time
looking at the less familiar material.
Q: What is your advice if I am simultaneously studying Subject SA1?
A: Subject SA1 builds on the common principles developed in Subject ST1, but
requires a much greater depth of knowledge and understanding. Consequently,
there is a degree of overlap between the two subjects – both in the Core Reading
and also possibly in the types of questions that are likely to appear on the exam
papers. It is therefore important to assimilate the key ideas presented in Subject
ST1 before tackling the same ground in Subject SA1.

We suggest that you aim to cover the Subject ST1 course as quickly as possible,
so as to get a general feel for the principles underlying health and care, together
with an overview of the course content. It also makes sense to quickly review
the relevant Subject ST1 material prior to working through each chapter in
Subject SA1. From time to time over the study session, and particularly at the
revision stage, it might also be a good idea to review the Subjects ST1 & SA1
Course Notes at the same time, along with the Question and Answer Banks. In
particular, it is always worth thinking about how each idea or principle is
presented in each of ST1 and SA1 and hence how it might consequently be
examined in either exam.
Q: What should I do if I discover an error in the course?
A: If you find an error in the course, please check our website at

www.ActEd.co.uk/Html/paper_corrections.htm to see if the correction has
already been dealt with. Otherwise please send details via email to
ST1@bpp.com or send a fax to 01235 550085.
Q: What calculators am I allowed to use in the exam?
A: You are allowed to use one of the following calculators:
• Casio FX85ES
• Hewlett Packard HP9S
• Hewlett Packard HP 12C Platinum
• Sharp EL531WB
• Texas Instruments BA II Plus
• Texas Instruments TI-30XIIB
This is the current advice from the profession. However we strongly

recommend that you check on the profession’s website for the latest details.

7 Syllabus
The full Syllabus for Subject ST1 is given here. The numbers to the right of each
objective are the chapter numbers in which the objective is covered in the ActEd course.
Aim
The aim of the Health and Care Specialist Technical subject is to instil in successful
candidates the ability to apply, in simple situations, the principles of actuarial planning
and control needed in health and care matters on sound financial lines.
Links to other subjects
Subject CT3 — Probability and Mathematical Statistics: provides a basic grounding in

statistics.
Subject CT4 — Models: covers some stochastic models used in health and care.
Subject CT6 — Statistical Methods: covers some of the mathematical methods relevant
for this subject.
Subject CA1 — Core Application Concepts covers the general underlying principles
affecting all specialisms.
Subject SA1 — Health and Care Specialist Applications will use the principles
developed in this subject to develop a deeper understanding of health and care insurance
business and United Kingdom practice.

Objectives
On completion of this subject the candidate will be able to:
(a) Understand the principal terms in health and care. (Chapter 29)
(b) Describe and understand the main types of contract. (Chapters 1 to 4)
• Critical Illness
• Income Protection
• Long Term Care Insurance
• Hospital Cash
• Major Medical Expenses
• Private Medical Insurance
• main example variations of contracts issued

• group and individual covers
• purpose of contracts to insured
(c) Outline the principles by which health and care insurance contracts are designed
and the interests of the various stakeholders in the process. (Chapters 5 and 6)
• customer attraction and clarity

• insurer control and profitability
• regulators’ satisfaction
• employer as purchaser
• other stakeholders: equity, guidance notes, sales processes, IT
(d) Understand the operating environments in which health and care insurance
products and services are traded. (Chapters 7 and 8)
• propensity to purchase versus drive to sell — meeting customer needs

• methods of sale
• remuneration of sales channels
• types of expenses and commission
• influence of Inflation on benefits, premiums and expenses
• regulatory environment on sales and reporting
• professional guidance constraints and opportunities
• role of IFA in the group risks market

(e) Explain the likely role of the State in the provision of alternative or
complementary health and care protection packages. (Chapter 9)
• lump sums and regular incomes

• flat-rated and earnings related
• different viewpoints for the retired, for the employed, for children
• simpler methods of funding these outgoes
(f) Understand and apply the techniques used in pricing health care insurance
products in terms of: (Chapters 10, 14 to 18)
• data availability
• assumptions used
• equation of value
• formula approach
• cash flow techniques
• group risk assessments
• options
• guarantees

(g) Understand the nature of the risks facing the insurer. (Chapter 23 to 25)
• data — own experience, insured experience, population data, overseas

data
• claim inception and termination rates
• claim cost information: by treatment, per diem, length of stay, medical
inflation
• investment performance
• expenses and inflation
• withdrawals
• mix of new business by nature and size of risk and by source
• volumes of new business
• guarantees and options
• competition
• management of insurer
• counterparties in distribution
• counterparties in provision of medical services
• counterparties in reinsurance
• regulation and fiscal developments
• customer service shortcomings / reputational risks
• internal audit failures/fraud
• physical risks including IT recovery
• aggregation and concentration of risk
• catastrophes
• non-disclosure — underwriting at outset versus underwriting at claim
stage
• earlier screening/diagnosis
(h) Understand how insurers use reinsurance to manage their risks and the
reinsurance products involved. (Chapter 26)
• product design and pricing

• individual risks (large and/or unusual)
• aggregate risks (accumulation from event or portfolio)
• other financial risks

(i) Describe how insurers manage their risks in ways other than reinsurance.
(Chapter 27)
• review actual claims experience against pricing basis
• service level agreements with out-sourcers
• competence assessments for key inhouse staff
• checks on policy data
• surveys on customer service satisfaction
• underwriting as gatekeeper and risk analysis
• claims management — in line with policy conditions and underwriting
• Policyholders Reasonable Expectations
• controlling the distribution process
(j) Describe the principal modelling techniques appropriate to health and care
insurance. (Chapters 13 to 15, 19)
• asset liability modelling

• actuarial models — stochastic models and Monte Carlo simulation
– objectives and requirements
– basic features
– uses (pricing, return and capital, profitability assessment)
– volatility and sensitivity
• multi-state modelling in pricing, reserving and reporting
• comparison of formula and cash flow approach
• cash flow approach to price setting
• model office methodology in assessing capital requirements
• when to use deterministic models (systematic risk assessment
• when to use stochastic models (random risk measure)
(k) Understand the assumptions which are crucial to pricing and valuation.
(Chapters 10 to 12, 20)
• morbidity
• mortality
• lapses
• claim amount
• expenses
• investment return
• taxes
• solvency margins
• profit requirements

(l) Understand the purposes for and methodology by which valuation and reserving
are performed. (Chapter 21)
• the role of statistical and individual case estimates

• the uses of deterministic and stochastic processes
• purpose of calculation
• supervisory (solvency, prudent, prospective)
• experience review (realistic retrospective pricing and conditions)
• management information (realistic, prospective)
• embedded values (various)
• fair valuation (realistic)
(m) Understand the purposes and practices of supervisory reporting. (Chapter 21)
• principles of setting statutory reserves

• difference in assumptions from pricing
• sensitivity analysis
• strength of basis
• valuation of assets and consistency
• solvency margins and solvency assessment
(n) Describe the principles of investment underpinning health and care

insurance. (Chapter 22)
• cash flow and liquidity

• matching and immunisation
• fund manager assessment
• asset valuation
• effect on product development and pricing
• customers’ PRE
(o) Describe the principles by which the experience from a health insurance
operation is used to refocus business planning. (Chapter 28)
• reasons for monitoring experience

• data required
• analysis of mortality, disability, claim amount, recovery and withdrawal
rates
• analysis of expenses, sales rates and investment experience
• analysis of surplus and profit, cause and effect
• use of results to revise the models used and assumptions underlying

8 Summary of useful information – Subject ST1

No of Syllabus Tutorials
Part Chapter Title
pages objectives 3 full days
1 H&C insurance products – income protection 55 (b)
2 H&C insurance products – critical illness 28 (b)
3 H&C insurance products – long-term care 40 (b)
4 H&C insurance products – PMI & related 28 (b)
1 products
5 Product design and stakeholder interests (1) 48 (c)
6 Product design and stakeholder interests (2) 43 (c) 1
9 State healthcare provision 22 (e)
10 Assumptions (1) 55 (f),(k)
2 12 Assumptions (3) 20 (k)
13 Models (1) 24 (j)
14 Pricing (1) 27 (f),(j)
15 Pricing (2) 53 (f),(j)
16 Pricing (3) – Group risk assessments 18 (f)
17 Costs of options 27 (f) 2
3 18 Pricing (4) – other considerations 21 (f)
19 Models (2) 15 (j)
21 Reserving 38 (l),(m)
4
22 Investment 35 (n)
5 25 Nature of risks (3) 14 (g)
3
26 Reinsurance 52 (h)
27 Other risk management techniques 39 (i)
28 Monitoring and feedback into the control 51 (o)
6 cycle
29 Glossary 34 (a) 2
Send queries or feedback on Subject ST1 by email to ST1@bpp.com.
ActEd’s website: www.ActEd.co.uk
The profession’s website: www.actuaries.org.uk

8.1 Assignment Deadlines – ST Subjects

For the session leading to the April 2008 exams – ST Subjects
Marking vouchers
Subject Assignments Mocks
ST2, ST4, ST6 12 March 2008 19 March 2008
Series X and Y Assignments
Recommended
Series Subject Assignment Final deadline date
submission date
ST1-6 X1 28 November 2007 9 January 2008

X
ST1-6 X2 12 December 2007 23 January 2008
ST1-6 X3 16 January 2008 6 February 2008
ST1-6 X5 13 February 2008 5 March 2008
ST2, ST4, ST6 20 February 2008 12 March 2008

X6
ST2, ST4, ST6 23 January 2008 27 February 2008

Y Y1
ST1, ST3, ST5 30 January 2008 5 March 2008

Y2

Y3
Mock Exams
Recommended
Subject Final deadline date
submission date
We suggest that you work to the recommended submission dates where possible.
Please remember that turnaround of your script is likely to be quicker if you submit it
well before the final deadline date.

For the session leading to the September 2008 exams – ST Subjects
Marking vouchers
ST2, ST4, ST6 20 August 2008 27 August 2008
ST1, ST3, ST5 27 August 2008 3 September 2008

Recommended
Series Assignment Final deadline date
submission date
X1 28 May 2008 9 July 2008

X
ST1 – ST6 X2 11 June 2008 23 July 2008
X3 25 June 2008 30 July 2008
X4 9 July 2008 6 August 2008
X5 23 July 2008 13 August 2008
X6 6 August 2008 20 August 2008
Y1 2 July 2008 23 July 2008

Y
ST1 – ST6 Y2 23 July 2008 6 August 2008
Y3 13 August 2008 20 August 2008
Mock Exams
Recommended
submission date
We suggest that you work to the recommended submission dates where possible.
Please remember that turnaround of your script is likely to be quicker if you submit it
well before the final deadline date.

This page has been left blank so that you can cut out and use the file tabs.

9 File tabs
You might want to use the tabs printed below to label your course files. You will only
need two course files for the Combined Materials Pack but we have given you nine tabs
so that you can choose which ones to cut out in order to label your files.
ST1 ST1 ST1

Health & Care Health & Care Health & Care
Specialist Technical 2008 Exams
2008 Exams
2008 Exams Q&A +
Assignments
ST1 ST1 ST1

2008 Exams 2008 Exams 2008 Exams

File 1 File 2
ST1 ST1 ST1

Specialist Technical
2008 Exams
Q&A Bank

This page has been left blank so that you can cut out and use the file tabs.

ST1: Index Page 1
ST1 Index
Accelerated critical illness insurance .................................. Ch1 p11
Ch15 p25
Glossary
Accident and sickness insurance ......................................... Ch 1 p31
Ch15 p33
Acute illness ........................................................................ Glossary
Activities of daily living (ADLs) ........................................ Ch2 p16
Ch3 p12
Glossary
Activities of daily working (ADWs) ................................... Ch2 p17
Glossary
Actuarial control cycle – see Control cycle
Affinity group...................................................................... Glossary
Aggregate excess of loss reinsurance .................................. Ch26 p28
Age-at-entry pricing ............................................................ Glossary
Aggregation of risk.............................................................. Ch24 p10
Analysis of embedded value profit...................................... Ch28 p33
Analysis of surplus .............................................................. Ch28 p30
Analysis of valuation surplus .............................................. Ch28 p30
Anti-selection ...................................................................... Ch2 p6
Ch6 p3
Glossary
Appointed representatives – see Tied agents
Arbitrage – see Tax arbitrage
Assessment period ............................................................... Glossary
Asset-liability matching....................................................... Ch22 p6
Asset-liability modelling ..................................................... Ch22 p17
Asset model ......................................................................... Ch13 p11
Asset share........................................................................... Glossary
Asset valuation .................................................................... Ch22 p23
Assumptions ........................................................................ Ch10
Ch11
Ch12
Ch20
Ch21 p13, 19, 20
Bancassurance ..................................................................... Glossary

Basis – see assumptions
Benefit amount (assumption) .............................................. Ch11 p3
Benefit limitation................................................................. Glossary
Best-estimate reserving ....................................................... Ch21 p26
Brokers – see Independent financial advisor

Page 2 ST1: Index
Budget policies .................................................................... Glossary

Bulk rate............................................................................... Glossary
Burning cost......................................................................... Ch16 p7
Glossary
Buy-back option .................................................................. Ch17 p2
Cafeteria-style benefits – see Flex schemes

Capital.................................................................................. Ch1 p2
Ch8 p13
Ch12 p2
Ch14 p19
Ch21 p24
Ch24 p13
– see also Free assets
Capital asset pricing model (CAPM)................................... Ch12 p4
Capitation basis (dental plans)............................................. Ch4 p11
Glossary
Career break......................................................................... Glossary
Case estimates (of reserves)................................................. Ch21 p3
Cashflow model ................................................................... Ch13 p13
Ch14 p9
Cash (investment) ................................................................ Ch22 p4
Cash plans............................................................................ Ch4 p9
Ch5 p28
Ch15 p34
Glossary
Catastrophe reserves ............................................................ Ch21 p10
Catastrophe risks.................................................................. Ch24 p10
Change of occupation .......................................................... Glossary
Children’s benefit ................................................................ Ch2 p13
Chronic illness ..................................................................... Glossary
Churning .............................................................................. Ch27 p26
Claim amount (assumption) – see Benefit amount
Claim escalation rates .......................................................... Glossary
Claim inception and disability annuity method ................... Ch 15 p8
Claim incidence rates (estimation of) .................................. Ch10 p23
Claim notification period..................................................... Glossary
Claim recovery rates (estimation of) ................................... Ch10 p24
Claims in transit reserves..................................................... Ch21 p10
Claims – late notification..................................................... Glossary
Claims management – see Claims underwriting
Claims paid, claims incurred ............................................... Glossary
Claims pre-authorisation – see Pre-authorisation
Claims reserves.................................................................... Ch21 p6, 9

ST1: Index Page 3
Claims underwriting ............................................................ Ch5 p22, 46

Ch27 p22
Clawback (of indemnity commission)................................. Ch8 p4
Ch11 p17
CMIR12............................................................................... Ch15 p18, 23
Coinsurance ......................................................................... Ch5 p30
Glossary
Commission......................................................................... Ch8 p2
Community rate/rating......................................................... Ch4 p13
Glossary
Competition ......................................................................... Ch18 p8
Comprehensive cover .......................................................... Glossary
Concentration of risk – see Aggregation of risk
Consistency.......................................................................... Ch12 p14
Ch20 p7
Continuation option............................................................. Ch1 p28
Glossary
Continued Personal Medical Exclusions (CPME) .............. Glossary
Continuing care retirement communities (CCRCs) ............ Ch5 p24
Control cycle ....................................................................... Ch7 p17
Ch28 p35
Conventional method (of costing options) .......................... Ch17 p9
Ch24 p4
Ch28 p13
Corporate fixed-interest stocks............................................ Ch22 p4
Cost of capital...................................................................... Ch12 p2
Cost plus .............................................................................. Glossary
Counselling.......................................................................... Ch27 p23
Counterparty risk ................................................................. Ch24 p6, 7
Ch27 p26
Credibility............................................................................ Ch16 p6
Creditor insurance ............................................................... Glossary
Critical illness insurance...................................................... Ch2
Ch6 p10
Ch8 p9
Ch15 p25
Ch20 p18
Ch24 p16
Glossary
Cross-subsidies .................................................................... Ch6 p19, 27
Ch11 p9

Page 4 ST1: Index
Customer interests/needs ..................................................... Ch5

Ch8 p23
Ch27 p9
Data...................................................................................... Ch6 p23

Ch10 p7, 10
Ch23 p3
Ch27 p7
Data risk............................................................................... Ch23 p3
Ch27 p7
Day case admissions ............................................................ Glossary
Deductible – see Excess
Deferred period.................................................................... Ch1 p18
Glossary
Definition of incapacity/claim (IP)...................................... Ch1 p15
Glossary
Demographic assumptions................................................... Ch10 p5
Dental plans ......................................................................... Ch4 p11
Deposits back (reinsurance)................................................. Ch26 p16
Deterministic model ............................................................ Ch13 p16
Ch19 9
Ch23 p10
Direct expenses.................................................................... Ch28 p21
Direct marketing .................................................................. Ch7 p5
Glossary
Direct sales force ................................................................. Glossary
Discounted payback period.................................................. Ch14 p17
Distribution channels – see Sales channels
Dread disease insurance – see Critical illness insurance
Earlier screening/diagnosis.................................................. Ch24 p11

Earned premium .................................................................. Glossary
Earnings period (indemnity commission)............................ Ch8 p3
Economy (influence of) ....................................................... Ch8 p26
Ch10 p9
Elective surgery ................................................................... Glossary
Embedded value................................................................... Ch19 p2
Ch20 p6, 9
Ch28 p33
Equalisation reserve............................................................. Ch21 p10
Equation of value – see Formula approach
Equities (investments) ......................................................... Ch22 p4
Equity – see Cross subsidy
Equivalence principle – see Formula approach

ST1: Index Page 5
Excess .................................................................................. Ch4 p8

Ch5 p30
Glossary
Excess of loss reinsurance ................................................... Ch26 p26
Exclusions ........................................................................... Ch5 p17
Ch27 p14, 17
Glossary
Expense experience analysis ............................................... Ch28 p17
Expense loadings ................................................................. Ch28 p28
Expense model..................................................................... Ch13 p10
Expense risk......................................................................... Ch23 p13
Expenses (assumption) ........................................................ Ch11 p7
Experience monitoring – see Monitoring
Experience rating/rated........................................................ Ch4 p13
Ch16 p6
Glossary
Extra premium ..................................................................... Ch27 p14
Facultative reinsurance........................................................ Ch26 p10

Glossary
Fair value reserves ............................................................... Ch21 p27
Financing and financial reinsurance.................................... Ch26 p6, 20, 34
Fiscal regime – see Taxation
Fixed expenses..................................................................... Ch11 p7, 11
Ch 18, p8
Fixed-interest stocks............................................................ Ch22 p3
Fixed-price surgery.............................................................. Glossary
Flex schemes/benefits.......................................................... Ch1 p29
Ch16 p6
Floating-rate stocks ............................................................. Ch22 p3
Formal care.......................................................................... Ch3 p6
Formula approach ................................................................ Ch14 p3
Ch15 p8
Forward funding .................................................................. Ch9 p12
Free assets............................................................................ Ch22 p12
– see also Capital
Free cover ............................................................................ Ch1 p29
Ch16 p2
Glossary
Functional assessment tests (FATs) .................................... Ch2 p17, 18
General practitioner (GP) .................................................... Glossary

Government stocks .............................................................. Ch22 p3
GP referral ........................................................................... Glossary

Page 6 ST1: Index
Group business .................................................................... Ch1 p27

Ch2 p19
Ch4 p13
Ch6 p15
Ch7 p16
Ch16
Ch21 p6
Glossary
Group reserving ................................................................... Ch21 p6
Guaranteed insurability options........................................... Ch1 p24
Ch6 p10
Ch17
Ch24 p2
Guaranteed premium rates................................................... Glossary
Guarantees ........................................................................... Ch6 p20, 26
Ch18 p2
Ch24 p2
Health maintenance organisation (HMO)............................ Glossary

Hospital bands ..................................................................... Ch5 p30
Glossary
Hospital cash plans – see Cash plans
Housepersons....................................................................... Glossary
International classification of diseases (ICD)...................... Glossary

Immediate needs long-term care insurance/annuity ............ Ch3 p21
Glossary
Immunisation (investment).................................................. Ch22 p10
Incapacity............................................................................. Glossary
Incidence rates – see Claim incidence rates
Income protection insurance................................................ Ch1
Ch5 p14
Ch6 p9
Ch8 p9
Ch15 p3
Ch20 p16
Ch24 p13
Ch27 p23
Glossary
Increase options ................................................................... Glossary
Incurred but not enough reported (IBNER) reserve ............ Ch21 p9
Incurred but not reported (IBNR) reserve ........................... Ch21 p9
Glossary
Indemnity basis (dental plans) ............................................. Ch4 p11

ST1: Index Page 7
Indemnity commission ........................................................ Ch8 p2

Indemnity policy.................................................................. Glossary
Individual business (definition of)....................................... Glossary
Individual surplus reinsurance – see Surplus reinsurance
Informal care ....................................................................... Ch3 p5
Inflation ............................................................................... Ch8 p23
Ch11 p5, 14
Inflation risk ........................................................................ Ch23 p13
In-patient.............................................................................. Glossary
Insurer interests/needs ......................................................... Ch6 p3
Interest (assumption) – see Investment return
Internal audit failure risk ..................................................... Ch24 p9
Internal rate of return........................................................... Ch14 p16
Investigative surgery............................................................ Glossary
Investment ........................................................................... Ch22
Investment return (assumption)........................................... Ch11 p18
Ch28 p29
Investment risk .................................................................... Ch22
Ch23 p10
Keyman/keyperson cover .................................................... Ch5 p19

Glossary
Lapse.................................................................................... Ch10 p27

– see also Renewals
Lapse and re-entry ............................................................... Ch10 p30
Linked-claims condition (IP)............................................... Ch1 p19
Glossary
Limited benefit (IP) plans.................................................... Glossary
Limited insured information (group contracts) ................... Ch16 p3
Liquidity .............................................................................. Ch22 p22
Locum protection insurance ................................................ Ch5 p16
Long-term care insurance .................................................... Ch3
Ch5 p11, 24
Ch6 p13
Ch8 p9
Ch15 p30
Ch20 p14
Ch24 p18
Glossary
Loss ratio ............................................................................. Glossary

Page 8 ST1: Index
Major medical expenses insurance ...................................... Ch4 p6

Ch5 p31
Glossary
Managed care....................................................................... Glossary
Management ....................................................................... Ch24 p5
Ch25
Ch27
Marginal costing .................................................................. Ch11 p12
Margins ................................................................................ Ch12 p9
Ch20 p4
Market experience ............................................................... Ch28 p12
Matching .............................................................................. Ch22 p6
Meeting customer needs – see Customer interests
Medical history disregarded ................................................ Glossary
Medical inflation.................................................................. Glossary
Medical underwriting – see Underwriting
Mix of business – see New business mix
Model office......................................................................... Ch13 p9
Ch14 p19
Ch22 p17
Model point.......................................................................... Ch13 p4
Ch19 p6
Model risk............................................................................ Ch23 p6
Models ................................................................................. Ch13
Ch19
Monitoring ........................................................................... Ch18 p4
Ch28
Moral hazard........................................................................ Ch6 p3
Moratorium underwriting .................................................... Ch6 p5
Ch27 p16
Glossary
Morbidity risk ...................................................................... Ch23 p6
Mortality (estimation of)...................................................... Ch10 p26
Mortality/morbidity investigations ...................................... Ch28 p9
Mortality risk ....................................................................... Ch23 p6
Mortgage repayment protection........................................... Ch5 p14
Multiple-state modelling...................................................... Ch15 p3
Mutual insurer...................................................................... Ch25 p3
Net present value ................................................................. Ch14 p14

New business mix (assumption) .......................................... Ch11 p26
New business mix (risk) ...................................................... Ch23 p17
New business monitoring .................................................... Ch28 p7

ST1: Index Page 9
New business strain ............................................................. Ch1 p2

Ch11 p25
New business volume (assumption) .................................... Ch11 p25
New business volume (risk) ................................................ Ch23 p19
No-claims discount.............................................................. Ch1 p23
Ch4 p3, 14
Glossary
Non-disclosure..................................................................... Ch24 p11
Non-medical limits .............................................................. Ch11 p11
Glossary
Non-proportional reinsurance.............................................. Ch26 p25
Glossary
North American experience method (of costing options) ... Ch17 p7
No Worse Terms (NWT)..................................................... Glossary
Occupational definitions/classes ......................................... Ch1 p14

Ch2 p15
Glossary
Open enrolment ................................................................... Glossary
Operational risk ................................................................... Ch27 p5
Optical plans........................................................................ Ch4 p12
Option reserves.................................................................... Ch21 p6
Options – see Guaranteed insurability options
Original terms reinsurance .................................................. Ch26 p15
Glossary
Out-patient........................................................................... Glossary
Outstanding claims reserves ................................................ Ch21 p9
Overheads ........................................................................... Ch11 p7
Ch28 p21
Over-insurance .................................................................... Ch1 p13
Ch27 13, 18
Parameter risk...................................................................... Ch23 p6

Pay-as-you-go (PAYG) funding.......................................... Ch9 p11
Pensions solutions ............................................................... Ch3 p13
Permanent health insurance (PHI)....................................... Ch1 p5
Personal accident insurance................................................. Ch1 p32
Glossary
Personal capability assessment (PCA) ................................ Ch1 p17
Ch5 p17
Glossary
Physical risks ....................................................................... Ch24 p9

Page 10 ST1: Index
Private medical attendant’s report (PMAR) ........................ Glossary

Product design ..................................................................... Ch6
Ch11 p13
Ch14 p19
Policy fee ............................................................................. Ch11 p13
Policyholders’ reasonable expectations (PRE).................... Ch22 p24
Ch27 p25
Policy liability model........................................................... Ch13 p10
Policy limits......................................................................... Glossary
Pre-authorisation (of claims) ............................................... Ch5 p30
Ch6 p12
Ch27 p24
Glossary
Pre-existing conditions (PEC) ............................................. Ch27 p16
Glossary
Preferred provider organisation (PPO) ................................ Glossary
Pre-funding – see Forward funding
Pricing.................................................................................. Ch4 p13
Ch6 p4
Ch10-12
Ch14-18
Ch28 p28
Pricing group contracts ........................................................ Ch16
Pricing guaranteed insurability options ............................... Ch17
Pricing of cash plans............................................................ Ch15 p34
Pricing of CI contracts ......................................................... Ch15 p25
Pricing of IP contracts ......................................................... Ch15 p3
Pricing of LTCI contracts .................................................... Ch15 p30
Pricing of PMI contracts...................................................... Ch14 p9
Ch15 p31
Pricing using cashflow methods .......................................... Ch14 p11
Primary (medical) care ........................................................ Glossary
Private medical insurance (PMI) ......................................... Ch4
Ch5 p28
Ch6 p12
Ch8 p8
Ch14 p9
Ch15 p31
Ch20 p10
Ch21 p3, 7
Ch24 p17
Ch27 p24
Glossary

ST1: Index Page 11
Professional guidance.......................................................... Ch6 p21

Ch8 p21
Profit criteria........................................................................ Ch14 p14
Profit sharing ....................................................................... Glossary
Property (investment) .......................................................... Ch22 p4
Proportional reinsurance...................................................... Ch26 p13
Proportionate benefit ........................................................... Ch5 p8
Glossary
Proprietary company............................................................ Ch25 p3
Prospective reserves ............................................................ Ch21 p6
Quota share reinsurance ...................................................... Ch26 p18
Random fluctuations risk..................................................... Ch23 p6

Rating factor ........................................................................ Ch16 p11
Reasons for reinsurance....................................................... Ch26 p2
Recovery rates – see Claim recovery rates
Regulator/regulation ............................................................ Ch6 p13
Ch8 p11
Ch18 p8
Ch22 p14
Ch24 p8
Rehabilitation/partial benefits ............................................. Ch5 p8
Glossary
Reinsurance ......................................................................... Ch6 p8
Ch18 p13
Ch26
Reinsurance default risk ...................................................... Ch24 p6
Renewals.............................................................................. Ch28 p8
Replacement ratio................................................................ Ch1 p12
Ch5 p16
Ch27 p23
Glossary
Reputational risk.................................................................. Ch24 p9
Ch27 p9
Residence............................................................................. Glossary
Reserving............................................................................. Ch20 p2
Ch21
Resilience testing – see sensitivity testing
Retention limit (reinsurance)............................................... Ch26 p38
Return on capital.................................................................. Ch14 p20
Ch18 p10

Page 12 ST1: Index
Reviewable contracts/premiums.......................................... Ch1 p25

Ch5 p13
Ch6 p6
Ch18 p4
Glossary
Rider benefits....................................................................... Glossary
Risk...................................................................................... Ch12 p6
Ch23
Ch24
Ch25
Risk-based capital................................................................ Ch21 p24
Risk cell ............................................................................... Ch16 p10
Ch28 p12
Risk discount rate ................................................................ Ch12 p4
Risk equalisation.................................................................. Glossary
Risk excess of loss reinsurance............................................ Ch26 p27
Risk management – see Management
Risk premium reinsurance ................................................... Ch26 p16
Glossary
Sales channels...................................................................... Ch6 p18, 21

Ch7 p3
Ch27 p26
Secondary care..................................................................... Glossary
Selection – see Anti-selection and Selective lapse
Selective lapse/withdrawal .................................................. Ch1 p26
Ch10 p29
Self insurance....................................................................... Ch4 p14
Selling (propensity to buy versus sell) ................................ Ch8 p7
Sensitivity testing ................................................................ Ch18 p2
Ch19 p6
Ch21 p23
Service level agreements ..................................................... Ch27 p3
Sickness – see Morbidity/mortality
S(ID) Tables......................................................................... Ch15 p18
Smoker/non-smoker rates .................................................... Glossary
Solvency capital................................................................... Ch21 p24
Solvency margin arbitrage................................................... Ch18 p14
Stakeholders......................................................................... Ch5
Ch6
Stand-alone CI insurance..................................................... Ch2 p11
Ch6 p10
Glossary
Stand-alone LTCI plans....................................................... Ch3 p14

ST1: Index Page 13
State healthcare provision.................................................... Ch8 p8

Ch9
Ch10 p9
Statistical estimates (of reserves) ........................................ Ch21 p3
Statistical risk ...................................................................... Ch12 p7
Ch19 p8
Ch23 p6
Statutory reserves ................................................................ Ch21 p15
Stochastic model.................................................................. Ch13 p16
Ch19 p9
Ch22 p17
Ch23 p10
Stop-loss insurance/reinsurance .......................................... Ch4 p14
C26 p30
Glossary
Sum-at-risk reinsurance....................................................... Ch26 p14
Sum insured differential ...................................................... Ch11 p14
Supervisory reserves – see Statutory reserves
Surplus reinsurance ............................................................. Ch26 p22
Glossary
Survival period (CI)............................................................. Ch6 p10
Switch (PMI) ....................................................................... Glossary
Systems................................................................................ Ch6 p22
Tax arbitrage........................................................................ Ch18 p14

Taxation............................................................................... Ch8 p16
Ch11 p26
Telemarketing...................................................................... Glossary
Terminal illness ................................................................... Ch2 p11
Glossary
Tertiary care......................................................................... Glossary
Tied agents........................................................................... Glossary
Total permanent disablement (TPD) ................................... Ch2 p12, 14
Glossary
Treaty reinsurance ............................................................... Ch26 p10
Glossary
Underwriting........................................................................ Ch6 p5, 16

Ch24 p11
Ch27 p12
See also Claims underwriting
Unearned premium reserve (UPR) ...................................... Ch21 p7
Unemployment benefit (IP)................................................. Glossary
Unexpired risk reserve (URR)............................................. Ch21 p7

Page 14 ST1: Index
Unique selling proposition (USP)........................................ Ch12 p11

Unit-linked contracts ........................................................... Ch1 p23
Ch3 p17
Ch12 p13
Ch18 p5
Unit rate ............................................................................... Glossary
Valuation – see Reserving and Asset valuation

Volume (of business) – see New business
Voluntary group................................................................... Glossary
Waiting-list plans................................................................. Ch4 p8

Waiting period ..................................................................... Ch1 p18
Glossary
Waiver of premium.............................................................. Ch1 p19
Glossary
Withdrawal – see Lapse and Renewals
Withdrawal experience analysis .......................................... Ch28 p13
Withdrawal risk ................................................................... Ch23 p15
With-profits ......................................................................... Ch1 p23
Windfall payments............................................................... Ch5 p20
Worksite marketing ............................................................. Ch7 p7
World Health Organisation (WHO)..................................... Glossary
Written premiums ................................................................ Glossary

ST1-01: Health and care insurance products – Income protection Page 1
Chapter 1
Health and care insurance products
Income protection
Syllabus objective
(b) Describe and understand the main types of contract:

– Income protection.
– Critical illness.
– Long-term care insurance.
– Private medical insurance.
– Major medical expenses.
– Hospital cash.
Describe and understand:
– examples of the main variations of the contracts issued
– group and individual covers
– purpose of contracts to the insured.
Income protection is covered in this chapter.
0 Introduction
This chapter and the next three chapters cover the basic contract types of
income protection insurance (IP), critical illness insurance (CI), long-term care
insurance (LTCI), private medical insurance (PMI), major medical expenses
(MME) and hospital cash upon which the examiners will base their questions.
Chapter 1 describes IP policies and some associated accident and sickness policies.
Chapter 2 describes CI insurance, Chapter 3 describes LTCI and finally Chapter 4
describes PMI and similar policies.

Page 2 ST1-01: Health and care insurance products – Income protection
This section discusses some general issues that apply to all the different contracts. The
remaining sections of this chapter discuss IP policies and related policies.
Some of these contracts (IP, CI and LTCI) are usually sold as long-term policies with
initial terms greater than five years, but others, particularly PMI, are sold as one-year
policies that can be renewed each year.
It should, however, be noted that questions may be asked where two or more of
these basic contract types are combined as a package.
When answering questions about package products you will find it helpful to think
about the separate underlying component contracts. Of course there may also be some
synergy between the components (eg increased claims on one component may be
associated with reduced claims on another component).
For each contract type a description is given of how the benefits provided may
be useful to a consumer. An outline of the risks associated specifically with
each product is given in later chapters. The macro aspects of risk are also
covered later in the course.
Risk will be covered in Chapters 23 to 25 of the course.
0.1 New business strain
A familiarity from earlier subjects of the concept of new business strain, and the
consequent requirement for capital to write a new contract, is assumed.
However, just in case you are feeling a little rusty …
Let’s look at policies that provide benefits in the future in return for regular level
premiums payable either until death or the occurrence of the insured event, whichever
happens first (eg pre-funded long-term care insurance or a critical illness insurance).
Consider first the cashflows that occur when a contract is written. A large proportion of
the costs associated with the contract may occur at the start of the contract, because of
items such as marketing, underwriting (the process of assessing risks) and initially
setting the policy up on the company’s computer systems. In many markets it is also
common practice to pay a commission to the provider of the business, for example the
company’s own salesperson or an independent broker.
This means that the net cashflow (ie premium income less outgo) in the first year will
be low or, often, negative. This will lead to a similarly low (or negative) asset share
immediately following the issue of the policy. (Remember that the asset share is
essentially just the accumulated cashflows up to any particular date, at the actual rates
of return earned by the company.)

A further issue is that the insurance supervisory authorities may require that money
(reserves) be specifically set aside to ensure that the company is able to meet its future
obligations to policyholders. It is a commonly accepted principle that the required
amount of such reserves should be assessed on a prudent basis. Capital is tied up
because of this need to set aside reserves larger than those the company really believes
are needed to meet payouts to policyholders.
The company may also have to maintain a minimum amount of assets in addition to
those backing its (prudent) assessment of liabilities. Such a “required solvency margin”
(or “solvency capital requirement”) ties up further capital.
The combination of the initial cash outflow, the need to hold prudent reserves and the
need to establish any required solvency margin means that money has to be found
initially in order to write the business. Hence there is an “initial capital strain”.
Because we all like formulae, this initial capital strain can be written:
C0+ = V0+ − A0+
where C0+ = Capital strain at time 0 +

V0+ = Statutory reserves and solvency margin at time 0 +
A0+ = Asset share at time 0 +
and time 0+ is the point immediately after the policy has been issued, after the first
premium has been paid, and all the initial expenses have been incurred.
Long-term policies are usually secured by a level premium paid regularly while the
policy remains in force. The first premium will be small compared to the initial
expenses of selling and setting up the policy and so A 0+ will be negative, and the
requirement for initial capital C0+ will be substantial. Depending on the contract
design and the particular supervisory regulations, this capital may be recouped quickly
or only slowly. All other things being equal, a company is likely to prefer contract
types and designs that recoup the invested capital quickly, so that it can be “recycled” to
fund the capital requirement for further profitable business.
Short-term policies are secured by a single premium paid when the policy is issued, or
by a series of, say, monthly premiums paid during the one-year contract. C0+ will be
much smaller than for a long-term policy with a similar sized initial premium.

Question 1.1
(i) Why might consumers who purchase a long-term policy prefer a contract with
regular level premiums, rather than ones that may change from year to year?
(ii) PMI is usually a one-year contract. Each year the insurer will offer renewal of
the contract with (usually) unchanged terms, but with a new premium. Some
policyholders, particularly the older ones, object to these arrangements.
(a) Why might some policyholders be unhappy with this?
(b) Why is it difficult for insurers to offer the kind of policies that would
remove this unhappiness?

1 Income Protection
1.1 Definition and aims of the product
Income Protection (IP) is the modern name for Permanent Health Insurance (PHI)
in many markets, having been around for over 100 years under that name. Its
name was changed recently to reflect more accurately the nature of the coverage
and this name has been adopted in many territories worldwide. For this reason
we shall use this name for the product in this subject throughout and later also
in Health and Care Specialist Applications (SA1).
The name Permanent Health Insurance emphasised the fact that the insurance company
must continue to pay a valid claim for as long as the conditions for claiming are
satisfied (eg the claimant is sick and has not reached retirement age). However, in
recent years, it has become clear that this name is confusing to customers. Some people
may have confused coverage with private medical insurance (PMI) – for example,
thinking that PHI would cover medical costs, whereas the policy provides a regular pre-
determined level of income whilst ill. The industry agreed on a change of name that
would be clearer, and it was hoped would attract more customers.
IP is also known as disability income insurance in some markets, such as in the USA.
IP is insurance that provides the insured with regular, short or long-term

payments during periods of incapacity.
Incapacity in this context means being unable to work due to illness or injury. The term
disability has also been used, but the industry recommendation in some countries is that
the term incapacity rather than disability should be used (eg in policy wording).
So IP benefits are in the form of a temporary annuity that continues until the insured
recovers, dies or the annuity term ends, whichever event occurs first. To make
premiums more attractive (lower) and to match the insured’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 insured’s employer (or
both) pay sickness benefits for short-term sickness.
The aim of an IP product is to replace part of the income that the insured life
would have earned if he or she becomes unable to work due to accident or
illness. IP therefore pays a benefit in the form of a regular income. The insured
event that gives rise to this benefit being paid is easily 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 products, the policy document needs to
define carefully the situation or circumstances which need to exist in order that
the benefit becomes payable, and under what circumstances it will cease.
Unemployment, redundancy, early retirement and reluctance to return to work
are a few examples of situations which should not be covered by the policy and
not all kinds of illness/physical injury will be covered either (eg HIV, attempted
suicide). The insurer needs to ensure that the policy is not misused in such
circumstances.
It is quite common for someone to be unable to work for a period, recover, and
later become unable to work again. Therefore the policy is usually written as a
long-term policy under which a number of separate periods of benefit payment
can occur, without the policy ceasing.
Unlike under private medical insurance, premiums do not usually increase with
age, although inflation linking is common.
The age of the policyholder at the date of policy issue (and other rating factors) will
determine the initial premium. For example, this initial premium will increase with the
age at entry.
Subsequently, under an inflation-linked policy, both the premium rate and the benefits
will be increased at the same rate as the rate of inflation specified in the policy (eg price
inflation or wage inflation). Often, these increases will be subject to a maximum annual
increase, say 5% pa.
The insurer may reserve the right to revise the premiums should claims
experience across the whole portfolio be poor (and may reduce premiums if the
experience is good).
If the policy has guaranteed premiums then the premium cannot be changed. If the
policy has reviewable premiums, then the premium may be changed on the review date.
However, the review is a 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 pooling of risk
is maintained.
Question 1.2
What is permanent about permanent health insurance (PHI)?

Question 1.3
Give reasons why increasing the benefit each year, in line with an inflation index, might
be popular with policyholders.
There are also group IP products, bought by employers wishing to provide

benefits to their employees.
Even an employer who is already offering an ill-health retirement pension as part of an

occupational pension scheme may wish to offer an IP scheme in order to provide
income to employees on temporary as well as permanent disability. In many countries
employers also have a legal obligation to pay statutory sick pay to their employees
during the first few weeks of sickness (eg in the UK employers are obliged to pay
statutory sick pay from the fourth day of sickness until the end of the 28th week of
sickness).
A group IP scheme would provide a way for the employer to cover some of the risk of
having to make such payments.
Question 1.4
A friend already has a pension policy that includes provision for payment of an
ill-health retirement pension from the date on which he is permanently unable to work.
He has asked you if it would be sensible to buy an IP policy.
Write a note that explains the additional benefits that would be available from an IP
policy.

1.2 Nature of the product
IP products are complex.
We will see later in the course how, for example, the product design, underwriting,
claims’ management and pricing of IP products are all more complex than they are for,
say, life insurance products.
There are actuarial difficulties with the methodology used to measure morbidity
risk.
There are also practical difficulties with systems, with underwriting at policy
issue and at the claim stage, and with managing claims and measuring
experience.
These issues will be covered later in the course.
These difficulties present even more opportunities than usual for actuaries to
become involved in multi-disciplinary teams with non-actuaries. While a detailed
knowledge of other disciplines, such as underwriting and claims, is not
essential, it is useful for the actuary to be aware of the standard approaches in
the industry, and to be aware of which approach his or her office is using.
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
offices will vary markedly and the standard tables are generally out of date.
Question 1.5
Published morbidity tables are based on the combined experience of all the offices
contributing to the study.
(i) What factors are likely to give rise to the large differences in the rates observed
for different offices?
(ii) What factors are likely to cause the published tables to become out of date so
quickly?
There is certainly the potential to lose a lot of money on an IP 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.

Question 1.6
I have just sold an IP policy to a 20-year old. The benefit is £5,000 pa, paid during any
period of sickness after a deferred period of six months and which occurs before the
policyholder attains age 60. The benefit ceases when the policyholder attains age 60.
The premium is £10 per month and no premium is payable during any period when
sickness benefit is payable.
Using this policy as an example, explain why there is “the potential to lose a lot of
money” and why “the true experience will not be known for a long time”.
The diagram below shows the main elements of the product cycle:
Product
design
Valuation Pricing
Experience Marketing
monitoring Sales
Claims Underwriting
management
The Product Cycle
All areas (pricing, underwriting, claims management, marketing and sales,

experience monitoring, valuation) within an organisation make an important
contribution to the experience that emerges. Experience will vary widely by
office, but it is imperative that the practices employed by each area are reflected
in the premiums charged (eg weaker claims management should be reflected in
higher premium rates).
Administration systems must be able to cope with the complexity of IP designs.

A system must exist to pay claims, and record a lot of information about each
claim. An obvious example is that the system should not only be able to record
the date a claim starts, but also the reason for the claim and the date it ceased,
and why.

Underwriting and claims management are more complex for IP than for most
other life assurance products. Both have fundamental implications for the
resulting claims experience.
Question 1.7
Underwriting for both term insurance and income protection is basically about assessing
the health of the proposer. Why should the process be so much more difficult when the
proposal is for an income protection rather than a term insurance policy?

2 Product features of individual IP business

The following sections look at the different features that might be incorporated
into a product, from a rating viewpoint.
A rating feature is a characteristic of the benefits of the policy that directly affects the
premium charged. This 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 the benefit
amount and the deferred period are rating features.
2.1 Policy conditions
IP is often seen as a complex product and the most complex part of the product
is the policy conditions, which must 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
risks.
Here we are looking at risk from the point of view of the insurance company.
By careful wording of the policy we want to ensure that the office can make reliable
estimates of its expected cost of claims for any block of business.
General policy conditions need to be clearer than has historically been the case.
Unclear policy conditions run the risk of being interpreted by the courts or
regulatory supervisor in favour of the claimant, if disagreement over entitlement
to claim led to a dispute. Policy conditions should aim to:
● reflect the true intentions of the office
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 office has no
control
The office 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
office 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.

● be, as far as possible, simple and unambiguous, so as 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 supply 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 premium
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 non-qualifying claims.
2.2 Replacement ratios and over-insurance
The replacement ratio is usually defined as the ratio of post-claim income to pre-
claim income, in both cases net of income taxes.
Note that there are other definitions of the replacement ratio. 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 higher the replacement ratio, the lower the incentive to
return to work and the poorer the morbidity 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.
There is some evidence that people enjoy the social aspects of being in the workforce,
but that return to work after long-term sickness is a difficult transition for many people.
Question 1.8
Why should returning to work after long-term sickness prove so difficult?

A linked-claims period (in the past termed an “off-benefit” period) in the policy
conditions (see Section 2.4), 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.
Some states regard IP benefits as a form of income, and so these benefits are taxed in
the same way as income is taxed. Other states do not tax IP benefits. The tax treatment
of benefits has a direct effect on the replacement ratio.
The tax treatment of IP premiums and benefits is covered in detail in Subject

SA1.
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 not keeping up with benefits
This might happen if a policy had benefits which increased automatically on
each policy anniversary or if salary reduced (eg through part-time working), or a
combination of these two.
● a reduction in the tax levied on IP claims, applying to existing
policyholders
● multiple policies or receipt of other non-disclosed sources of income.
These other sources refer to income while sick.
Question 1.9
In what ways does over-insurance, as reflected in a high income replacement ratio,

make it more difficult for the insurer to control the cost of claims?
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
● quality training of those conducting the sale, reducing the incentive to
over-insure
● regular reviews to ensure that the level of benefit remains appropriate
● clearer policy conditions highlighting the likely action at the claims stage
in the event of over-insurance.

Assessing income is straightforward for those salaried employees with one job.
However, many self-employed people purchase IP insurance. The self-employed often
have incomes which fluctuate over time, and proof of income is not straightforward
because accounts are usually only prepared on an annual basis for tax purposes. For
efficient tax planning such individuals may receive income partly as salary and partly as
dividend income, and in small businesses there may be complex arrangements for the
payment of family members.
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 corresponding refund of
premiums, this can result in a policyholder having paid for cover to which he or
she is 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 circumstances to prevent
over-insurance is known as financial underwriting.
2.3 Incapacity criteria
Occupational definitions
The insured’s occupation affects IP product design in two ways:
(a) The price charged

(b) Claim payment
The effect of occupation on the price charged
IP rates are usually dependent on the policyholder’s occupation. Most

occupations are divided into 4 or 5 classes. 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:
Class 1 = 100%
Class 2 = 175%
Class 3 = 300%
Class 4 = 400%
These classifications, and the multiples used, can vary among insurers and between
territories.

The categorisation 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
due, for example, to mental illness. Claims experience can also be worse when the
demands of the occupation require complete recovery before the insured can resume
working.
Question 1.10
Some 20 years ago, teaching was rated (in the UK) as a class 1 occupation, but more
recently many companies have rated teaching as a class 2 or 3 occupation.
Why has this happened?
The class into which a particular occupation falls may vary by office. Sometimes
some occupations (such as doctors or dentists) might have entirely separate
rates.
Question 1.11
Why do you think occupations such as doctors or dentists might have separate premium
rates?
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
(eg housepersons and the unemployed).
For those not in paid employment an alternative criterion for assessing incapacity, such
as one based on inability to perform various tests (see below), will be used. However,
the most common approach is to use an occupational-based definition.
Most definitions are currently 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 (eg the first two
years) of claim followed by inability to perform any occupation thereafter
● inability to perform any occupation.

The expected claims cost will usually be highest for the “own occupation” definition
and lowest for the “any occupation” definition. These two definitions are
straightforward compared to the “any other suited occupation by education, status or
training” definition, which has the potential for dispute at the claims stage. With
effective counselling and rehabilitation the policyholder usually welcomes the
opportunity of rejoining the workforce at a reduced salary, which is then augmented by
the policy benefits to the level insured prior to sickness.
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:
● functional assessment tests (FATs)
● activities of daily living (ADLs)
● activities of daily working (ADWs)
● personal capability assessment (PCA).

Example
The following is an example of a personal capability assessment used by a major

insurer.
Total benefit is payable if you were in a full-time occupation before incapacity and
because of this incapacity you:
● are unable to perform at least three of the defined personal capabilities below
or
● suffer one of the defined serious illnesses defined below.
Personal capabilities
1. Rising from a chair: the ability to rise, without assistance, from a dining room
chair that has arms.
2. Standing: the ability to stand for ten minutes with one hand for support.
3. Walking: the ability to walk 200 metres on a level surface without having to
stop.
4. Stairs: the ability to walk up and down a flight of 12 stairs, with two feet on each
stair if required.
5. Bending: the ability to bend or kneel, from a sitting or standing position, and
touch the floor with either hand.
6. Lifting and carrying: the ability to pick up with either hand, from knee height, a
two kilogram weight and carry it for five metres.
7. Transport: the ability to get in and out of a standard saloon car passenger seat.
8. Manual dexterity: the ability to use a keyboard or grip a pen with either hand.
9. Fits and blackouts: the ability to retain, or have the potential to retain, a driving
licence for a car without fits or blackouts preventing this, based on a reasonable
medical opinion.
Serious illnesses
10. Blindness: total permanent and irreversible loss of sight in both eyes.
11. Terminal illness: advanced or rapidly progressing incurable illness where, in the
opinion of an attending consultant and our Medical Officer, the life expectancy
is no greater than 12 months.
12. Complete dependency: to be totally incapable of caring for oneself, requiring
24-hour medical supervision in a hospital or nursing home.

Question 1.12
Outline the advantages and disadvantages to the insurer of using the PCA test described
above, as opposed to using the occupation-based criterion of “inability to perform your
own occupation and any other occupation to which you are suited by education, status
or training”.
2.4 Deferred period
An insurer will not usually pay benefits during the first few weeks of sickness.
This is known as the deferred period. The main reasons for most contracts
having a non-zero deferred period are:
● to integrate with employer-supplied benefits
● to reduce the cost of claims to the insurer (and therefore the price
(premium))
● to reduce the insurer’s administration costs (and therefore the price
(premium))
● to meet true customer needs; most policyholders would not want to
submit a claim for a couple of days off with ’flu.
A deferred period is applied throughout the policy rather than being a total
moratorium at the commencement of the policy. The latter is sometimes known
as a waiting period, but is now uncommon in product design.
Question 1.13
(i) How might the use of a waiting period help in the management of a portfolio of
income protection policies?
(ii) Why do you think that more recent policies do not include a waiting period?
The most common deferred periods in the market are 4, 13, 26 and 52 weeks.
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. The main reasons for such a design are
the first two points listed above.

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.
Question 1.14
How does a linked-claims (off-benefit) period encourage claimants to try working

again?
Recently it has become common to insert a policy condition that requires the insured to
notify the insurer when they have been sick for a given period (eg one month), even
though the deferred period is much longer than this.
Question 1.15
What is the insurer hoping to achieve by the use of this early notification condition?
2.5 Waiver of premium
Most IP policies will include the condition that premiums are waived (credited without
the insured making payments) during periods when benefits are payable. This will
usually be charged for by a small percentage addition to the premium rate.
2.6 Expiry age or term
The expiry age is the age at which benefits cease and is often the same as
expected retirement age. There are cases where this is not the case; an example
is mortgage business, which is usually written for a fixed term rather than to an
exact age.
The minimum potential term of five years ensures that IP business is classified as
long-term rather than short-term business.
Typical expiry ages in the market are 50, 55, 60 and 65, with 60 currently being
the most common. Other expiry ages are sometimes offered (either intermediate
or lower for those with lower normal retirement ages, eg professional
sportsmen).
Some policies are written for an exact duration in years.
This is common where the benefits of a policy are assigned to a third party (eg designed
to make the repayments on a 25-year mortgage).

Also some policies which 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 the deferred period),
when any new sickness could not result in a claim.
2.7 Escalating benefits and premiums
IP 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.
Nowadays increasing benefits are much more common. Examples of escalation

rates include a fixed percentage eg 5% or increasing in line with some form of
published prices or earnings index. Any link to an index would usually be
subject to a cap.
It is common to offer a link to an index of consumer prices (eg retail price index (RPI)
in the UK) subject to a maximum increase of, say, 5% pa. The chosen index should be
one that is familiar to, and well understood by, policyholders (eg one that is frequently
discussed in the newspapers and on TV). However a link to an earnings index, such as
the National Average Earnings Index (NAEI) in the UK, may provide a better way of
maintaining living standards during incapacity.
It is not prudent 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 office in matching assets and liabilities. For this
reason, insurers restrict the level of fixed rate escalation that they will offer on
new business.
Benefits may increase at different rates in and out of claim, though this can lead
to complex product design in some cases.

Some specific examples are:
● 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.

For example, benefits and premiums each year increase by the rate of inflation
subject to a maximum of 5% pa, but once a claim commences, the claim
payment remains constant.
This is an unusual design motivated perhaps by a desire to encourage a
return to work. A more common design is to have some escalation in
claim with a higher escalation out of claim.
● Some escalation in claim, no (or lower) escalation out of claim. This is

slightly more common. If the design is such that, following a claim
terminating, the benefit reverts to the level of the pre-claim benefit this
might be difficult to justify.
Designs in which benefits escalate when not claiming usually feature escalating
premiums as well. A simple and popular design has the premiums increasing at
the same rate as the benefits. This effectively means that the increase is based
on the premium assumptions prevailing when the original contract was effected.
Some protection against adverse trends in claims experience (and high inflation)
may be obtained by an alternative design whereby the increase in premium is
based on the current premium rate for additional benefit, using the age at time of
increase. This will usually mean a greater rate of escalation of premiums than of
benefits, unless rates have reduced. There are a number of possible variations
on these two designs.
2.8 Occupational changes
Some policies require that the office is told if the insured changes job, with the
intention of modifying the premium if necessary. In practice, the recent trend
has been away from requiring such notification. 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 office would be able to carry out
the former occupation.
As an insured gets older, those that decide to change occupation often move to less
demanding jobs (eg policemen become shopkeepers), and so there is a reduced
likelihood of selection against the office.

2.9 Residence, location
In many territories, policies typically make no allowance for residence or location

of policyholder within the country of insurance under individual IP contracts.
While there is undoubtedly evidence to indicate that risk varies with residence or
location, the office will look at the balance of risk within its book in determining
premium levels, without explicitly subdividing its tariff or charging loadings.
Where its distribution methods or brand appeal lead to a concentration of
policyholders with particular claim propensities, the office will reflect this in its
pricing structure.
So, although marketing or other considerations may lead us to decide not to use place of
residence as a rating factor, we will allow for the fact that place of residence affects the
expected claims cost when determining prices, if there is evidence that claim costs vary
by place of residence.
For example, if distribution channel is a rating factor and we know that different
channels attract different proportions of policyholders by place of residence, we 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.
Group IP pricing is an extreme example of this where the office takes into
account all inherent risk components in quoting a specific price usually without
any cross-subsidy from elsewhere in its book.
Residence conditions are still found in many policies. The wording stipulates
areas of the world eg USA, Australia, EU countries, where the policyholder may
temporarily reside, with full coverage continuing. Outside of these territories,
the office asks to be advised of change of residence (for longer than a limited
period) so that the terms of the contract might be reconsidered. With the
growing availability of first class medical assistance around the world, the
insistence of insurers on such notification is mollifying and their reaction to its
receipt is seldom more than a file note.
Question 1.16
(i) Why does the insurer require the policyholder tell it about a change of residence
and reserve the right to reconsider the policy terms in the light of this new
information?
(ii) How could the policy terms be changed?

Residence affects risk in three ways from an insurer’s perspective:

● 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.
The cost and ease of getting evidence to accept the claim initially and evidence
to substantiate the continuation of the claim are often the main reason for
geographical limits. Additionally the management of the claim (eg visits and
rehabilitation options) may be more difficult.
2.10 No claims discounts, with profit and unit-linked designs
In most markets it is usual for IP policies to be written on a non-profit basis, with

no benefit being paid if an IP claim is not made.
The sum at risk under an IP policy is very large compared to the regular premium. So
once expenses and expected claims are taken into account there is little surplus to build
up an asset share. Policy conditions usually state explicitly that the policy will not have
a value on surrender or maturity.
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 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 non-profit policies,
because of the savings element in with-profits policies.
Contracts have also appeared which feature a discounted premium if no IP claim

has been made.
This is a way of rating the policy by experience to make up for any limited underwriting
done at the outset.
Unit-linked IP is also found in some markets these days, 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.
Unit-linked life insurance policies were discussed in Subject CT5, and we will revisit
some of the principles used there later in this course when we look at pricing.

Question 1.17
(i) Describe the cashflows in the first year of a unit-linked whole of life insurance
policy. The policy is secured by level annual premiums. 95% of each premium
is allocated to the purchase of units. The management expenses of 1% of the
unit fund and the mortality charge are deducted from the unit fund at the end of
each year.
(ii) How would the cashflows differ if it was an IP policy?
2.11 Guaranteed insurability and other options
Many insurance policies include guaranteed insurability options (GIOs). This

may mean for instance that the policyholder is able to increase the sum assured
at the office’s standard rates for the then current age when a particular life-event
occurs, without supplying further medical evidence. For example, it is possible
to offer an option that allows the policyholder to increase the benefit on marriage
or buying a new house. Normally a GIO would only be available if the policy was
issued at standard rates (ie there was no rating on account of medical conditions etc).
Question 1.18
(i) Why are GIOs popular with policyholders?
(ii) From the insurer’s point of view, which of the following do you consider to be
satisfactory life events to associate with a GIO and which are unsatisfactory?
Explain your reasoning in each case.
(a) Starting a job with a new employer at an increased salary
(b) Having a 40th birthday party
(c) Buying a new car
(d) The birth of a child
(e) Running a marathon in under 3 hours.
(iii) Based on your thoughts about these situations, describe the characteristics of a
satisfactory life-event.
(iv) What limits should be placed on the additional insurance that can be bought
under a GIO?

Such options are less common with IP than with life cover, because the main
point of IP is usually to replace salary. For products that aim to protect, say,
only mortgage repayments, a GIO might be more logical.
In practice many policies do not maintain exactly the replacement ratio which
applied when the policy was issued. This is because salary varies over time,
whereas the IP benefit will either remain level or will increase in line with an
index. A fairly recent GIO in some markets offered the ability to change cover,
say annually, in line with the change in income.
2.12 Guaranteed and reviewable rates
There are 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.
A common middle-ground is for the premium to be guaranteed for the first (say)
5 years of a contract, with the office having complete freedom to review the
premium thereafter.
In this case the premium will be guaranteed for the first five years of the term. At this
point the insurer will review the premium rates and quote the guaranteed premium for,
say, the next five years.
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 which is guaranteed for the full term.
As we have said, long-term health and care products are usually protection products that
are characterised by sums at risk that are very large compared to the premiums charged.
Such products will usually have a small asset share compared to the sum at risk.
If the underlying risk only changes slowly over time and there are relatively large
amounts of data available to assess the risk, then the office can determine the future
expected claims costs with a high degree of precision. This is the case, for example,
with term insurance.

However, the risks associated with IP change over time in ways that the office cannot
foresee with any precision. Some diseases that were a major cause of sickness in the
past (eg polio) are now no longer a cause of long-term sickness. Diseases that in the
past went unrecognised have become important causes of long-term sickness. Ailments
that previously resulted in death are now treatable, but result in a restricted lifestyle (eg
heart attacks).
Superimposed on these changes are changes in the workplace, such as more shift
working and more automation in the workplace. Employer’s expectations have also
changed – for example they now expect employees to retrain for a different job after a
prolonged period of sickness.
An IP contract might have a term of more than 30 years. The insurer’s estimate of the
expected claims cost of such a contract will have a large standard error, so the
guaranteed premium will include a substantial contingency loading. This loading may
make the premium look very expensive to the policyholder.
A product that is in theory fully reviewable can, for reasons such as market
pressures, be difficult to review in practice. An office that bowed to pressure
and did not increase rates on business due to prospective bad experience would
have to be careful that it did not create a policyholders’ reasonable expectation
that there would never be such increases.
The review is for a portfolio of policies and not for individual policies. The insurer will
reassess the expected future claims experience for the remainder of the policy term and
use these results to determine the premium that will be offered to existing policyholders
until the next review. All policyholders being considered will be offered the same set of
premium rates irrespective of their past claims experience.
The review should not be used as an opportunity to make good an adverse claims
experience in the period since the last review. However, past experience may well
influence the insurer’s assessment of future experience. To this extent, the reviewed
premium rates will reflect mistakes made in the past.
Reviews of premiums can result in “selective lapsing” or “selection against the

office”. This is where the healthy lives lapse their policy (or accept reduced
benefits instead of paying the increase in premium) whilst those either claiming
or in poor health agree to the increase. For this reason some offices have
restricted increases on review, possibly to a maximum percentage each year.
Where experience is better than expected, some offices will reduce the
premiums on their reviewable products.
Given the greater uncertainty over future claims experience for health products,
premium guarantee loadings appropriate to IP would be expected to significantly
exceed those for a mortality product.

The large loading to pay for the guarantees means that reviewable IP rates can look very
attractive to prospective policyholders.
Question 1.19
Explain the difference from the point of view of the insured of buying IP insurance for
the next twenty years by:
● buying a 20-year IP policy with premium reviews every five years
● buying a series of four 5-year IP policies each with guaranteed premiums.
2.13 Group income protection
Group schemes can be set up by any affinity group (eg motoring organisation, trade
union), but are most commonly set up by employers for their employees.
The employer is the policyholder even though those insured are the employees.
Employers can use such schemes to insure their liability to pay statutory sickness
benefits and to provide discretionary sick pay to employees.
Alternatively, the employer may administer the scheme with each employee paying his
or her own premiums (eg by salary deduction). In these cases the benefits are paid
directly to the employees.
Benefits
It is normal to base the scheme benefit on salary gross of tax. This would have a
maximum benefit of perhaps two-thirds to three-quarters of gross salary,
perhaps with some offset in respect of entitlement to state incapacity benefits.
Having benefits based on gross salary will make the administration of the scheme
easier.
However, net pay schemes are offered by some insurers. In these cases,
incomes after tax are compared and a claimant can receive up to 90% of net
pre-disability income.

In addition to covering the scheme members’ salaries, additional cover may be

provided under the group policy. Examples are options to include:
● employee pension contributions
● employer pension contributions
For example contributions to an occupational pension scheme or an
employer-sponsored personal pension scheme.
● employer state welfare contributions
● employee state welfare contributions.
For example, in the UK, national insurance contributions and statutory sickness
payments made by the employer.
Policy benefits are allowed to escalate whilst in claim in order to maintain the
claimant’s standard of living.
A continuation option may be offered. This allows the employee of a company to

effect an individual policy without providing evidence of health when he or she
leaves the service of the employer. Benefits are limited to those which were
offered under the Group IP policy. These limitations are required because the
experience of this business has not been favourable.
The employee may have left employment because of minor health-related problems.
Furthermore, anti-selection is very likely, as those who consider themselves most likely
to benefit from the continued cover are most likely to apply for it.
The majority of insurers use a definition of incapacity that requires a total

inability to follow the insured’s normal occupation and provides that he or she
should not be gainfully following any other occupation.
Incapacity under an income protection insurance contract is usually related to

occupation in some form, but for group contracts the position is much less
clear-cut than with individual policies. In many instances, particularly under
large schemes, the insurer will have no specific information relating to the
occupation of individual members.
All employees will be eligible to join provided they fulfil an “actively at work” criterion
and fall within the “free cover” limits (see below).
Although in general terms changes in occupation involving significant increases

in risk should be notified to the insurer, the policy conditions usually refer to the
member’s “normal occupation”.

Flexi benefits, or flex schemes, allow the employee to choose the benefits he or
she would like to have from a number of options offered by the company. There
will be a list of core benefits that everyone is entitled to with each individual
having the option to buy additional types of benefits.
Although flexi benefits (also known as cafeteria benefits) give employees greater
flexibility to match benefits to needs, they present insurers with problems of
anti-selection and increased administration.
The insured can choose the benefits for which they think they have the greatest
probability of making a claim. The insurer will need to keep more detailed records of
each member’s eligibility for benefits.
There are also difficulties in determining basic risk costs. All providers offering
flex schemes require a core benefit to be insured.
Free cover
Free cover is the amount of cover automatically granted without underwriting to

individuals in a group scheme.
The aim of free cover is to reduce the cost of underwriting to the insurer and to
avoid irritating the client by asking too many people to be medically examined.
Most companies have a free cover formula that is aimed at enabling most lives in
most schemes to be accepted without underwriting provided that the scheme
has compulsory membership. More highly paid employees are likely to have
benefits above the free cover level. The formula should be set taking into
account all the information known about the scheme. For reasons of statistical
credibility and the limitation of anti-selection, free cover levels will be lower on
smaller schemes.
We need to avoid the possibility of one individual carrying a large proportion of the
total risk in the group scheme.
Free cover, or “non-selection”, is granted to IP schemes with more than a

specified minimum number of members provided that membership is
compulsory, and benefits are maintained at a level specified by a formula,
usually related to scheme salary.
To qualify for free cover, members must satisfy an “actively at work”

qualification which varies from insurer to insurer, as do the regulations
controlling the subsequent admission of those members failing to qualify initially
through being off sick.
So, for example, at the date of joining we may require that an employee has been
continuously at work for the preceding two months.

Question 1.20
Explain why each of the following features of a group IP scheme enables an insurer to
offer a high free cover limit:
● compulsory membership
● a minimum number of members in the scheme
● the use of an “actively at work” criterion
● a prescribed benefit formula.
The free cover limit is now more commonly known as the non-selection limit (NSL).

3 Short-term accident and sickness insurances
3.1 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 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.
The contract is most often available through employer-sponsored or affinity

group schemes and may thus not be individually underwritten.
Personal policies are also available.
The contract has a relatively low premium for the money sums offered, in view of
the low risk of claim.
Policies providing short-term cover for accident and sickness along with unemployment
(ASU) are popular in some markets, particularly when linked to the repayment of
loans (eg mortgages).
This type of insurance is not the same as IP insurance. In particular, benefits will cease
after a specified fixed number of years (eg one year).
The product is also short term in that it 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.
Indeed, short-term accident and sickness policies are sometimes sold along with IP,
because they typically have shorter deferred periods (if any). For example, in cases
where IP is only available with long deferred periods (say 52 weeks), an accident and
sickness policy could provide short-term cover for this period.
Accident and sickness policies are usually not subject to underwriting, and so they can
be useful for people for whom the long-term risk cannot be underwritten, except at
prohibitively high rates.

3.2 Personal accident
Personal accident policies are also short-term renewable. They provide lump sum
benefits to compensate for bodily injury suffered as the result of an accident. Usually
policies have a rider benefit that pays reduced benefits if the insured’s children suffer an
accident.
Benefits are usually specified fixed amounts in the event that an insured party
(this may include the policyholder’s family as well as the policyholder) suffers
the loss of one or more limbs or other specified injury. This is not indemnity
insurance because it is not possible to quantify the value of the loss, for
instance, of an arm.
Here the perils are any form of accident that results in the loss of limbs or other
specified injury.

Example
Here is an example of a typical personal accident policy. The text is taken from a direct
mailing to potential customers.
If you have an accident that results in any of items 1 to 9 in the Benefits Table you will
be entitled to the benefits shown.
Benefit level
Items Insured or Partner Children

1. Permanent Total Disability £100,000 £5,000
2. Loss of Use of:
(i) one limb £50,000 £2,500
(ii) two limbs £100,000 £5,000
3. Loss of Sight in:
(i) one eye £50,000 £2,500
(ii) two eyes £100,000 £5,000
4. Loss of Hearing in:
(i) one ear £20,000 £1,000
(ii) two ears £100,000 £5,000
5. Loss of Use of:
(i) Shoulder £12,500 £625
(ii) Hip £10,000 £500
(iii) Knee £10,000 £500
(iv) Ankle £10,000 £500
(v) Wrist £10,000 £500
6. Loss of Use of:
(i) one thumb £7,500 £375
(ii) one forefinger £5,000 £250
(iii) any other finger £5,000 £250
7. Loss of Use of:
(i) one big toe £5,000 £250
(ii) any other toe £2,500 £125
8. Daily Hospitalisation
(Up to a maximum of 180 £50 per day £2.50 per day
days)
9. Accidental Death £10,000 £500

Whatever your occupation or medical history, these low premiums will give you instant
cover for up to £100,000 worth of personal accident insurance.
£4.95 per month for you only

£6.20 per month for you and your children
£7.27 per month for you and your partner
£8.52 per month for you, your partner and children
Question 1.21
The premium for an individual is £4.95 and the (implied) premium for the all the
children in a family is £1.25 (ie £6.20 – £4.95).
Why is the monthly premium for a whole family much less than might be expected from
these base premiums ie 2 ¥ £4.95 + £1.25 = £11.15 ?
Measure of exposure to which premiums are related
For the purpose of setting premiums, insurance companies try to determine measures
which give an indication of how much risk there is within each policy. These measures
are called measures of exposure.
In practice, the chosen measure of exposure should meet two key criteria:
(a) It should be a good measure of the amount of risk, allowing for both the
expected frequency of claim and the expected severity of claim (ie the average
claim amount). In other words, the total expected claim amount should be
proportional to the exposure.
(b) 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 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.
Given a measure of exposure, risk can be further classified by rating factors. These will
be discussed shortly.

For both personal accident and health insurance the true measure of exposure is
the person-year because the cover is defined 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 we 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 charges a rate
assuming an average family unit size and, hopefully, gets it right on average.
Question 1.22
Describe the risk that the insurer will be exposed to as a result of using a standard rate
to cover the whole family.
For group policies the number of people covered by any one policy may need to
be adjusted at the year-end and the premium adjusted in line with their risk
characteristics. Under personal accident insurance if policyholders can select
more than one unit of sum insured, this too will need to be reflected in the
exposure.
For group schemes, where the scale of benefits is linked to salaries, the exposure
measure is often the sum insured or the total salaries.
In some cases the policy will allow the insured to select a number of “benefit units”. So
the exposed will need to be weighted by the number of units selected and the measure
of exposure will be a benefit unit year rather than a person year.
Claim characteristics
Claims are usually reported quickly and also settled without much delay
although they are sometimes subject to dispute. Most claims under health
insurance cover fall in the range of a few hundred to a few thousand pounds.
Personal accident claims are as defined in the cover and can be very large.
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.

As well as paying out on specified injuries, many personal accident policies will make a
payment if the insured is “permanently and totally disabled”. It may, however, take
several months or years before establishing that this is the case for these claims.
Risk factors and rating factors
Risk factors are those characteristics of the insured event that are known or suspected to
influence the claims cost. A rating factor is a factor that is actually used to determine
the premium.
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. Other factors are:
● age
● sex
● health condition
● dangerous pastimes.
Other proxy measures (ie rating factors) for health condition include family
genetics, smoker status, past medical history and gym membership.
Personal accident insurance usually uses a very simple proposal form. This means that
the information we can collect about the risk factors is limited. Questions about age,
occupation and dangerous pastimes are possible, but detailed questions about medical
history are not usually asked.
For those that belong to a group scheme we may only know their age and the industry in
which they work. Here the industry in which the insured works is being used as a rating
factor whereas the underlying risk factor is the insured’s occupation.

Chapter 1 Summary
Income protection
Income Protection (IP) is a long-term insurance contract that provides the insured with
regular, short- or long-term payments during periods of incapacity in return for a regular
premium.
Incapacity means being unable to earn an income as the result of illness or accident.
However IP insurance can be extended to those who work but are not paid (eg house
persons, students) and those who are temporarily without work (eg unemployed).
Even if the policyholder’s claims experience is adverse or his health deteriorates, the
terms and conditions of the policy cannot be altered. However, if the premiums are
reviewable, rather than guaranteed, these can be changed on any review date, but only
as a result of the experience of the portfolio of policies as a whole being different from
that expected (ie not based on individual claim experience).
The terms and conditions can be reviewed if rating factors specified in the policy
change (eg occupation, area of permanent residence). The policyholder is often
required to notify the insurer of such changes.
The incapacity criterion is part of the policy conditions. Examples are:

● 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 (eg the first two years)
of claim followed by inability to perform any occupation thereafter
● inability to perform any occupation.
The alternatives to an occupational definition define the claim event in terms of an

inability to perform various tests, regardless of occupation. Examples of tests are:
● functional assessment tests (FATs)
● activities of daily living (ADLs)
● activities of daily working (ADWs)
● personal capability assessment (PCA).
These criteria for incapacity are often used for those who work but are not paid or who
are temporarily without work.

The benefits can:

● be available for a fixed term or for a term usually ending at the insured’s normal
retirement age
● be subject to a waiting period at the start of the policy (usually imposed by the
insurer) during which premiums are payable but the insured is not eligible for
benefits
● be subject to a deferred period at the start of each period of incapacity (usually
chosen by the policyholder) during which no benefits are payable
● increase at a specified rate (chosen by the policyholder) from the start of the
policy (with a corresponding increase in premiums)
● increase at a specified rate during any period for which benefits are payable
● be paid at a reduced rate if the insured works part time or works in a less
well-paid job than before becoming unable to work
● be subject to a linked-claim period (usually imposed by the insurer) so that
periods of incapacity separated by less than the linked-claim period are treated
as if they were one continuous period of incapacity
● be increased without further evidence of health if a “life event” specified in the
policy occurs and the policyholder has opted for this benefit and paid an extra
premium from the outset.
The premiums can:

● be waived during periods when benefits are payable (the policyholder usually
chooses this option)
● be subject to increase in line with any regular increase in benefits
● be guaranteed throughout the term of the policy or reviewable by the insurer at
regular intervals specified in the policy.
Both financial and risk underwriting are required.
Financial underwriting guards against over-insurance and consequent moral hazard by

checking income replacement ratios.
Risk underwriting uses age, sex, occupation (divided into risk classes), deferred period,
smoking status, medical history and lifestyle as rating factors.

Group schemes
Group schemes can be set up by any affinity group but are most commonly set up by
employers for their employees.
In the case of the latter, the employer is the policyholder even though those insured are
the employees. Employers can use such schemes to provide sick pay to employees.
The stringency of the underwriting, the rating factors used and the premium levels are
influenced by:
● whether or not scheme membership is compulsory
● the structure of the benefits (ie prescribed formula or not)
● the level of the free cover limit
● the number of scheme members.
Short-term accident and sickness policies
Accident and sickness insurance policies have similarities to income protection in that
they provide regular income for as long as the claimant remains disabled. However,
these are short-term renewable policies and benefit payments are limited to a specified
period (eg often one year). Additionally a fixed lump sum may be paid if the
policyholder sustains permanent bodily injury as the result of an accident.
Personal accident
Personal accident policies are short-term contracts that provide lump sum benefits to
compensate for bodily injury suffered as the result of an accident. There is no
requirement that the loss has to prevent the insured from working, and policies can be
bought by any adult. Usually policies have a rider benefit that pays reduced benefits if
the insured’s children suffer an accident.
The rating factors used are usually very simple (eg age, occupation). The measure of
exposure is usually the person-year.

This page has been left blank so that you can keep the chapter
summaries together for revision purposes.

Chapter 1 Solutions
Solution 1.1
(i) Why regular level premiums are preferred
Consumers tend to see health and care risks as long-term risks. Usually the risks
increase with increasing age, eg as you become older you are more likely to incur costs
for medical treatment.
The consumer will want to transfer these risks to an insurance company in return for a
risk that they find acceptable, eg a level regular premium payable until they die or until
the risk ceases for some other reason.
If the insurer offers a one-year renewable contract then the premiums will increase each
year in line with the expected claims cost each year. There may come a time when,
despite the fact that the renewal premium is fair, ie equal to the expected claims cost
plus a small loading, the consumer is unable to find the resources to pay the premium
and so is faced with the possibility of lapsing the policy and taking on the risk himself.
This means the policy will not satisfy the consumer’s original needs. A regular level
premium avoids this possibility.
(ii) (a) Why some policyholders are unhappy
Some policyholders are unhappy because of the scenario we have outlined in part (i).
The difficulty is not likely to arise until the expected claims cost in the next year
becomes substantial. This will happen when policyholders are older.
(b) Why it is difficult for the insurer
In order to offer regular level premiums for a long-term contract, the insurer must be
able, in a statistical sense, to assess the long-term risks.
This would not be as difficult if the events being insured remained the same over time,
so all that the insurer had to do was to forecast how the chance of any insured event
occurring was expected to change over time. However the insured events (ie the kinds
of ailments that require treatment and the regimes used for treatment) are very difficult
to predict. As one ailment becomes treatable in a cheap and effective way, so other
ailments become more prevalent and are treated using regimes that have developed in
response to the emergence of the new disease.
The costs of these emerging treatment regimes are difficult to predict.

So it is difficult for insurers to estimate the long-term expected claims costs. The
distribution of the estimates will have a large variance and result in the requirement for
large contingency loadings in the premiums. The resulting premium levels may be too
high to be acceptable.
Under short-term renewable policies, the insurer reserves the right to review the
premium each year, often under certain specified conditions. The insurer will be able to
estimate the expected claims costs in the next year with more certainty, and so the
contingency loadings in the premium will be much smaller.
The insurer might also review the benefits every few years so that the policy keeps pace
with advances in medical technology.
Solution 1.2
Once a valid claim is in payment, the insurer must continue to pay the claim for as long
as conditions for claiming are satisfied.
If the policy is written on guaranteed terms, then the terms and conditions of the
policy, ie benefits payable by insurer and premiums payable by the insured, are fixed.
No matter how adverse is the insured’s own claims experience or how poor is the
insured’s current state of health, the insurer cannot cancel the policy mid-term, nor can
the insurer vary the benefits or the premiums. The original insurance cover and the
original terms and conditions are permanent.
If the policy is subject to periodical review, then premiums may change from time to
time. However, the premiums will change by the same amount for all the policies in a
particular risk group, irrespective of their individual claims experience. Only if the
policyholder accepts the revised terms of the policy will cover then continue.
As long as the insured does not breach the terms and conditions of the policy (eg pays
premiums on time, notifies the insurer of changes in occupation), the insurer cannot
cancel the policy.

Solution 1.3
Policyholders are concerned to secure long-term cover for the risks they face.
There is a danger that increases in wages may erode the level of cover over time,
relative to normal income. Automatic increases in benefits will mean that the level of
cover will be maintained, at least to the extent that the policyholder’s income is
increasing with the inflation index used.
Solution 1.4
Both an ill-health retirement pension and an IP policy provide cover for lost income as a
result of being unable to do your job as a result of sickness or accident. The level of
benefit – typically about two thirds of pre-disability income – is often roughly the same
in each case.
You will only be eligible for an ill-health retirement pension if you are judged to be
permanently unable to do your job between now and your normal retirement age. An
ill-health retirement pension would then be paid for the rest of your life.
The eligibility conditions for the payment of IP benefits are less stringent. For example,
you just need to be judged as being temporarily unable to do your job. IP policy
benefits would cover all periods of temporary sickness until the date of normal
retirement, provided they last longer than the deferred period in your policy. When you
reach normal retirement age your pension would start to be paid from the pension
policy.
An IP policy, with a deferred period equal to the period for which your employer and/or
the State has promised to pay your benefit (at around the level of your normal salary)
and a term lasting until your normal retirement age, would ensure that your income was
maintained if you were sick and temporarily unable to work normally at any time before
normal retirement age.
So an IP policy complements the ill-health retirement benefits from a pension policy by

providing cover for periods when you are temporarily unable to work.
But to some extent the IP policy will duplicate the ill-health retirement benefits because
it will also provide benefits if you are permanently unable to work.

Solution 1.5
(i) Differences in rates between offices
Published morbidity tables show rates (eg claim inception and termination rates) by age
and deferred period accepted at normal rates of premium.
The composition of the business written by each office will vary by other significant
factors (eg the mix of those insured by occupation, social class, residence etc). The
variation in these factors will cause the rates to differ from office to office. For
example, a greater proportion of manual occupations will, all other things being equal,
lead to higher claim rates.
There will also be differences between offices in the stringency of their initial
underwriting, eg some may charge higher premiums but use less extensive
underwriting.
Each office will attract a different class of policyholder because their policies offer
different levels of benefits, have different terms and conditions, have different
exclusions etc.
Offices will use different definitions of being unable to work (eg “unable to undertake
the insured’s own occupation”, “unable to undertake any occupation to which the
insured is suited by virtue of education or training”). Different definitions will lead to
different numbers of claims being admitted and so to different claim rates.
These rates will also be influenced by the thoroughness of the office’s claims
underwriting procedures and subsequent claims management.
(ii) Rates that change rapidly with time
To some extent sickness is a social phenomenon. Whether or not someone is unable to

work is a matter of opinion rather than a matter of fact. Opinions change over time, for
example at one time any form of psychiatric illness was thought to mean that a person
should not work but, with modern drugs and various forms of personal support,
opinions have changed and work is now sometimes seen as part of the treatment.
Advances in medicine (eg “keyhole” day surgery) and changes in the nature of work
(eg less manual work, more computer-based sedentary jobs) mean that some accidents
and illnesses are less likely to prevent someone following their normal occupation for
an extended period. However, there are new types of claims emerging from these new
jobs, such as repetitive strain injury (RSI) and work-related stress.
Such changes can occur within a decade and so claim rates can change quickly.

Solution 1.6
“The potential to lose a lot of money”
The initial sum at risk is:
£ ( Policy term - Deferred period ) ¥ 5000 = £197,500
while the premium collected in the first few years will amount to a few hundred pounds
less initial expenses and sales commissions. The claim strain at risk is very large. To
some extent this can be controlled by selling a large number of policies and by using
reinsurance.
“The true experience will not be known for a long time”
The insurer will have used current published morbidity rates suitably adjusted to
calculate the premium. The policy has a 40-year term and morbidity rates will change
markedly over this period. We will not know the true experience for another 40 years,
although of course we will see this experience emerging over this period.
The morbidity basis consists of incidence rates for new sickness claims and recovery
(claim termination) rates.
We can check the incidence rates we have assumed in our premium basis against the
emerging experience each year (assuming, of course, that the exposed to risk is large
enough for the estimated rates to have small enough standard errors). But data to
estimate the claim termination rates will be very scanty and will only emerge over many
years (or even decades).
The Core Reading is referring to eventual profit on a block of policies. This will not be
known until all the policies have reached the end of their terms.

Solution 1.7
Underwriting is about assessing the health of the proposer, but more precisely it is about
assessing the risk to the insurer in terms of the probability and size of claim.
The probability of dying is relatively simple to assess as it is mainly affected by age and
sex.
The probability of being unable to follow your normal occupation as a result of illness
or accident is affected by many more factors (eg lifestyle factors), and the “hurdle” that
must be jumped to establish a valid claim will depend on the nature of the occupation.
For example, even minor illnesses and injuries may prevent a manual worker from
doing his job, whereas the same illnesses and injuries would not prevent an office
worker from earning a living. So in addition to assessing the proposer’s health we need
to assess the demands of their normal occupation.
The total cost of claims depends on how frequently the insured makes claims and also
the length of the period for which he claims. The length of a period of sickness is
influenced by lots of health factors (eg the kinds of illness that are most likely to result
in the life being unable to work). The cost of a claim for a term insurance policy is
fixed (ie the sum assured).
Solution 1.8
Going to work is a matter of habit. As a result of long-term sickness people get into
different habits and have forgotten “how to go to work”.
If it is a long time since you worked it will be like starting a new job, you will worry
about being able to do your job successfully and how you will fit in. This is made
worse by the fact that you will be expected to be able to resume your old role
immediately and will not receive the same concessions as those starting a new job.
You may also worry about the demands of the job making you sick again, with perhaps
a consequent “loss of face”.
If you have been given a less demanding role to help you back into work, you may feel
you have lost status and thus experience some humiliation in returning to work.

Solution 1.9
If the IP policy provides an income almost equal to or larger than their current salary
policyholders may be tempted to feign sickness so that they get paid without working.
If they are already claiming there will be a temptation to prolong the claim because they
will not be much better off if they return to work.
These are examples of moral hazard – the temptation for the insured to make a
fraudulent claim or to exaggerate a claim.
If the policy conditions allow high replacement ratios then the insurer will have to
investigate claims more thoroughly in order to counter moral hazard.
Solution 1.10
The rating of an occupation depends upon its expected claims experience.
These changes suggest that many insurers have seen a rise in claims from those in the
teaching profession. Most teachers will be entitled to generous sick pay from their
employer in addition to statutory sick pay for the first 28 weeks of sickness absence.
This means that the majority of teachers who have IP policies will have policies with
deferred periods of six months or more. So insurers will have experienced increased
long-term sickness absence rates amongst teachers.
.
The most significant changes that have taken place in the teaching profession are likely
to do with the increased pressures of the job. This is likely to have resulted in an
increase in stress-related illnesses (such as psychiatric illnesses and heart attacks). This
is the main reason for the increased levels of long-term sickness absence.
Solution 1.11
It is probably due to IP being a popular cover amongst such professions. Doctors and
dentists are often self-employed, and so some insurance companies will have sufficient
experience on such professions to be able to calculate separate premiums for these
occupations if they so wish.
There may also be an argument that people in specialist occupations, such as dentists or
surgeons, may present particular risks to the insurer. For example, a dentist that
damages a finger may not be able to work until it is fully recovered.

Solution 1.12
The advantages for the insurer are:

● The PCA tests are precisely described, and so there will be fewer disputes as to
whether or not the conditions for the payment of a claim are satisfied. The
occupational definition is open to interpretation as to which occupation the
insured may be suited to.
● The PCA tests identify generic skills necessary to be capable of work, and so are
applicable to all occupations. Claims assessors do not need to spend time
becoming familiar with the demands of lots of occupations.
● The PCA tests imply a measured level of incapacity, and so are unlikely to result
in windfall claims.
The disadvantages for the insurer are:

● Some people may be unable to find gainful employment but do not satisfy the
necessary PCA tests to qualify for claim. Such cases may lead to bad publicity
and damage to the insurer’s reputation.
● Potential policyholders may see the PCA tests as irrelevant to the risks they
face, ie in the eyes of the proposer the tests have little to do with their being
prevented from working by illness or accident.
Solution 1.13
(i) How a waiting period helps
The aim of a waiting period is to control selection against the office. There is a risk that
those who think they have an increased chance of falling sick will choose to buy an IP
policy. The proposal form, which includes detailed medical and other questions, may
not suggest that the proposer has an increased risk of sickness, perhaps because the
current symptoms have not resulted in the proposer seeking medical advice and thus
providing details in answers given on the proposal form. A period at the start of the
policy (eg three months during which premiums are paid but there is no entitlement to
benefits) may dissuade prospective policyholders from seeking insurance because 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.

(ii) Why waiting periods are rare in recent policies
While a waiting period may allow the medical questionnaire in a proposal to be simpler
and underwriting to be completed more quickly, the idea of paying premiums with no
entitlement to benefit will not appeal to prospective policyholders.
More recently, policies have tended to have longer deferred periods. A longer deferred
period has a similar effect on proposers to a waiting period. It is more difficult for
proposers to select against the office, as it is more difficult for proposers to predict a
forthcoming illness that will last long enough to result in a claim payment.
Solution 1.14
Most policies include a long deferred period so that the policy benefits complement
sickness provision from other sources, such as statutory benefits or benefits from the
employer.
If you return to work and relapse into sickness within a short period you would have to
serve another deferred period before receiving policy benefits. As a result you may tend
to delay returning to work until you are certain of not falling sick again within a short
period of time. With a linked-claim 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.
Solution 1.15
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 as the end of the deferred period approaches, the
insurer can conduct a thorough claims assessment process and so be in a position to pay
a valid claim immediately 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.

Solution 1.16
(i) Why the insurer needs to know
Any change in the area of permanent residence represents a significant change in the
risk factors.
The insurer is concerned about whether or not the risk of sickness and accident is
different in the new location from that originally 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 health care. The risk of accidental injury may be different as
well.
(ii) How the policy can be changed
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.
Solution 1.17
(i) Unit-linked whole of life
At the beginning of the first year the premiums will flow into the non-unit fund. The
proportion of these premiums allocated for investment (95%) will be paid into the unit
fund. These transactions will have the effect of leaving the initial charges in the non-
unit fund. The initial expenses will be taken from the non-unit fund.
At the end of the first year the annual management charges (1%) and the mortality
charges will be deducted from the unit fund and be paid into the non-unit fund. The
sums assured due on death would be paid from the non-unit fund.
(ii) IP policy
The only difference for an IP policy is that there will be a morbidity charge rather than a
mortality charge. This will reflect the expected cost of sickness benefits in respect of
claims arising during the year.

Solution 1.18
(i) Why GIOs are popular with policyholders
A GIO allows policyholders to buy cover for events that are new and unexpected
(ie unexpected at the date of buying the original policy), without providing further
evidence of health.
The qualifying events include many of the events that policyholders think might result
in the need for extra insurance. So policyholders see GIOs as a valuable extension of
cover.
Provided their need for additional insurance arises as a result of one of the qualifying
events, the only penalty for buying more insurance at a later date will be the higher
premium resulting from their increased age.
(ii) Satisfactory qualifying life events
(a) Starting a new job with a new employer at an increased salary:
We might suspect that those seeking and being successful in obtaining a new job are
likely to be more healthy than the average. There will also be the need for extra
insurance to maintain a satisfactory income replacement ratio as a result of the increased
salary. This is a satisfactory event from the point of view of the insurer.
(b) Having a 40th birthday party:
While there might be some evidence that the propensity to party is associated with good
health, it is far from conclusive. The event provides no evidence of satisfactory
financial underwriting. This is not a satisfactory event.
(c) Buying a new car:
The act of buying a car is not associated with good or bad health. The purchase might
indicate that the insured has spare cash funds or a satisfactory credit rating, but this does
not provide any form of financial underwriting. This is not a satisfactory event.
(d) The birth of a child:
Just as marriage tends to select out those in better health than the average, so the birth of
a child works in a similar way. Increased family size will provide a reason for
additional insurance, although it may not be a satisfactory check on an already high-
income replacement ratio. This event is more likely to be satisfactory than
unsatisfactory, and in fact it is actually used by many insurers.

(e) Running a marathon in under 3 hours:
Yes, this will certainly select out those in better health. However, it does not provide
any form of financial underwriting. On balance, this event is more likely to be
satisfactory than not.
(iii) Characteristics of qualifying events
Qualifying 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.
A secondary consideration is financial underwriting – the event should if possible lead

to the need for increased insurance cover so that there is no incentive to over-insure
with the temptation to claim. In part this can be addressed by checking income
replacement ratios or by underwriting at the claims stage.
(iv) Limits on the amount of additional insurance
It would be sensible to place an upper limit on the increase (eg 50% of the original
policy benefit) and also an overriding limit on the benefit (eg a 60% income
replacement ratio). These will not be seen as onerous by the policyholders, who usually
see the GIO as a way of avoiding medical underwriting. They will also seek to avoid
over-insurance in order to avoid a restriction on the benefits paid if a claim is made.
Solution 1.19
Benefits will cease at the end of each policy, so if the insured experiences long-term
sickness the cover under the 20-year policy may be more valuable to him than one
where sickness payments will stop at the end of the current 5-year term. This difference
in benefits will be reflected in the premiums.
Buying the 20-year policy with reviewable premiums will ensure guaranteed cover for
the whole period, provided that the insured is accepted at the outset.
Buying the series of policies will mean the insured is subject to underwriting every five
years. If their health deteriorates then they may not be accepted at standard rates (or at
all) in the future. So cover for the whole period of 20 years is not guaranteed.
However, the 5-year policy will give the insured (particularly if he is healthy) more
flexibility. For example, he can change benefit level, deferred period and definition of
incapacity to meet his changing needs every 5 years.

Premiums for the reviewable policy may change up or down at each review date. These
changes will be the result of changing expected future claims experience for the
portfolio of policies to which the insured’s policy belongs. The reviewed premium
should not increase as a result of the insured being older.
Premiums for each five-year policy will reflect the insurer’s view of the expected claims
experience and expenses for the next five years. The premiums will also reflect the
increase in the insured’s age and any changes the insurer has made to the profit criteria
being used. The increase in premium each five years is likely to be significant, mainly
on account of increasing age.
Policyholders who lapse early in the 20-year period will be better off under the 5-year
policy. This is because there is usually no surrender value on IP policies, and they will
pay lower premiums initially compared to the (level) premium under the 20-year policy.
Overall initial expenses will be higher on the four 5-year policies, as underwriting and
selling costs will be incurred four times. This will be reflected in increased premiums
overall.
On the other hand, the insurer has more flexibility to change premiums and benefits
every 5 years under the 5-year polices. This is because, although the 20-year policy is
reviewable every 5 years, in practice there are constraints on the degree to which the
required changes to premiums and benefits can be made (ie to avoid selective lapsing
and customer dissatisfaction). This will result in the 20-year policy requiring a higher
contingency loading in the premium.
Solution 1.20
Note that the free cover limit fixes the amount of insurance that can be offered to a
member of the group scheme without any form of underwriting except, perhaps, for an
“actively at work” qualification.
Compulsory membership
This will ensure that the insurer gains both the good risks and the bad risks and not just
a selection of the worse risks. This means that there can be some cross-subsidy between
members of the scheme, with the better risks paying more than their expected claims
costs and the worse risks paying less than their expected claims cost.
If membership were voluntary, it is more likely that the poorer risks will join, as they
will benefit more from the scheme and will not be excluded by underwriting.

A minimum number of members in the scheme
The average annual claims cost per member will be the subject of random variation
from year to year. The size of this variation is inversely proportional to the square root
of the number of scheme members. So the rate of decrease in the standard error of the
average claim size per member is more rapid for small numbers of members than it is
for larger numbers of members. When a certain size is reached the rate of decrease will
be very small. So if we impose a minimum membership of about this size, it will be
less likely that the premium income each year will be less than the actual claims cost.
The use of an “actively at work” criterion
Those who have been actively at work are less likely to claim in future than those who
have been absent as a result of sickness or injury.
This is a cost-effective form of underwriting. The prospective member does not have to
provide any information, and the criterion can be readily verified from the employer’s
records. A criterion of actively at work for the preceding two months should reduce the
likelihood of selection against the office to an acceptable level.
A prescribed benefit formula
The benefit will usually be related to the employee’s salary by means of a simple
formula. This will prevent worse risks over-insuring and good risks choosing to under
insure with a consequent adverse impact on the actual claims cost.
Solution 1.21
There are two possible contributing reasons for this.
Expenses
The sale of each policy will incur significant initial expenses (eg advertising, setting up
the policy records) and also renewal expenses (eg premium collection).
The size of these expenses will be largely independent of the number of lives that are
insured on each policy. The initial expenses will be spread over the expected duration
of the policy.
Because the premiums are small, the allowance for expenses in the premium (ie the
charge) will be a significant part of each premium.

For example, if the total expense charge is £2.63, then the risk premium for each adult
might be £2.32, and that for all the children in a family £1.25. So the premium for a
family policy would be:
£2.63 + 2 ¥ £2.32 + £1.25 = £8.52
Selection
Individuals taking out policies on their own are likely to be anti-selective, ie they will
be taking out insurance because they perceive themselves to be a high risk. In
combination, a family group is likely to be less anti-selective in relation to each
individual member than if equivalent non-associated individuals took out the policy.
For example, if a Mr. Goonsplatter thinks a personal accident policy is a good idea, he
may as well get additional cover for Mrs. Goonsplatter and for all of the little
Goonsplatters, especially as this cover is really cheap. Mrs. Goonsplatter probably
wouldn’t have bothered with the insurance had she been on her own, unless she had
considered herself to be a particularly high risk – QED.
Note the above logic applies equally if you swap Mr. and Mrs. Goonsplatter around in
the above example.
Solution 1.22
The insurer will be exposed to the risk of selection. The policy might only be attractive
to large families. This would particularly be the case if other insurers do use the actual
family details in the rating process. The insurer would usually market the policy very
carefully to minimise the selection risk.

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ST1-02: Health and care insurance products – Critical illness Page 1
Chapter 2
Critical illness
Syllabus objective

– Income Protection.
– Critical Illness.
– Long Term Care Insurance.
– Private Medical Insurance.
– Major Medical Expenses.
– Hospital Cash.
Critical illness is covered in this chapter.
0 Introduction
This chapter and chapters 1, 3 and 4 cover the basic contract types of income
protection insurance (IP), critical illness insurance (CI), long-term care insurance
(LTCI), private medical insurance (PMI), major medical expenses (MME) and
hospital cash upon which the examiners will base their questions.
Chapter 1 described IP policies and some associated accident and sickness policies.
This chapter describes CI insurance, Chapter 3 describes LTCI and finally Chapter 4

Page 2 ST1-02: Health and care insurance products – Critical illness
The first section of Chapter 1 discussed some general issues that apply to all these
different contracts. You may like to reread this section quickly to remind yourself of
the key issues before studying the remainder of this chapter.

1 Critical illness cover
1.1 Introduction
This insurance product is known by many different names in different territories,

for example, dread disease insurance, serious illness insurance, crisis cash,
living assurance and critical illness cover. It is this last phraseology, often
abbreviated to CI, which will be used in this Core Reading.
The benefit under a critical illness policy is typically a lump sum that is payable if
the policyholder suffers one of the defined conditions. The product may also be
structured to provide regular income.
In this latter case the lump sum benefit is used to buy an impaired life annuity that
provides a regular income from the date of a valid claim until death.
A critical illness product may be considered as a hybrid with benefit payable in

any of the following ways:
• upon the happening of an event, independent of the extent, eg having a
heart attack or a stroke, where specific medical evidence would be required to
check that the events had actually occurred
• on reaching a defined degree of impairment, eg losing the ability to walk
unaided or losing the ability to speak
• on undergoing a surgical procedure, eg having a major organ transplant or
having a heart bypass operation.
The product is not designed to indemnify the policyholder.
The sum assured is not designed to return the insured to their position (in financial or
other terms) before the insured event occurred, but is chosen independently by the
insured.
In this way, critical illness 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.
Critical illness insurance can be provided as an additional feature of a term insurance

policy. Such policies are called accelerated critical-illness term insurances and the sum
assured is paid on the diagnosis of an insured critical illness or death, whichever event
occurs first. Alternatively, critical illness 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 critical illness policy is a pure protection product as it is not certain that the sum
assured will be paid. It is possible that the insured 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.
The policy will end when the first event occurs, although in some cases, the insurer will
allow the policy to be reinstated as a term insurance without further evidence of health.
The insured events are much more difficult to define and validate than the event of
dying. This means that the wording of the policy is very important.
Question 2.1
(i) Compare and contrast the cover provided by critical illness and income
protection policies.
(ii) Describe the kind of person for which each type might be suitable.
1.2 Characteristics
There are three characteristics of an illness or condition that make it appropriate

for inclusion in a critical illness product:
• it is a condition perceived by the public to be serious and to occur
frequently
• each condition covered can be defined clearly so that there is no
ambiguity at 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 an important concept. 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. Creutzfeldt Jakob Disease (CJD) is an example of this – despite very
low incidence many insurance companies either specifically added it to the list
of named conditions or confirmed that it would be covered under a more
generalised dementia definition.

CJD is a degenerative brain condition that is thought to be transferred from cows to

humans by eating infected beef. There is currently no cure for the condition. There
have only been a few cases in the UK, but they have received extensive media coverage.
To be included, an illness, if not life threatening, should at least be lifestyle

threatening.
It is the expense of adapting to a new lifestyle, such as part-time working or difficulties

in getting around, that sometimes provides the motivation for seeking CI insurance.
Ideally illnesses should not be so rare that there is a negligible risk of

occurrence, so that they each add value in their own right.
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.
So for example:
• cancers are usually restricted to those where malignant tumours have invaded
adjacent tissue
• heart attacks require evidence that the heart muscle has been damaged as
evidenced by enzyme changes in the blood.
We want the policy to cover critical illnesses, and not lead to windfall payments for less
serious conditions where the insured’s lifestyle is changed very little in the longer term.
Sufficient data
In practice, the last characteristic (sufficient data) has been difficult to achieve.
Any critical illness condition 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 in the overall rate. The requirement to predict
future trends is particularly onerous.
From the date on which cover is extended to a new condition, it takes some time for
sufficient claims experience to build up for us to be able to estimate the incidence of
claims in the insured population. Of course, there will usually be population-wide data
about the incidence of the new condition, but the insured population will be a select
group, typically with higher average income and better educational levels than the
population at large.

In order to price new conditions, we need to be able to estimate future incidence rates.
Advances in preventative medicine can have a profound effect on future rates, and such
advances are very difficult to predict, eg new vaccines, the success of campaigns to
change dietary habits.
The ability to avoid anti-selection is sometimes added to the list of desirable

features of a critical illness condition. Examination of early claims leads to a
suspicion of a 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

office and the insured. For example, the insured 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 insured 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 moratorium period (eg 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.
1.3 “Core” and “Additional” conditions
In many markets, the diseases and surgical procedures which are considered
critical illnesses are split, for policy purposes, into Core and Additional
conditions. The conditions that fall within the definitions “Core” and
“Additional” are reviewed from time to time.
Some markets have gone so far as to standardise the claim definitions for many
of the diseases and clinical procedures. Thus many insurers and reinsurers
have co-operated to produce a single set of wordings for the most common
conditions found in CI policies and these would be used in contracts.
For example, the UK CI market uses agreed industry-wide wording for its definitions.
Until recently, these were categorised into “Core” or “Additional” conditions.
Question 2.2
What were the advantages to the insurers and reinsurers of this cooperation?

The core conditions
Listed below is an example of “Core” conditions, ie 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 which will
account for maybe 90% of all claims.
The sample list of core conditions is as follows:

• cancer
• coronary artery by-pass surgery
• heart attack
• kidney failure
• major organ transplant
• multiple sclerosis
• stroke.
These are the core conditions that were, until recently, used in the UK market.

Example
This is the UK industry-wide definition of heart attack. You do not need to be familiar
with particular definitions, but from this example you should be aware of the need for
precise definitions.
Heart attack – of specified severity
Death of heart muscle, due to inadequate blood supply, that has resulted in all of the
following evidence of acute myocardial infarction:
• Typical clinical symptoms (for example, characteristic chest pain).
• New characteristic electrocardiographic changes.
• The characteristic rise of cardiac enzymes or Troponins recorded at the
following levels or higher:
– Troponin T > 1.0 ng/ml
– AccuTnI > 0.5 ng/ml or equivalent threshold with other Troponin I
methods.
The evidence must show a definite acute myocardial infarction.
For the above definition, the following are not covered:
Other acute coronary syndromes including but not limited to angina.
To the layperson the terminology is complex, but precision is essential if the definitions
are to be effective in controlling claims. Primary responsibility for these definitions lies
with the insurance company’s medical staff.
Question 2.3
At the beginning of Section 1.2 three characteristics of claim conditions are described,
and it is argued that these are the characteristics that need to be satisfied before a
condition is included in a critical illness policy.
Describe how the agreed “heart attack” condition satisfies each of these characteristics.

The additional conditions
“Additional” conditions are those non-core conditions which will perhaps be

included in some 75% of critical illness cover policies on the market at any one
time.
A sample list of additional conditions might include the following:

• Alzheimer’s disease
• AIDS/HIV contracted by blood transfusion
• AIDS/HIV contracted during occupation
• aorta graft surgery
• benign brain tumour
• blindness
• coma
• deafness
• heart valve replacement or repair
• loss of limbs
• loss of speech
• motor neurone disease
• paralysis/paraplegia
• Parkinson’s disease
• terminal illness
• third degree burns.
Definitions relating to surgical procedures are usually less complex than those relating
to medical events.

Example
This is a UK industry-wide definition. Again, you do not need to know the details.
Aorta graft surgery – for disease
The undergoing of surgery for disease of the aorta with excision and surgical
replacement of a portion of the diseased aorta with a graft. The term aorta includes the
thoracic and abdominal aorta but not its branches.
For the above definition, the following are not covered:

• Any other surgical procedure, for example the insertion of stents or endovascular
repair.
• Surgery following traumatic injury to the aorta.
Question 2.4
In recent times health services have increased the use of screening programmes with the
aim of detecting diseases at an early stage in their development when they can be
treated more effectively. Examples are screening programs for breast cancer, cervical
cancer and prostate cancer.
Describe the possible impact on critical illness claim costs of these developments.
Question 2.5
What is and is not a “critical illness” depends on the current state of medical knowledge
and the extent to which that knowledge has been incorporated into day-to-day
preventative and curative health care.
A prospective policyholder wants to remove the financial risks associated with

contracting a critical illness from his or her life by buying a suitable policy.
However, a press article has said that, in offering a 25-year CI policy with fixed policy
definitions and guaranteed premiums, insurers are deluding policyholders into thinking
that they have insured the critical illness risk over the period of cover.
(i) Explain whether or not you agree with this statement.
(ii) Explain whether or not the terms and conditions of a policy that could be
reviewed every five years might be more attractive to policyholders.

1.4 Terminal illness
Terminal illness is often added to complete the overall cover. It does not relate
to a specific disease. Instead its definition involves the severity of a condition
and its effect on life expectancy.
Terminal illness cover ensures that all conditions that significantly reduce life
expectancy are covered, albeit at a late stage. Many perceive this as an
equitable benefit – a policyholder could otherwise suffer a severe illness that
reduces life expectancy significantly but does not qualify for benefit.
The extent to which terminal illness extends the cover provided and hence its
additional cost depends very much on what other benefits are provided by the
product. Although terminal illness can be used to fill some apparent gaps in the
cover, in some cases these will be small. The key question is the extent of the
residual benefits provided by the terminal illness cover.
As we have discussed, CI cover can be provided as a rider to a term insurance contract

or on a stand-alone basis. The addition of a terminal illness benefit will have a different
impact in each of these cases.
For an acceleration product the main effect of terminal illness cover is to bring
forward (or accelerate) the payment of the death benefit and therefore the cost of
the benefit is very small.
This is because the effect is only to change the time of a benefit that is already included
in the cover provided by the policy.
For term products (ie claim acceleration products with a fixed policy term) there may
also be a few additional claims towards the end of the policy that will impact cost
more significantly. If terminal illness benefit ceases 12 (or 24) months prior to
the end of the term, these additional claims can be avoided.
Question 2.6
Why is it that the terminal illness benefit only gives rise to additional claims for events
close to the end of the policy term?
Terminal illness does not fit as naturally into a stand-alone critical illness plan
where a death benefit is not payable. In this case it is a genuine “extra” cost
because a new benefit is being provided and the incidence of the various causes
of terminal illness will need to be established.

1.5 Extra conditions
There are a number of other conditions which, with the growing popularity of the
contract and the increasing competitiveness of markets, are being included in
critical illness cover policies in many territories.
Competition can be on price (premium levels) or quality (the extent of the cover
provided).
These extra conditions are:

• children’s benefit
• Creutzfeld Jacob disease
• chronic emphysema
• diabetes
• pre-senile dementia
• rheumatoid arthritis.
Any additions should be considered carefully with regard to the desirable

characteristics of a critical illness.
Question 2.7
List the desirable characteristics of a critical illness condition with regard to its
suitability for cover under a CI insurance contract.
Lengthening the list of illnesses for which the benefit is paid out might only
provide a minimal increase in the cover for the client. For example, the
incidence of some conditions may be low at the ages where the benefit is
available. In other cases the illness may already be covered by a total permanent
disablement (TPD) benefit, although perhaps at a later stage of the illness. Many
offices are not attempting to cover every conceivable condition. Over 90% of all
claims arise from the core illnesses, and the availability of a cheaper product
with less depth of coverage may increase the sales penetration across the public
in general.
Some insurers have offered policies that restrict cover to high profile illnesses such as
cancer and heart related conditions. These policies will be cheaper and provide
“budget” cover resulting in sales to a wider market than the more comprehensive
policies.
TPD will be discussed in Section 1.7.

1.6 Children’s benefit
Cover can be provided for each child of the policyholder, usually until they reach
the age of 18. An interesting 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 inflictable disabilities 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.
Fears regarding the level of claims under this benefit have proved unfounded
and increasingly only claims resulting from pre-existing congenital defects are
typically excluded.
The cost of this cover is minimal compared to the high perceived value of this
benefit to parents. Even cancer, the second largest single cause of death of
children (exceeded only by accidental causes) does not demonstrate high
incidence (relative to the adult levels) with one in every 10,000 children
diagnosed as having cancer each year in Britain. Most other serious childhood
diseases are also rare.
Question 2.8
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 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.
Comment on this suggestion.

1.7 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 (defined as being unable to follow your
normal occupation) 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.
Insurers will usually maintain a category of incurred but not settled (IBNS) claims while
they wait for the final outcome of the disability to become clear.
However, if diagnosis is unequivocal, most insurers will pay the benefit

immediately. The definition of disability considers the severity of the condition
and the extent of disablement. This contrasts with critical illness benefits that
normally relate to the diagnosis of an illness rather than to its effect.
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”. It is unlikely that every single element of the job or function is
failed completely. Even severe disability will usually still leave the individual
able to do something that could be argued to be part of the job or function. If the
disability isn’t a major or substantial part of the role then failure is not
considered total.
TPD combined with critical illness benefits
TPD cover complements critical illness cover despite the different nature of the
criteria for payment.
The cost of TPD will depend on the definition of disability used (see below).
When added to a critical illness product the extra cost will also depend on the
conditions covered by that product. Many critical illness conditions could also
lead to a valid TPD claim, thus there can be significant overlap between the two
types of benefit. For example, analysis of claims confirms that a number of
paralysis and dementia cases are acceptable TPD claims. This explains why
TPD can be added on the more extensive products for little additional cost.

Definitions of disability
There are three main types of definition:

• occupation-based
• related to Activities of Daily Living (ADLs)
• definitions using working activities or functional abilities.
The first and third points are the same as those you saw in Chapter 1 relating to income
protection. ADLs will be discussed below, and in more detail in Chapter 3 on long-term
care insurance (LTCI).
The relative merits of each are discussed below.
Occupation-based definitions
Disability is established by the inability to carry out an occupation. This could

relate to the inability of the life assured to perform:
• their own occupation
• all occupations to which suited by education, training or experience
• any occupation.
When costing for the three different benefit definitions it is important to make an
allowance for interpretation. Whilst a pricing actuary would regard the inability
to perform “any” occupation as very severe, in practice a more lenient
interpretation is often made. Consequently claims are effectively paid on a more
generous basis than priced. In these circumstances, it is important that the
results of experience monitoring are fed back into pricing.
This is an example of the use of the actuarial control cycle, which you will be familiar
with from Subject CA1.
Most people are still able to carry out some form of occupation even though their
disability prevents them from performing their own. For example, repetitive
strain injury (RSI) would prevent a copy typist from typing, which would be
considered the major and substantial part of her role, but not from doing other
clerical duties such as filing or answering the telephone. A relatively minor
illness such as epilepsy could lead to a bus driver losing his licence and thus
being unable to fulfil the major part of his job and needing alternative
employment.

Where an occupation requires certain skills, and those skills could easily be
impaired by a minor disability an “own” occupation definition is not suitable. A
small impairment to the hand, for example, may preclude a pianist from playing
professionally, but he will still be able to secure alternative employment. As the
disability would not need to be severe, claims would be paid frequently and on
minor injuries.
The cost of providing such cover on an own occupation basis would be

prohibitive. However, application of the “any” occupation definition may be
perceived to be unfair and hence cover may be provided on the “all occupations
to which suited by education, training or experience” definition.
Occupations that carry an above average accident or health risk involving

physically strenuous work, eg site workers in the building trade, would usually
be only offered TPD cover on an “any occupation” definition since the costs of
more comprehensive cover would be high and often difficult to quantify.
It is desirable for the insurance company to be flexible in its underwriting

philosophy. Offering all the above definitions will extend the range of people for
whom TPD benefit can be provided. Individuals who are not eligible for “own”
occupation may be offered an alternative definition.
Activities of Daily Living (ADLs) definitions
Occupation-based definitions may be criticised because they cannot be applied

to housewives, househusbands, those not in employment or those past
retirement age.
Alternative criteria for payment of the benefit are the policyholder’s inability to
perform a number of normal everyday tasks. These are commonly known as
Activities of Daily Living (ADLs). Definitions of these criteria are often similar to
those found under long term care insurance policies (see Chapter 3) and typically
include:
• feeding
• dressing
• washing
• toileting
• mobility
• transfer.
Detailed explanations of these definitions are given in Chapter 3.

A common requirement for the payment of the benefit is the failure of the insured
to be able to undertake, unaided, a given number of the ADLs above, commonly
three or four. It may be harder to satisfy this definition than an occupation-
based one.
An ADL definition has several advantages over an occupational definition. It can

be applied to a wider range of lives, and can be applied beyond retirement. This
offers the simplicity of using only one definition throughout the term of the
policy. It is also less subjective than one based on the ability to perform an
occupation. TPD written on this basis throughout life is often called Loss of
Independent Existence.
Alternative definitions
Other alternatives to occupation-based definitions are definitions based on

activities of daily work (ADWs), personal capability assessments (PCAs) and
functional assessment tests (FATs).
With these definitions the activities include skills like dexterity, mobility and
communication. They can be more objective, particularly if the “skills” defined
relate to occupational class.
We will now give an example of a functional assessment test used by a major insurer.
You are not expected to be familiar with the detail in the example, but you should be
able to describe the nature of ADWs and FATs.

Example
You will be considered physically incapacitated if you pass three of the following seven
tests at any given time:
Getting up from a chair

You can’t get up from a chair without using its arms. Without using its arms means
without using the arms of the chair and without the help of any other person, object or
appliance.
Standing
You can’t stand for a period of ten minutes. The ability to stand means the ability to
stand and do light tasks using one hand for support.
Walking
You can’t walk a distance of more than 200 metres on flat ground without stopping.
Walking means normal walking without the use of sticks, crutches or other devices.
Lifting
You can’t lift a 2kg bag of potatoes from counter height using either hand. Either hand
means that both arms have to be disabled to pass this test. This test is not about lifting
the bag with both hands together. The bag of potatoes does not have handles.
Walking up and down stairs

You can’t walk up and down a flight of 12 stairs without holding on or taking a rest.
This means you can’t do both these tasks within a reasonable period and not necessarily
one immediately after the other.
Bending and kneeling

You can’t bend or kneel to pick up something light from the floor and straighten up
again without help. This activity begins from the standing position. It is designed to
find out if you can do common tasks that are required in the average home or
workplace.
Using your hands

You can’t turn on a sink tap or cooker control knobs with one hand. You will satisfy
this test if you can’t do these tasks with either hand. Tasks may be done a little more
clumsily with the non-dominant hand, but this test is concerned with ability not
performance.

Alongside this test of physical incapacity there would be an overriding test of mental
incapacity.
Question 2.9
List the advantages of the Functional Assessment Tests in the Example over a test for
total permanent disablement based on the ability to follow your normal occupation.
1.8 Group critical illness
Group critical illness will be seen as a valuable benefit by staff and can be used
by an employer as part of the overall benefits package to attract and retain staff.
Equally groups of employees, trade unions and members of associations such
as motoring organisations might buy it. The benefit can be provided to those
employees and individuals for whom income protection insurance is not
available, including some blue-collar occupations, and is of particular value
when TPD cover is included.
The same basic principles of group life insurance hold for critical illness
benefits. In essence, the key requirements to establish a group scheme are:
• There is a definition of who is eligible for benefits under the scheme.
• The benefits under the scheme are clearly defined:
– by size
– by definition of a valid claim
– by the period of benefit (if applicable).
There are other factors to consider in good scheme design, in particular the
insurer has to restrict anti-selection or, if present in a limited form, make a
charge for it. Restrictions involve applying exclusions, setting free cover limits,
ensuring members are actively at work when cover begins, setting take-up rates
on voluntary schemes and laying down take-over terms where the insurer
accepts a scheme previously insured elsewhere.
So schemes with a minimum number of members, in which membership is compulsory,

and where benefit levels are determined by a fixed formula related to salary, present
fewer opportunities for selection against the office. As a result, such schemes can have
more generous free cover limits and smaller premium loadings.


Chapter 2 Summary
Critical illness insurance is a pure protection product with the sum insured payable if
the policyholder suffers one of the insured conditions during the term of the policy. In
nearly all cases level premiums are paid until an insured event occurs, the insured dies
or the term of the policy ends, whichever event occurs first.
The sum insured is usually a lump sum specified in the policy, but the product may also
be structured to provide an annuity.
The conditions specified in the policy usually consist of a “core” list of illnesses that are
expected to account for, say, 90% of claims, together with a list of “additional”
conditions. Nearly all insurers will include the core conditions, and will also include
some of the additional conditions. It is common to add a category of “terminal illness”
so as to include all the life-threatening illnesses and conditions that have not been
specifically mentioned in the policy. In a similar way, some policies extend cover to
total permanent disability (whatever the cause) so as to include all illnesses and
conditions that are lifestyle threatening too.
The criteria for the inclusion of an illness or condition are:

• it is a condition perceived by the public to be serious and to occur frequently
• each condition covered can be defined clearly so that there is no ambiguity at
time of claim
• sufficient data are available to price the benefit.
In many markets, industry bodies have agreed definitions to determine whether or not
an insured illness or condition has occurred.
Terminal illness is usually a matter of medical opinion (eg a consultant’s opinion that
the insured’s expected future lifetime is less than 12 months).
Total permanent disability requires that the disability is permanent with no hope of
recovery. Total disability can be related to the ability to follow the insured’s normal
occupation, the ability to perform certain activities of daily living or to functional
assessment tests.

Most critical illness insurance is provided in one of two forms:

• Accelerated critical-illness insurance where the sum assured is paid on the
diagnosis of an insured condition or death, whichever event occurs first.
• Stand-alone critical-illness insurance where the sum insured is only paid on the
diagnosis of an insured condition. No payment is made on death.
Sometimes a policy on a parent will have a rider benefit to provide similar cover for the
life of the insured’s children. A claim in respect of a child would not terminate the
policy. Sometimes the sum insured for these claims is restricted.
Employers can use group critical illness policies as part of the reward package for staff.
The underwriting of these group schemes must be considered carefully in order to

prevent selection against the office. This is usually done by the use of eligibility rules.
For example:
• all staff must join at the first opportunity
• benefits are fixed by rules related to salary
• a minimum proportion of eligible employees must join the scheme.

Chapter 2 Solutions
Solution 2.1
(i) Compare and contrast the two policies
Both IP and CI provide cash benefits rather than an indemnity for the policyholder.
IP seeks to indemnify the policyholder against loss of income while he or she is

prevented from working because of injury or illness. It is not a true indemnity product
because the benefit is restricted to the minimum of the benefit chosen by the
policyholder and a limit (eg 60% of pre-sickness income) imposed by the insurer. The
insured will always suffer some loss as a result of the insured event. This acts to reduce
the likelihood of fraudulent claims (moral hazard).
IP provides a regular income from the end of the deferred period until the insured
returns to work or the policy term ends, whichever event occurs first. Often benefit
payments (and premiums) may be linked to an index of wage or price inflation.
CI provides a fixed lump-sum monetary benefit (chosen by the insured), usually

irrespective of the loss incurred by the policyholder, as a result of the insured event
occurring. Like IP, CI benefits (and premiums) may be linked to an inflation index.
IP provides cover for repeated occurrences of the insured event – the inability to earn a
‘normal’ wage – during the term of the policy. The insured event is specified in terms
of outcomes (inability to work normally) rather than causes (illnesses or accident
preventing you from working), and so it is widely drawn. Cover (and premiums) do not
cease until the death of the policyholder or the end of the term. However, premiums
may be waived during periods when benefits are being paid.
CI provides cover for a single occurrence of the insured event. Once the sum assured
has been paid the cover (and premium) ceases. The insured event is usually specified in
terms of causes, eg a list of illnesses or medical conditions that lead to the payment of
the sum assured. However, sometimes cover is extended by the use of an outcome
event, eg total permanent disablement whatever the cause. So the cover is much more
restricted than that provided by an IP policy. For example, a broken leg might lead to
an IP payment, but not to a CI payment; a stress-related illness might lead to an IP
payment but not to a CI payment.
CI insurance could be seen as an accelerated form of life assurance, whereas IP

insurance is more like an ill-health pre-retirement pension.

(ii) Kind of person who should buy each policy
The kind of person who should buy each policy is the person who has residual risks
(after taking into account all the other benefits to which they are entitled), that match
the risks insured by that policy.
An employed person whose employer provides a comprehensive sick pay

scheme (eg paying a large proportion of normal salary for the first 12 or 24 months of
sickness), together with an occupational pension scheme that includes an ill-health
retirement pension, will have little need for IP insurance. However, there may be a gap
between the time at which sick pay ceases and an ill-health retirement pension begins.
In addition, an IP policy would provide cover for long-term absence from work that was
not sufficient to justify retirement on grounds of ill health.
On the other hand, a self-employed person would have an immediate need for IP
insurance, irrespective of whether they had dependants.
In general, CI insurance will be suitable for anyone who would consider a lump sum
payment useful should they become critically ill, whether for repaying debts, replacing
lost income, or paying for care or treatment.
Someone with IP insurance or equivalent income protection may still have a need for CI
insurance, though arguably to a lesser extent as the uses of the benefit partly overlap.
In countries where there is no comprehensive free medical care, people often use the CI
sum assured to pay for the treatment needed as a result of the critical illness.
Solution 2.2
An agreed definition will draw upon the experience of lots of insurers, and is more
likely to be free of ambiguity.
In addition, insurers will want to be able to settle claims quickly with few disputes (and
so reduce the expense and threat to reputation that a disputed claim settlement
produces). Agreed definitions will help here, as there is less possibility of claimants
producing case law from other insurers to support their disputed claim.
There will be a sharing of current and future expertise in the interpretation of current
medical conditions and future advances, and so the costs of developing and maintaining
policy conditions will be shared, resulting in reduced costs for each insurer.

With standardised claim conditions, policies are likely to be easier for prospective
policyholders to understand, sales staff to explain and for comparisons to be made
between products from different insurers.
Industry-wide information and education may make the definitions better understood.
The result will be more sales in general, leading to increased business for all insurers,
and bigger increases for those who offer better customer service etc.
With standardised definitions it will be easier to collect compatible industry-wide data.

This will mean better information on which insurers can assess risks. This increased
information may result in lower risk loadings and lower premiums, thus further
increasing the potential size of the market.
Reinsurers will enjoy similar benefits, as their fortunes are likely to follow those of the
insurers.
Solution 2.3
Certainly heart attacks are perceived to occur frequently. For example, many
individuals are aware of friends or relatives who have suffered a heart attack, and heart
attacks have a high profile in medical dramas on TV.
Such attacks are seen as serious and requiring extended hospital treatment. In many
cases an operation is needed together with continuing medication and perhaps a change
in lifestyle.
We have seen in Section 1.3 that defining exactly what is meant by a heart attack is
difficult. Great care has been taken in the UK industry-wide definition to explain
precisely all the evidence required for a heart attack to be severe enough to constitute a
valid claim. For example, there are specific levels of cardiac enzymes, or particular
muscle proteins (called troponins), that must be attained or exceeded.
Heart attacks are a common occurrence and a large proportion of claims will result from
this cause, and so there should be adequate data to estimate claim incidence rates. If the
insurer’s own data are not sufficient, other sources such as other insurers or population
medical statistics could be used.

Solution 2.4
CI has a fixed sum assured and it is only the incidence rates that will affect claims costs.
Effective screening is likely to detect more incidents, but with a greater proportion of
these being at an earlier stage of the disease than in the past.
In general this will tend to increase claim incidence rates and so increase costs.
However, some of the incidents detected at an early stage may not qualify as claims,
eg cancers that have not invaded adjacent tissues.
As a secondary effect, screening may lead to the development of effective treatments

that considerably reduce the adverse effects of the insured condition, and result in more
windfall claims (ie claims where the sum insured is paid, but the insured suffers little or
no financial or other loss).
Solution 2.5
(i) Has the critical illness risk been insured?
If a policy offers cover for a list of conditions that are currently important, it is unlikely
to provide comprehensive cover for those conditions that will be “critical” in, say, 10 to
15 years time.
Compare the conditions that were the cause of death and serious illness in 1950 (polio,
tuberculosis, organ failure) and 1975 (most malignant tumours, organ failure) with those
that are most important now (heart disease, some cancers). From this, you can see that
medical advances have a profound and rapid impact on the prevalence of serious
illnesses.
(ii) Would a five-year reviewable policy be more attractive to policyholders?
A policy that could be updated every five years should make cover more comprehensive
and relevant. But it is not the policyholder who is reviewing the benefits offered and
the premiums that must be paid. The insurer will undertake the review.
Policyholders may be concerned that the insurer might use each review to manipulate
the policy to its advantage, eg by increasing premiums or by restricting cover. They
would be reassured if there were some restrictions on the insurer’s actions.

Of course, policyholders have the option not to accept the revised terms. The fact that
policyholders can compare the reviewed range of benefits and the level of premiums
with those available in the market from other insurers will act as a check on the
reviewed terms offered by the current insurer. Those in good health could seek cover
elsewhere. This would increase selection against the office, and so would be an
incentive for the office to keep premium increases to a minimum, and update benefits so
that they matched those currently offered by other insurers.
Solution 2.6
A terminal illness is usually defined as an illness that in the opinion of a hospital

consultant will result in the death of the insured within 12 months.
A benefit payable on diagnosis of a terminal illness more than 12 months before the end
of the policy term is just a death benefit paid 12 months earlier than it would have been
under a policy that had no terminal illness benefit. So the extra claims costs is
approximately equal to 12 months’ investment return on the sum assured.
A benefit payable on diagnosis of a terminal illness within 12 months of the end of the
policy term is an additional benefit, because the corresponding “death benefit” is
expected to occur after the end of the policy term. The expected cost of this additional
benefit could be substantial.
Solution 2.7
• It should be a condition perceived by the public to be serious and to occur

frequently. It should be serious in the sense that, if it is not life threatening, then
it should at least be lifestyle threatening.
• It should be a condition that can be defined clearly, so that there is no ambiguity

at time of claim. It should add value to the policy (ie not have a negligible risk
of occurring).
• There should be sufficient data available to price the benefit, both now and in the
future.

Solution 2.8
The key issue is whether the expected additional claims costs will be covered by other
sources of additional income. Principally this additional income will come from
increased volume of sales that will reduce the fixed costs per policy.
We have increased the “quality” of the product (see Section 1.5). The additional benefit
is easily understood by policyholders and may prove attractive, particularly if our sales
are predominantly to the higher social classes where children generally remain
dependent on their parents to higher ages than in the lower social classes.
The increased claims costs will depend on the incidence rates for critical illnesses.
Incidence rates for critical illnesses at these ages should be investigated, but are likely to
be low. So the additional costs are likely to be small.
The most important factor will be the sum assured offered on a child. If this is the full
sum assured, then the costs might be significant and there may be a temptation for
proposers to select against the office (underwriting will be on the assured life rather
than the child’s life). So if it is not already a policy condition, limiting the sum assured
on a child to, say, 25% of the main sum assured or making it a fixed sum of a similar
magnitude would be sensible, and is unlikely to reduce the expected increase in sales.
Solution 2.9
The FATs test is based on skills that apply to the unemployed, as well as those with a
job. The test could also be applied to a person of any age. The skills tested are easily
understood by policyholders, and are such that policyholders can see that they are
directly related to day-to-day living.
Occupational tests only apply to those in employment, and need to be specific for each
occupation. Considerable expertise may be needed to develop and apply occupational
tests.
FATs are quite precisely defined and may be easier to apply in practice.

ST1-03: Health and care insurance products – Long-term care insurance Page 1
Chapter 3
Long-term care insurance
Syllabus objective

– Income protection.
– Critical illness.
– Long-term care insurance.
– Private medical insurance.
– Major medical expenses.
– Hospital cash.
– purpose of contracts to the insured..
Long-term care insurance is covered in this chapter.
0 Introduction
This chapter and chapters 1, 2 and 4 cover the basic contract types of income
Chapter 1 described IP policies and some associated accident and sickness policies and
Chapter 2 describes CI insurance. This chapter describes LTCI and finally Chapter 4

Page 2 ST1-03: Health and care insurance products – Long-term care insurance
the key issues before studying the remainder of this chapter, which is about LTCI and
related policies.

1 Long-term care
In this section we describe what is meant by long-term care and discuss the types of
care that are needed. We then look at how this care can be provided.
1.1 Defining long-term care
With the phenomenon of an ageing population present in many of the world’s

economies, the focus of national attention is often on the allocation of resources
to provide long-term care.
Other groups in the community apart from the elderly require long-term care, eg those
disabled from birth and those disabled as the result of an accident. The family and the
State are usually seen as the providers of care for those disabled from birth. For those
disabled as the result of an accident, the costs of care are sometimes met from
insurance, such as personal accident or employers’ liability policies, or from awards
made as the result of litigation in the civil courts. In some countries, the State
compensates anybody suffering injury as the result of an accident. These arrangements
are known as “no fault” compensation schemes.
While in this course we mostly make reference to long-term care for the elderly, you
should not lose sight of the fact that LTCI benefits can be paid with respect to disability
arising at any age.
The responsibility in many countries is split between the State through its
welfare programme, and the individual, through assets accumulated during the
working lifetime. The insurance solution will concentrate on the latter form of
protection and investment, though it will frequently have a role to play in
partnering governments in State provision.
This approach is taken in many insurance markets, including the UK, but other
approaches are possible.
Definition
Long-term care might be defined as:
All forms of continuing personal or nursing care and 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 centre, 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 medical care, as it is not principally concerned with curing or
alleviating particular medical conditions.
While the underlying cause of the changes in a person’s circumstances may be

medical (eg arthritis, a 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 the
expectation is that ability levels will deteriorate, or at least not improve, in the future.
However, someone needing long-term care may also need acute medical
intervention at some stage just as any able-bodied person can become ill and
need medical treatment.
Long-term care covers a very 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 to maintain well being.
The costs of care can be divided between living costs, housing costs and
personal care. These might be defined as:
• living costs – food, clothing, heating and amenities, etc
• housing costs – rent, mortgage payments and council 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, eg the need for a warmer home, the need for special foods.
The housing costs are often referred to as the “hotel” or accommodation

element of the total costs.
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 accommodation (eg a bath hoist).
For living and housing costs, it is the increase in 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 care and other forms of personal care.
Nursing care is the narrowest form of long-term care and can be defined as care
that requires the specific knowledge or skills of a qualified nurse. The definition
of nursing care is open to individual interpretation. At its most restrictive this
would include the assessment of health-care needs and specific interventions
that require technical competence and knowledge of disease states, which only a
registered nurse can provide. A broader definition of nursing care might cover
the costs of a registered nurse in providing, delegating or supervising care in
any setting. However, the definition to encompass either State provision or
insurer responsibility will invariably depend on the purpose for which it is used.
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 minimise future dependence on long-term care. These
services should incorporate intensive therapy and support.
The care is intermediate between hospital care and care provided in the home.
1.2 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.
Question 3.1
Why are most of these carers aged over 60?
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.
The continuing supply of informal care will have a direct impact on formal care costs.

Question 3.2
Why should the supply of informal care have an impact on formal care costs?
The supply of informal care is influenced by factors such as the availability of viable
alternatives, the proportion of women working, the geographic dispersion of families,
changing family structures (eg through divorce, re-marriage, falling birth rates), as well
as the attitudes of different generations.
The extent of informal care is influenced by the cultural and religious traditions in the
community. So in some countries, eg Mediterranean countries, the provision of care by
the extended family and by charitable organisations may be much more extensive than
in other countries.
If the informal care sector shrinks, for whatever reason, then the demand for insurance
products may increase.
1.3 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 is also encouraged
by government policies to promote “care in the community”.
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 owned and managed residential homes. Some residential
homes will be owned and managed by charities set up to serve particular community
groups (eg Chelsea pensioners, all of whom served in the armed forces and are now in
need of care).

Question 3.3
Every one faces the risk of needing long-term care in old age. Think about your own
personal circumstances.
(i) Describe the long-term care risks that you will face in your old age.
(ii) How do you plan to manage these risks?
(iii) Are you left with some risks that you have no idea of how to manage? Could
insurance solve your risk management problem? If so, what type of insurance
would suit you? Try to describe the benefits you would need and how you
would like to pay for these benefits.

2 Insurance solutions
Long-term care insurance is a product that aims to indemnify the insured for the
additional costs of day-to-day living when they are in need of long-term care that
qualifies for payment under the terms and conditions of their policy. However, in order
to control claims costs, in some cases these payments for different categories of care are
subject to over-riding maxima. In this case the policy does not provide full indemnity.
Many products provide cash benefits rather than covering the direct costs of care, so
these are not indemnity products.
Long-term care insurance is now a concept that encompasses a wide spectrum

of products, however there are two generic types of cover.
The first type, called pre-funded plans, are purchased by relatively healthy
people to protect them against the future risk of disability.
These plans can be 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.
The second type, called immediate needs plans, are purchased by long-term care
claimants to protect them against the uncertain survival duration.
These contracts are in effect impaired-life annuities secured by a single premium paid at
the start of the contract when the insured needs care as a result of failing health.
These two structures form part of a continuum as insurers seek to offer cover to
as many applicants as possible. Some pre-funded products specifically cover
disabled lives who are almost at the point of triggering the claims definition.
Pre-funded products are considered in Section 3 and immediate needs products

are covered in Section 5.

3 Pre-funded products
To understand the range of pre-funded solutions it is necessary to separate the
benefit type from the method of funding and the product structure.
Benefit types
The benefit payment is dependent upon the claims definition, which may be
triggered by a single event or by a multiple set of events.
Some plans will pay benefits based only on the level of disability defined as being
unable to undertake a specified number of activities of daily living (ADLs), or a similar
criterion based on an alternative disability scale. Other plans have more complex
triggers. For example, in addition to satisfying a disability criterion, the insured must
also need care during the night or care that can only be provided in a nursing home.
The single event may itself depend on a level of disability and its continuation for
a specified period. Different benefits may also be payable dependent on the
level of disability. For more restrictive plans it may require all of the events to be
triggered (eg one or more events, including a minimum age, prior nursing care,
entry into a nursing home, as well as a minimum level of continuing disability).
The earliest long-term care insurance plans in the US required a period of prior
hospitalisation, followed by entry into a nursing home.
All these alternatives are attempts to define precisely the insured event or events in
language that will be understood by the policyholder and reduce the chance of any
dispute at the claim stage. The more stringent is the definition, the less likely is the
insured event and in general the lower the premium will be.
The multiple-event trigger may require the disability event to be the first event
from a list specified in the policy conditions (eg for an integrated rider plan such
as critical illness cover).
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.
Long-term care benefits can be added to a CI policy. 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 Alzheimer’s disease, stroke, Parkinson’s disease, rheumatoid arthritis, pre-senile
dementia and blindness) are already covered by the main CI policy.

Long-term care benefits can be provided as a rider on a whole of life insurance. This
contract 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.
Long-term care can be added to an IP policy, so that the cover continues beyond normal
retirement age. At the end of the IP term, the definition of disability would normally
switch from being occupation related (say) to one that is activity related (eg failure of
ADLs).
LTCI can also be a rider on a PMI policy. 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 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.
Question 3.4
It is often said that having LTCI as an integrated rider on an IP policy is not such a good
product design as rider benefits on CI policies, whole of life insurance policies or PMI
policies.
What are the problems of LTCI as an integrated rider on an IP policy?
The type of benefit could be selected from a range of alternatives, including a

single lump sum payment, an annuity certain, a lifetime benefit subject to on-
going disability, or a restricted benefit (eg payable for a maximum period, or to a
maximum total amount) subject to on-going disability.
Benefits can be defined in money terms (cash), or paid on an indemnity basis.
If an indemnity basis applies, the policy will provide benefits that are sufficient to make
up for the losses the insured incurs as a result of the insured event happening. For
example, the policy might offer nursing care that the insured was assessed as needing,
when he or she was 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, restrictions on where the care would be provided). This would be an indemnity
policy.
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).

Methods of funding
There are various methods of funding the insurance premiums, including:

• single payments
• regular payments
• restricted regular payments that either stop:
– at a certain age (eg normal retirement age)
– during a defined level of disability (ie with a waiver of premium)
• retrospective payment, from the equity released after the sale of the
home.
Question 3.5
How can a “retrospective payment, from the equity released after the sale of the home”,
fund a LTCI plan?
Question 3.6
One major long-term care insurer quotes a joint monthly premium of £28.64 for a
couple starting a pre-funded plan at age 55. If they were to delay starting their plan
until age 65, they would have to pay £242.36 a month for exactly the same cover.
In both cases the policy pays fixed cash benefits when an insured person is unable to
undertake three or more ADLs.
Additionally, should either or both lives be in poor health at the time of starting the
plan, the premiums would be even higher.
Explain why premiums increase with increasing age and deteriorating health.
Product structure
The product can also be structured as long-term business or general business.
The products could also be written either on or off-shore.

Unit-linked investment plans can be written “off-shore”, which means beyond the remit
of the legislation of the country in which the insured resides. These offer the
policyholder a wide range of investment funds, and access to the unit fund on death or
early surrender. These off-shore plans usually accumulate free from tax. This means
that the long-term care risk premiums and expenses are deducted from the gross
investment gains. Benefits are usually taxed when they are remitted to the country in
which the insured lives.
Claims definition
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.
We have discussed the advantages and disadvantages of standard definitions in

Chapter 2. The ideas described there for CI apply equally to long-term care insurance.
One such benchmark list of ADLs is:

• washing – the ability to maintain an adequate level of cleanliness and personal
hygiene
• dressing – the ability to put on and take off all necessary garments, artificial
limbs or other surgical appliances that are medically necessary
• 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
• mobility – the ability to move indoors from room to room on level surfaces at
the normal place of 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.
In addition, there may be a mental impairment trigger.
This means a need for care or supervision as a result of deterioration in, or loss of,
mental capacity from an organic cause. “Mental capacity” covers memory, knowing
who and where they are, an awareness of time and the ability to solve simple problems
and make rational decisions. An “organic cause” means a disease such as Alzheimer’s
or irreversible dementia, but excluding depression, or the side effects of other
medication.

The mental impairment trigger is usually an overriding one. The benefit is payable
when this condition is satisfied whether or not the insured is unable to perform any
ADLs.
The claims trigger requires the policyholder to be incapable of performing these

activities alone and without endangering the health or well-being of the
policyholder or others.
The carefully worded definitions create the impression that these judgements will be
objective. However, they all leave room for value judgements – for example, the
definitions do not say things like “be able to ascend a flight of 12 stairs”.
3.1 Pensions solutions
Long-term care has a natural link with pensions as they are both dealing with the
needs of people in retirement. The benefits could thus be thought of as
providing for one set of post-retirement needs. Some commentators have said
that the existing pension annuity is inappropriate for the needs of those in
extreme old age, because the income does not recognise the additional costs to
buy-in services as the person becomes less able. This is accentuated by the fact
that often the pension of a surviving female spouse has reduced significantly, as
well as being eroded by inflation.
The original idea of an occupational pension scheme was to provide for the
post-retirement needs of the scheme members and their dependants. This was at a time
when inflation was very low and most of those who retired at, say, age 65 expected that
they would have about 10 years of retirement. Their needs were adequately provided
for by a level annuity that reduced by, say, 50% when paid to a surviving spouse. Ill
health in retirement was usually of short duration and informal care was provided by the
extended family.
It is therefore natural to think that an occupational pension could provide for the current
post-retirement needs of its members. Unfortunately, longer expected periods of
retirement, the impact of inflation on the purchasing power of pensions, extended
periods of ill health in retirement and the demise of the extended family mean that the
current structure of benefits does not match today’s post-retirement needs.
There is also an argument that a pension is purely a savings vehicle and should
not be used to manage risk. However, this argument is also unconvincing,
because recognised pre-retirement pension benefits include death and ill-health
early retirement. Life insurers recognise that the pension annuity contains a
high level of implicit mortality risk through longevity.

In effect an annuity provides insurance against the risk of living too long. This risk is
pooled and those who die after a few years subsidies the annuity income of those who
live longer than expected.
One argument against extending the role of pensions was proposed on the basis
that there were already insufficient pension reserves and the cost burden of
employers was already high. Whilst these arguments carry weight for those
close to retirement, it may still be the most optimal approach for future
generations of pensioners.
There will only be an additional cost if the proposal is to pay out more than the current
pension level, when, for example, a pensioner reaches age 85 or satisfies a disability
criterion. A proposal to use the current pension fund to purchase an annuity that
increased on the first of reaching age 85 or satisfying a disability criterion would not
necessarily increase the costs of the pension scheme, but may result in an initial pension
that was inadequate when compared to pre-retirement salary levels.
A further innovation is the design of pseudo-pension annuity solutions that

incorporate a conventional annuity purchased from the pension fund, with a
rider long-term care insurance benefit that increases the pension income, either
paid from the pension tax-free lump sum, or from the ongoing pension income.
So the benefit takes the form of an impaired deferred life annuity. The period before the
annuity payments start is not fixed, but ends when a triggering event occurs. At this
point the life will be suffering from poor health, and so the annuity can be priced by
using impaired mortality. Most occupational pension schemes provide a lump-sum
benefit (usually tax-free) as well as a pension at the date of retirement. The policy
could be paid for by a single premium paid out of the lump sum benefit. Alternatively it
could be funded by level premiums paid from the occupational pension beginning at the
date of retirement and ending on the earlier of death or the event that triggers the
payment of the impaired life annuity.
3.2 Stand-alone products
One pre-funded long-term care insurance solution is a stand-alone protection

plan, which has sold significantly in many territories. The benefits are triggered
by the failure of a specified number of ADLs or mental impairment. 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. The full benefit is
also payable as a result of mental impairment. More recent plans have separated
the ADL triggers so that the benefit for each level of disability can be individually
selected.

Question 3.7
What are the advantages and disadvantages of a benefit design like the one described
above, where benefit levels vary with the number of ADLs failed?
It should be noted that these benefits are not dependent on the place of
residence (ie in the individual’s own home or a nursing home).
This comment is only relevant for policies with cash rather than indemnity benefits.
In the US it is standard for the benefit level to depend on place of residence and,
often, the plans require the same number of ADL failures, but pay a different
benefit according to residence.
Premiums
Premiums can either be regular or single. The former almost always escalates in
line with the chosen benefit escalation rate and includes a waiver of premiums
on triggering the disability benefit, or possibly a less severe level of disability.
Common benefits
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 three years.
Question 3.8
(i) What is the purpose of each of the three benefit options listed above?
(ii) What effect would each option have on the premium for a product secured by
level monthly premiums that are waived during periods of claim?
The maximum initial benefit is often limited. This is so that the insurance benefit
is linked to the additional long-term care costs incurred. However, more recent
plans have removed the upper limit, subject to satisfactory financial
underwriting.

Question 3.9
The purpose of underwriting is to control risks. What risk is controlled by financial

underwriting as described in the last paragraph?
The plans often provide a fixed number of monthly benefits to cover the cost of
any assistive devices. The assistive devices benefit addition is normally limited
to three or six months’ benefits. The aids, typically grab rails, bathing seats and
stair lifts, are provided so that the policyholder can regain independence and
defer the trigger of further benefits. Some plans provide personal alarms in
additional to the assistive devices to help people remain in their own homes.
Where the plan covers the costs of professional care, up to the benefit limit,
these benefits can be used to provide respite care support for non-professional
carers. Other plans provide cash benefits.
Another almost standard benefit is the provision of independent care advice at

the point of claim. Insurers have sought to help the policyholder understand the
care choices available to them and their rights to State support. Whilst these
support services are rarely included with other insurance protection products,
for long-term care insurance salespeople have seen this service as almost a
prerequisite.
The claimant is new to the market for care provision and has no experience of
purchasing care and care-related products, and so expert help to guide decision making
is likely to increase policyholder satisfaction. All the difficulties surrounding the
organisation of suitable care are likely to be made worse because the claimant will not
be in good health. It has become common in some markets to appoint a care manager
or advocate to help in decision making.
The most basic regular premium products do not provide a death benefit. Basic
single premium products amortise the single premium over five years, so that on
early death a part of the single premium is returned – reducing from the full
single premium at outset to zero after 60 months.
In addition, the most basic products do not offer a surrender benefit. In some
cases where regular premiums have been paid for a minimum period (eg five
years) a paid-up benefit will be available. This would normally reduce the benefit
amount, without altering the nature of the benefit. However, other alterations
that reduce the benefit payment period or limit the coverage period are possible.
Plans with longer deferred periods, lower rates of escalation, no death or

surrender benefits and limited benefit payment periods are less expensive and
provide an alternative to a reduced benefit amount.

3.3 Unit-linked investment products
Single premium unit-linked long-term care insurance products are a further

alternative. These were developed to recognise that whilst people would
purchase a savings plan they would rather avoid considering the subject of long-
term care. It was also recognised that a product with no surrender or death
benefits was generally unattractive. 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.
In buying a single premium long-term care policy, with no death benefit and no
surrender value, an individual must face the real possibility that the policy will pay no
benefits. By paying a larger sum into an investment fund that is owned by a
discretionary trust some of these undesirable features are avoided. If the insured dies
before receiving any long-term care benefits then the trust beneficiaries can inherit the
proceeds of the trust. However, the insured has a contingent claim on the trust fund if
they need long-term care. This contingent claim allows part or all of the trust fund to be
used to pay for their long-term care costs.
There is often a choice of long-term care insurance claims triggers that afford
different levels of fund protection:
• protecting the entire investment fund (ie both the initial investment from the
single premium and the investment growth)
• protecting the initial investment
• allowing the entire fund to be exhausted.
Prior to the insurance benefit starting, the policyholder would draw down from
his/her own unit fund through regular partial withdrawals. This would cease at
the point the selected insurance protection commences.
The choice of fund protection is equivalent to varying the deferred period.

Where the entire fund is protected then the minimum deferred period would
apply, normally three months, after which the insurance benefit would begin and
then no further withdrawals would need to be made from the unit-fund. Where a
part of the fund is protected the deferred period would vary according to the
difference between the fund value at the point of claim and the fund protection
benefit selected (plus the minimum deferred period). This would be calculated
according to the benefit amount selected.
So in effect the underlying policy always has the same minimum deferred period, but,
depending on the level of the fund and the protection chosen, this period can be
lengthened by making the LTC payments from the investment fund.

For example, suppose a policyholder invested a single premium of £8,000, and selected
a long-term care insurance benefit of £1,000 per month. If the fund at the time of claim
was £24,000, then the deferred period would be either 24 months for fund exhaustion,
or 16 months, where the initial investment was protected (plus the minimum deferred
period in both cases).
The unit-linked investment plan would receive a single premium and thereafter
would be subject to monthly long-term care risk-premium deductions. The risk
charges would cover the risk exposure during that period, which would depend
on the deferred period (which itself could be a function of the current fund value)
and the current age and benefit amount.
The longer the deferred period is, the smaller, all other things being equal, will be the
long-term care risk-premium deductions from the fund.
Question 3.10
A LTCI policy has a minimum deferred period of 26 weeks. The policy is a unit-linked
plan that was secured by a single premium of £10,000 paid at the start of the policy.
The policy provides care benefits of £300 per week. The policy guarantees that the
initial investment will be protected.
The insured is now in need of care. The unit fund has grown to £35,200.
Ignoring interest, what will be the total effective deferred period for the benefits
payable?
Some plans give no guarantee that the single premium would be sufficient to
provide lifetime long-term care protection. As the policyholder ages and the risk
charges increase (accentuated where the benefits also escalate) there may thus
be a concern that without a steady (and often high) level of investment growth,
the fund would implode. Some plans provide additional security by
guaranteeing protection from a fixed age, often 90. (This means that, providing
the fund is positive at age 90, no further risk premiums will be drawn to cover the
long-term care benefits.)
Plans have also sought to extend the guarantee so that the insurer accepts the
risk of fund exhaustion. In this case the investment choice is restricted to a
managed or with-profits fund. These plans move into the middle ground
between a stand-alone and investment based solution.
The complexity of these products will act as a barrier to sales. Most consumers will
need a considerable amount of initial and on-going financial advice if the product is to
meet their needs. This will add to sales costs.

4 Further developments of pre-funded products

To increase the level of consumer demand insurers have sought to introduce
many long-term care insurance benefit variants. Whilst this may have extended
the range of benefits and enhanced the quality of the plans for the consumer, it
may also have led to some confusion about product suitability. Some of the
variants may also prove to be costly for the insurers and reinsurers.
4.1 Guaranteed terms
Long-term care insurers may provide both guaranteed and reviewable product
variants. Guaranteed products might be introduced to recognise the fact that
policyholders who purchase a single premium plan may do so to indemnify
themselves against all future costs. They may be older with fixed pension
incomes, who 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 attaining age 65 or 70. After this age the insurer will not
be able to seek any further premiums or reduce the benefits. Insurers recognise
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.
Question 3.11
Why is the cost of guaranteeing premiums at older ages likely to be less significant?
Other offices may resist providing a full guarantee and may offer limited
guaranteed premium protection of five or ten years. This is complicated for the
consumer to understand and may just defer the point at which the premium will
be increased. This will negate the value of the guarantee.
Offices may offer a guarantee option, on both their regular premium and single
premium products.
The long-term nature of LTCI products and the large variance of the present value of
the cost of claims means that guaranteed premiums will include a substantial
contingency loading. This means that reviewable premiums are often significantly less
than guaranteed premiums, and this may be attractive to those seeking insurance.
Given the continuing uncertainty of the pricing basis, plus the additional
regulatory capital required as a result of the guarantee, the true costs to the
policyholder may be excessive. Furthermore, the policyholder may find that
experience proves to be more favourable, but the guaranteed premium rates
remain fixed.

So if the experience turns out to be better than the (prudent) assumptions in the pricing
basis, reviewable premiums may be reduced, but guaranteed premiums will remain
unchanged.
Given that almost all premiums are based on the policyholder’s age at entry and
on the risk of health deterioration, policyholders may be locked into
unnecessarily higher rates.
It should be noted that full guarantees are not offered in the US or in the UK.
4.2 Cash benefits
A further option is the move from the provision of care, subject to a maximum
monetary limit, to cash benefits. Salespeople are often keen to promote the
flexibility of cash benefits, compared with the more traditional plans where the
benefits were limited to the costs incurred, subject to an upper limit.
However, without this natural claims gatekeeper there is a risk of windfall

benefits, as the insurance may make payments without any financial loss being
incurred and the insurer must be more stringent in assessing claims. In
addition, the family may exploit the receipt of cash benefits and leave the elderly
person with inadequate care.
Question 3.12
(i) What are the advantages and disadvantages to the company of offering a plan
with cash benefits?
(ii) What are the advantages and disadvantages to the insured of having a plan with
cash benefits?
There is a risk here that the disability trigger alone will not be sufficient to
protect the office against the risk of exploitative claims. Insurers will find it
difficult to assess the full impact of any disabilities, in particular for older lives
who will be frail and in need of some assistance. The evaluation of ADLs is not
an exact science and the integrity of the claims process will depend on the
quality of the product design, as well as the underwriting and claims procedures.
We discussed this point at the start of Section 3. It is a particular problem in most LTCI
markets as the product is relatively new and demand is low. So the lack of experience
data makes it difficult to price, underwrite etc.
It should be noted that a small minority of US insurers offer cash benefits.

5 Immediate needs solutions

Immediate needs products have been available in many markets for some time.
They protect individuals needing care from their uncertain survival duration and,
thereby, provide certainty of their capital costs. The insurance provides a
guaranteed lifetime income on payment of a single premium. The premium is
individually calculated based on the health status of the applicant. These
products have also been extended from the provision of costs in a care home to
financing domiciliary care.
Question 3.13
Why is poor health bad news (in terms of the cost of a plan) for pre-funded plans but
good news for immediate needs plans?
Unlike pre-funded plans, these have immediacy of need. For the consumer the
insurance premium may help to determine the most appropriate nursing home.
Some plans sought to immunise the policyholder from future care cost
escalation by pre-agreeing benefit escalation rates with a specified list of
nursing homes. However, these were agreements between the policyholder and
care home and the life office needed to ensure that they were not responsible for
the quality of care, or the failure to honour the agreement.
Question 3.14
Are the immediate needs products described in this section indemnity products?
The benefit amount could be level or escalate, either at a fixed rate, often 5%, or
linked to an inflation index, plus perhaps 2%. As this is primarily a people
industry, costs should rise in line with average earnings over the long term.
Question 3.15
Explain the last sentence of Core Reading.
The policyholder can also select a death benefit. This could be structured as:
• a minimum payment period
• by amortising the single premium
• by providing capital protection of part of the single premium (part of the
premium paid will be returned on death).

The higher the level of death benefit selected, the less impact the policyholder’s
health status will have on the premium.
Question 3.16
A single premium immediate needs LTCI policy provides fixed cash benefits and a
return on death of the single premium paid less the cash benefits received.
Explain how the risks associated with the care benefits and the death benefit interact.
Using your explanation, justify the statement that the insured’s health status at the date
of issue of the policy is less important for policies with a large death benefit.
Immediate needs plans have often been considered to be equivalent to impaired

annuities. However, the product structure may be very different. The range of
structures have included pure endowments, purchased life annuities and
disability covers. In constructing the plan, consideration should be given to the
policyholders’ and life office’s tax positions, regulatory capital and benefits
flexibility.
The insured needs a continuing benefit on survival. A life annuity provides a survival
benefit as would a series of pure endowment policies. A policy that provided a regular
income only during periods of disability (a similar product to IP but with the qualifying
events defined differently) would meet an insured’s needs by providing an income when
necessary and not providing an income during periods when the insured was able to live
independently. (However such periods of recovery are rare in the case of those who
need long-term care.) The challenge to the actuary is to design a product which meets
these needs, but which at the same time provides the cheapest solution for the insured
by taking maximum advantage of tax reliefs and ensuring that expensive capital backing
requirements are kept to a minimum.
Question 3.17
Explain how, all other things being equal, a product design that leads to the smallest
possible capital requirement will provide the cheapest solution for the insured.

Example
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.
(i) Describe and quantify the risk faced by Alice.
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
• normal mortality follows ELT15
• the appropriate interest rate to use is 5% pa effective.
(ii) Using the information given, suggest an immediate needs solution to the risk
faced by Alice. Justify your suggestion.
Solution
(i) Risks faced by Alice
Alice has an immediate need to meet residual care costs of £18,000 pa. Her only
resource is capital of £75,000. Invested at 5% this capital might produce an annual
income of £3,750 pa, far short of her expected annual care costs. If she uses her capital
to fund her care costs she runs the risk of living too long, so that her capital is
exhausted.
Solving the equation:
18, 000an 5% = 75, 000
suggests her capital will run out in about 4.75 years.

Using ELT15 (Females) mortality as normal mortality we have:
Age, x qx loading qx¢ px¢

78 0.048 0.35 0.398 0.602
79 0.054 0.10 0.154 0.846
80 0.060 0.10 0.160 0.840
81 0.066 0.10 0.166 0.834
82 0.072 0.10 0.172 0.828
So there is a probability of about 0.3 that Alice will live for 5 years or more.
(ii) Immediate needs solution
We can do some rough calculations to determine the cost of an impaired life annuity.
Duration t ¢ +t
p78 t ¢
p78 t
v5% t
t
¢ v5%
p78
0 0.602 1.000 1.000 1.000
1 0.846 0.602 0.952 0.573
2 0.840 0.509 0.907 0.462
3 0.834 0.428 0.863 0.369
4 0.828 0.357 0.822 0.293
5 0.821 0.295 0.784 0.231
6 0.812 0.243 0.746 0.181
7 0.803 0.197 0.711 0.140
8 0.792 0.158 0.677 0.107
9 0.781 0.125 0.645 0.081
10 0.771 0.098 0.614 0.060
11 0.759 0.075 0.585 0.044
12 0.744 0.057 0.557 0.032
13 0.730 0.043 0.530 0.022
14 0.714 0.031 0.505 0.016
15 0.022 0.481 0.011
¢ @ 3.75 say. The insurer will need to allow for expenses and profits (say a
So a78
loading of 10%). So the net purchase price of the impaired life annuity might be such
that a lump sum of £10,000 buys an annuity of £2,425 pa. A capital sum of £75,000
would buy an immediate impaired life annuity of about £18,200 pa.
This removes the “risk of living too long” from Alice’s life and provides a solution to
paying for her care costs.

Chapter 3 Summary
What is long-term care?
Long-term care might be defined as including all forms of continuing personal or

nursing care and associated domestic services, for elderly people who are unable to look
after themselves without some degree of support. This may be provided in their own
homes, at a day centre, or in a State-sponsored or care home setting. It is about care for
those whose health is not expected to improve.
The provision of long-term care
The costs of care can be divided between living costs, housing costs and the cost of
personal care. We are concerned with the additional costs that result from deteriorating
health, not with the total costs. These additional costs will include a small component
of living costs, a slightly larger component of housing costs with the largest proportion
of additional costs being for personal care.
This care can be provided formally or informally. The supply of informal care comes
mainly from the extended family.
Formal care can be provided in a person’s own home or in a community setting in a

residential home, retirement community or a similar arrangement. Formal care involves
payment. The required payments are usually much greater than a person’s current
income.
While some people will not require any formal care during their lifetime, a small but
significant proportion of the population will require skilled care over an extended period
of time, resulting in substantial costs. This structure presents an opportunity for
insurance solutions.
Insurance solutions
Insurance solutions can be divided into two types:

• those that involve the payment of a single premium at the outset or regular
premiums during the period when no care is required, and benefit payments for
the care needed after this
• those for which a single premium is paid and care is funded immediately.
These are termed pre-funded plans and immediate needs plans respectively.

Pre-funded protection plans
Pre-funded plans require a trigger for the payment of benefits. This trigger is usually
defined as not being able to undertake a specified number of activities of daily living
(ADLs) with an overriding trigger of severe mental impairment.
Benefits can be the provision of care on an indemnity basis, the provision of care on an
indemnity basis subject to maximum cash payments in a given period, or fixed cash
amounts specified in the policy. Only the first of these is a true indemnity contract.
LTCI can be provided as a rider benefit added to another policy, eg a CI policy.
The costs of a plan can be controlled by the use of a deferred period before benefits are
paid or, in some markets, by limiting benefit payments to a maximum period.
Pensions solutions
LTC benefits can be provided by augmenting a pension. Increases would be subject to

an age or an impairment trigger. This can be pre-funded by using part of the lump sum
from an occupational pension at the date of retirement, or by paying a premium out of
the regular pension annuity.
Pre-funded unit-linked investment plans
An alternative is a unit-linked investment product rather than a pure protection product.

An investment plan allows some or all of the investment to remain part of the insured’s
estate on death. Such plans are often more attractive than protection plans, where all the
premiums paid are lost on the insured’s death.
Guaranteed vs reviewable premiums
The regular premiums on LTCI products can be either guaranteed or reviewable. The
substantial contingency loading included in guaranteed premiums means that they are
often significantly higher than reviewable premiums.
Policyholders are often on fixed retirement incomes, which are not compatible with
fully reviewable premiums. This makes it difficult for insurers to design products that
meet policyholders’ needs.

Immediate needs LTCI
Immediate needs plans have often been considered to be equivalent to impaired

annuities. However, the product structure may be very different.
To allay annuitants’ fears the contract often includes the return of part of the purchase
price on death. Most immediate needs solutions provide cash benefits. They are not
indemnity contracts. However, it would be possible to design a product providing
indemnity benefits.


Chapter 3 Solutions
Solution 3.1
Close relatives provide most of the informal care.
For couples, the more able person often provides this care and sometimes care is
provided by a brother, sister or cousin. This means that the care is often being provided
by someone of a similar age to the person needing care, who will usually be 60+.
A single surviving parent is often cared for by a son, a daughter or their immediate
family. So care is provided by the next generation after those requiring care.
Generations are separated by about 30 years. Those being cared for will be in their 80s
and 90s, so a large proportion of these carers will also be 60+.
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 responsibilities, and so only be willing to offer a few
hours of care each week.
Solution 3.2
An adequate supply of informal care will, all other things being equal, reduce the
demand for formal care.
If there were a decrease in the supply of informal care, the demand for formal care
would increase. At least in the short term, this will push up formal-care prices. The
increased prices might attract new entrants to the formal care market, and encourage
innovation in the provision of formal care. This increased supply and efficiency would
act to mitigate the short-term surge in prices.

Solution 3.3
This question is designed to encourage you to think about the role LTCI plays in
managing the long-term care risk. You will probably not have thought of all the issues
mentioned in the solution, and you may well have thought of issues that are not
mentioned in the solution. However, if you come away with a clearer idea of why
consumers might want to buy long-term care insurance, and why LTCI presents
particular problems for insurance companies, we will have achieved our aim.
For the purposes of the solution we have assumed that you are in your 20s.
(i) The risks you face
You first need to assess how likely it is that you will be alive at each age after, say, the
age at which you plan to retire, and that you will be unable to look after your day-to-day
needs on your own.
Living to a ripe old age and a pre-disposition to some debilitating conditions run in
families. So you might make an initial estimate of these probabilities by observing the
experiences of your near relatives.
Mortality has tended to improve by between 1% and 2% each year except at very old
ages. So you might use this and your own assessment of future mortality improvements
to assess your chance of survival.
Medical advances in the last 40 years mean that illnesses that presented severe
difficulties for your grandparents are now curable. So by the time you reach old age,
some medical conditions (eg respiratory difficulties) may be completely cured (eg by
surgical intervention or their effects mitigated by simple medications). There may be
technological advances that, for example, make washing and bathing a straightforward
process even for those with limited movement.
You will need to assess which illnesses and conditions are likely to prevent you looking
after yourself in 40 years’ time. Of course some of these illnesses may not yet have
appeared!
If you could answer all these questions you would have an assessment of the risks you
face.

(ii) Risk management
You now have to assess how you will be able to manage these risks.
You will need to consider who might provide care for you. How likely is it that your
family or others would provide (free) informal care for you?
Of course in the next 40 years patterns of working may change markedly. One view
might be that we will all stop work much earlier and enjoy a long retirement. Another
view is that we will continue to work but perhaps in a different job and for fewer hours
each week, to much older ages than we do at the moment. This might influence your
view of how wealthy you will be in retirement, and so to what extent you may be able to
pay others to care for you.
Consider how much would you have to pay for care, if you needed it.
It may be that the State will provide free or subsidised support services. But consider
what criteria you will need to fulfil to be eligible to receive State care and whether the
care offered by the State satisfy your needs in terms of amount and quality. Perhaps
you will be able to afford to pay for private care out of your normal income.
Your difficulty is to assess exactly what risks you will be unable to manage and, if
necessary, be able to pay for personally.
There will be some risks left over, that you do not think you will be able to manage by
using informal care or by buying care from your own resources. These risks might be
managed by buying insurance.
(iii) Role for insurance
Insurance could help by providing the services you think you will need but may not be
able to provide yourself, or by providing sufficient cash to purchase them.
There are so many unknowns that you may conclude that an insurance company is in a
position to design a policy that would cover the (very unpredictable) risks that you face.
Perhaps the best solution is for you, when you are young, to save on a regular basis and
in a flexible way, so that your savings could be used for the long-term care risk or any
other risk that you face.
Then as old age comes closer, the residual long-term care risks will become clearer and
it may well be possible to find an insurance policy that transfers these residual risks
from you to an insurance company, eg a pre-funded LTCI plan.

Alternatively, you could leave it until you were in severe ill health and needing lots of
care assistance. Then you could use your savings to buy an immediate needs LTCI plan
that would pay you an income for the remainder of your life. You could then use this
income to pay for your care.
Solution 3.4
There may be no link between the levels of income protection and the long-term care
benefits required. The level of income protection benefit depends on earnings, but the
level of long-term care benefit depends on the difference between the cost of care and
the amount the insured can afford to pay towards care costs.
This, and the fact that the IP protection benefits and the LTC benefits do not overlap,
means that the policy with a rider would resemble two policies packaged together rather
than an integrated product. There would be some saving in expenses, but few other
savings. The combined policy would not be much cheaper than buying two separate
policies.
LTCI has a good overlap with CI insurance, because many critical illnesses in old age
would generate the need for long-term care.
LTCI and PMI complement one another. The LTC benefits are similar to PMI benefits,
but relate to the provision of care for a condition rather than the provision of medical
treatment.
LTCI and whole of life insurance have a good overlap because LTC benefits can be
viewed as accelerated death benefits.
The IP+LTCI plan consists of two benefits that independently have proved to be of little
interest to consumers (compared to CI policies). So it is unlikely to generate a large
market. Adding LTCI (a product of little consumer interest) to CI or life insurance
(products with a lot of consumer interest) is likely to be more successful.

Solution 3.5
The insured is using an asset, the equity (ie the value of the property less any charges
secured against it) in their home to “pay” for the LTCI policy. When the property is
eventually sold (usually when the insured dies), the insurance company will be first in
line to receive the repayment of its loan from the proceeds of the sale. The charge
entered on the property register ensures that the insurance company has this right.
The insurance company will not actually receive the money until the property is sold.
The amount of the insurance company’s right to the property may therefore by
increased during the period to allow for this delay.
Solution 3.6
The expected premium payment term is the time from the date of purchase of the policy
until the date the benefits are payable.
If the policy is taken out at an older age, this will reduce the premium payment term, all
other things being equal, and reduce the amount of interest earned on the premiums.
If either or both lives are in poor health, this makes it more likely that claims will be
made and that benefits will be claimed earlier. These effects will increase the value of
benefits but reduce the premium payment term. There will also be less investment
return earned on the premiums.
Therefore in both of the above cases, premiums must be increased to ensure these are
adequate to meet expected benefits.
However, the overall effect in the second case (poor health), will depend on how the
person’s condition affects his/her overall expectation of life. If poor health is expected
to shorten life expectancy, this will reduce the value of benefits payable and so partly or
completely offset the increase mentioned above.

Solution 3.7
Advantages
If benefits are available on a sliding scale beginning when there is only modest
impairment (ie one ADL failed) then care is provided at an early stage. Provision at this
early stage may slow down the rate of deterioration of the insured’s health, thus
providing a better quality of life with a reduced overall cost of care during their future
lifetime.
The benefits may be a better match for many customers’ needs. If the product is more
likely to match need then it is more likely to sell well.
Customers may see the product as better value, as it seems more likely that they will
receive some benefits.
If this feature is novel, it may attract more interest from intermediaries.
Disadvantages
Set against this benefit must be the increased administrative costs for the insurer. If
premiums are waived when benefits are payable, then this may increase the cost of
premium waiver.
Pricing will be more difficult.
The design is more complex. This means more detailed sales literature is required and
more effort is required by intermediaries to explain the product to clients.

Solution 3.8
(i) Purpose
Length of deferred period
At the beginning of a period of illness that requires care, the insured 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 insured has no need for cover.
The period during which the insured has no need for cover will vary between
individuals, and so having a choice of deferred periods will enable the policyholder to
select the cover that suits their particular needs.
The deferred period also provides a period of adjustment so that the insured 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, having had time to weigh
up all the options available to them.
Benefit escalation
Care is largely a people-based function and so care costs are likely to rise with wage
inflation. As a person becomes older it is likely that they will need additional or
extended care. This will increase the overall costs of care.
Both these effects mean that benefits that increase in payment are more likely to match
the risks faced by the insured.
Length of payment period
In some countries the State offers to provide free care provided an individual funds the
first few years of care. So a policy with a limited care period would provide a
complement to State provision and thus appeal to a prospective policyholder.
(ii) Effect on premium levels
Length of deferred period
The longer is the deferred period the lower the premium will be, all other things being
equal.

Benefit escalation
The higher is the rate of escalation of benefits, the higher the premium will be, all other
things being equal.
Length of payment period
While the probability of a long period of benefit payment is small, the size of the
eventual claim payment will be very large. The result is that the expected costs of long-
term claims will be substantial. Having a limited benefit payment period could reduce
the premium substantially.
Solution 3.9
The risk is that the policyholder will buy a policy with the intention of making a
fraudulent claim or profiting from a real claim. This is a particular risk when the policy
provides cash rather than indemnity benefits.
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.
So financial underwriting must try to detect any attempt to over-insure. The level of
benefits chosen should be no greater than the current costs of care.
Solution 3.10
The initial investment is protected, so £35, 200 - £10, 000 = £25, 200 is available to pay
benefits.
25, 200
This amount will provide benefits for = 84 weeks. So the effective deferred
300
period will 84 + 26 = 110 weeks.

Solution 3.11
Only a proportion of policyholders will survive to older ages, and so the expected losses
from charging a guaranteed premium that is too low will decrease as the age at which
the guarantee applies increases.
Similarly a small increase in premiums at advanced ages will only have a small impact
on the total expected premium income for the policy.
Most policies will be sold with a premium waiver for when benefits are being paid. At
older ages many policyholders will either be receiving benefits or may expect to be
receiving benefits very soon, and so a premium review would generate little additional
income.
Solution 3.12
(i) Company
Advantages
For LTCI with indemnity benefits, both the number of claims and the amount of each
claim will need to be modelled in order to estimate the expected claims costs.
The amount of each claim is difficult to model because of the difficulties of estimating
benefit inflation. This is compounded by the difficulty of estimating the costs of new
treatments that may be introduced as the result of medical advances.
Fixed cash amounts avoid the problem of estimating the amount of each claim.
Because there is less uncertainty about the expected claim costs, the contingency
loadings in premiums for policies with cash benefits will be smaller, resulting in lower
premiums. So policies with cash benefits may be more attractive to policyholders.
When the policy provides cash benefits, the company will not need to organise contracts
with providers to deliver care. This will save money. But market pressures may force
the company to help and advise claimants on buying appropriate care with their cash
benefits.

Disadvantages
However, cash benefits may introduce problems. In particular the policyholder may
believe, or be led to believe, that the policy cover is “comprehensive”, but then find that
when a claim is made the cash is insufficient to buy adequate care. The policyholder
may complain that the person who sold them the policy misled them. Complaints of
this nature may lead to the company having to pay claims that were not allowed for in
the premium basis, or having to pay compensation for “mis-selling”. There would also
be a threat to the company’s reputation as a trusted insurer.
(ii) Insured
Advantages
The major advantage is the choice that cash presents. It allows the insured to choose
both the type of care and the provider. So if the insured has access to informal care they
could use the cash to compensate these carers, as well as buying additional care in the
usual way. They could spend their cash on unconventional “treatments” (eg a holiday),
that are unlikely to appear on a list of insured benefits.
Premiums will be lower than for policies with indemnity benefits.
Disadvantages
The major disadvantage is that the amount of cash may be inadequate to buy all the care
that is needed. This may be because of the nature of the claimant’s condition or because
costs have escalated since the sum assured was chosen at the outset of the policy.
The claimant will probably be inexperienced in buying care and unaware of the
alternatives available. Their health may also prevent them from devoting the required
time and attention needed to find and buy adequate care. As a result, the care obtained
may turn out to be inadequate or inappropriate.
Solution 3.13
Pre-funded plans
We have already seen in Solution 3.6 the effect that poor health can have on the
premiums for pre-funded plans.

Immediate needs plans
These plans are funded by a single premium so ill health will not shorten the expected
premium-paying period.
Poor health means a shorter expected annuity payment period. Therefore, for a given
single premium, the worse a proposer’s current health is, the higher will be the amount
of the immediate needs annuity payment.
Solution 3.14
No. The benefits promised are cash amounts; there is no promise to provide goods and
services to restore the insured to their state before the insured event occurred.
Solution 3.15
The provision of care is a “people industry” in that the majority of care is provided by
people – for example in washing, preparing food and feeding. The nature of personal
care is that it is one on one, and there are very few opportunities to use machines in
these tasks.
Therefore the majority of care costs are from wages, followed by the costs of providing
and maintaining buildings. So care costs are likely to increase at a rate close to wage
inflation.
Solution 3.16
The benefits from the impaired-life annuity are like a series of pure endowments. The
benefit on death is like a decreasing whole of life insurance.
The net single premium in each case is the expected cost of the benefits.
For a given annuity payment, poor health will reduce the expected value of the benefits
and decrease the purchase price of the annuity.
But poor health will increase the single premium for the whole of life assurance,
because it increases the expected value of the benefits.
These two effects on the single premium act in opposite directions, so the net change in
the single premium will be much smaller than the change in the purchase price of the
impaired life annuity with no return of premiums on death.

Similarly, better health will increase the purchase price of the annuity, but decrease the
single premium for the whole of life assurance, and so the overall effect will be smaller.
So the single premium for a policy with a substantial benefit on death will only change
by small amounts for a wide range of changes in the proposer’s state of health.
Solution 3.17
By “capital requirement” we mean the amount of shareholders’ funds that need to be set
aside in order to provide reserves during the term of the policy.
The capital requirement will not alter the level of profit from the product, but it will
alter the value of the profit by delaying its emergence. So to achieve the required value
of profit, the premium will have to be higher.
So a lower capital requirement will mean that the required profit criterion can be
achieved with lower premiums.

ST1-04: Health and care insurance products – PMI and related products Page 1
Chapter 4
Private medical insurance and related products
Syllabus objective

– Income Protection.
– Critical Illness.
– Long-term Care Insurance.
– Private Medical Insurance.
– Major Medical Expenses.
– Hospital Cash.
Private medical insurance, major medical expenses and hospital cash are
covered in this chapter.
0 Introduction
This chapter and the previous three cover the basic contract types of income
Chapter 1 described IP policies and some associated accident and sickness policies,
Chapter 2 described CI insurance and Chapter 3 described LTCI. This chapter

Page 2 ST1-04: Health and care insurance products – PMI and related products
the key issues before studying the remainder of this chapter, which is about PMI and
related policies.

1 Private medical insurance
1.1 Definitions and types of cover
PMI, whether individual or group, is usually an indemnity-based product that

seeks to provide compensation for the cost of private medical treatment. It
concentrates on acute types of treatments rather than chronic or incurable
conditions (these latter are viewed as the province of the local State healthcare
system).
Individual PMI is a short-term insurance contract, usually renewable annually. At each

renewal, the insurer can change the terms and conditions of the policy. Premiums are
usually calculated to provide cover over the year, and so these will normally change
each year too – for example, due to the increasing age of the persons covered.
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. In this case, there would be some penalty in terms of loss of
premium discount for claiming, although the scales in operation tend to involve steps of
the order of only 10% to 15%.
As these are short-term policies, cover is not guaranteed from one year to the next.
However, in practice, so long as the conditions of the policy are met, eg the
policyholder keeps paying the premiums, the insurer would not cancel policies on an
individual basis – but it might decide to cease renewal of all the policies of a product.
1.2 A UK model
The following table lists benefits of a typical comprehensive PMI product

available in many markets, which follow a UK model, at the current time. The
student should note the essential features of the coverage but not the details of
the amounts nor the limits.

Typical Benefits of a Comprehensive Medical Plan

A. Hospital Costs
1. Accommodation, nursing care, operating theatre, diagnostic Full Cover
procedures, surgical dressings and drugs for in-patient treatment
2. Specialist consultations and physiotherapy received as an in- Full Cover
patient
3. Accommodation, nursing care, operating theatre, diagnostic Full Cover
procedures, surgical dressings and drugs for day care operation
not involving an overnight stay.
4. Accommodation for one parent to stay in hospital with an insured Full Cover
dependent under 12 years old.
B. Specialist Fees
1. Surgeons' and anaesthetists' fees for in-patient and day care Full Cover
operations
2. Physicians' fees for in-patient treatment Full Cover
3. Out-patient treatment:
i) Specialist consultations Full cover
ii) Diagnostic procedures such as radiology and pathology Full cover
iii) Physiotherapy Up to £500 per policy
year
4. Radiotherapy, chemotherapy and scanning Full cover
C. Other Features
1. Private Ambulance £150 per policy year
2. Recuperative care, to include nursing and domestic services, Up to 3 hours care
immediately following in-patient surgical treatment covered by per day for a
the product and where the stay in hospital was for a maximum of 7 days
minimum period of 7 nights.
3. Maximum overall limit. None
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 and so forth would be covered, but
ancillaries such as newspapers, telephone calls or visitors' meals would not be
insured.
The following is a guide to what a standard policy might, and might not, include
within its contract conditions:
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, HIV/AIDS,
normal pregnancy, cosmetic surgery, gender reassignment (also known as sex
change), preventative treatment, kidney dialysis, mobility aids, experimental
treatment, experimental drugs, organ treatment, war risks, injuries arising from
dangerous hobbies (often called hazardous pursuits).
Many policies now cover types of treatment such as homeopathy and

acupuncture.
Question 4.1
(i) Why do policies restrict cover to the treatment of acute conditions?
(ii) How could an insurer distinguish between an acute and a chronic condition?
The above is only an example of a typical benefit structure common in the UK domestic
market. Other structures exist in other territories, including those provided by insurers
in a country for residents in that country living abroad (ie ex-pats).

2 Related PMI products

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 so as to increase penetration.
The standard product as outlined above will have most attraction in the higher
socio-economic groups and thus cheaper options may be made available to
widen distribution. Simple examples of this are products 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 (eg 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.
In many cases, these products would have different names to enhance

marketability, although the change from the original comprehensive product was
in one discrete area only.
Other cheaper options include the following broad types of product:
2.1 Major medical expenses (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 disadvantage; 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.
For example, Major medical expenses (MME) has existed in the UK as both:
● a short-term annually renewable product
● a long-term product, albeit with reviewable premiums.
Question 4.2
What are the main differences between the benefits available under the MME policy
described here those available under a CI policy?
It is to be noted that in the USA, the term “major medical expenses” is more akin
to the UK “private medical insurance”.
Question 4.3
A recent innovation is a policy that provides partial protection for people deciding
against comprehensive private medical insurance and ready to pay a share of private
treatment costs themselves. Premiums are significantly lower than for conventional
medical insurance. Policyholders handle arrangements with the hospital, negotiate fees
and pay for treatment themselves. They are reimbursed a percentage of fees by cheque
within seven days. There is a choice of three percentage levels of reimbursement: 30%,
50% or 75%.
Out-patient tests and consultations prior to treatment are not covered. Follow-up
out-patient consultations and treatment are covered for 90 days after leaving hospital.
The monthly premiums at age 50 are:
Level of benefit Monthly premium

30% reimbursement £7
(i) Describe the features of this policy that you think are attractive to the insurer.
Explain your answers.
(ii) What are the advantages and disadvantages of this policy for the policyholder?

2.2 Waiting list plans
Another approach to cover limitation in order 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 the policyholder can find free public healthcare for his or her
condition in that period and within a reasonable radius of 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.
2.3 Excess plans
A third approach to engender wider appeal is based on the assumption that the
insured person is probably happy to meet lesser expenses out of his or her own
pocket, 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 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.
A further advantage to the insurer is the likelihood that there is an incentive for
the patient to seek his treatment in the public system to avoid the payment of the
excess, unless the benefits and severity of the procedure offsets this outlay.
Companies may market a range of such products allowing the applicant to
choose the level of excess to suit his income levels.

Question 4.4
A major health insurer offers a high excess PMI policy with low premiums, by applying
one of three mandatory excess levels: £2,000, £3,000 or £5,000. The excess amount
applies to each claim. Above the excess amounts the policy provides comprehensive
cover. It also provides a treatment information service to assist the insured in choosing
and booking treatment that they pay for themselves.
The monthly premiums for a life aged 50 are:
Excess level Monthly premium

£2,000 £40
£3,000 £25
£5,000 £17
A prospective policyholder has noticed that increasing the excess from £2,000 to £3,000
saves a monthly premium of £15 (£10 per £1,000 of excess) but increasing the excess
from £3,000 to £5,000 only saves a monthly premium of £8 (£4 per £1,000 of excess).
Provide an explanation for this pattern of premiums.
2.4 Hospital cash plans
Cash Plans are a defined-benefit defined-premium insurance product. For

premiums as low as €2 or $2 per week, the subscriber and family are entitled to a
range of specific pay-outs dependent on certain healthcare related events.
These include:
● dental
● optical
● physiotherapy
● maternity
● hospitalisation
● recuperation
● hearing aids
● consultation.

Schedules of benefits are bought in “units” with equivalent levels of contribution

increase. The purpose of the arrangement is cash in hand as opposed to
reimbursement, thus reducing anti-selection; limits may apply to ensure that the
payout is no more than say 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 before benefit eligibility. Pre-existing conditions may also
impact on ability to claim.
Question 4.5
(i) Explain why it is not feasible to undertake full underwriting on cash plans.
(ii) Describe each of the following conditions and explain their purpose:
(a) a waiting period before a policyholder becomes eligible for benefits
(b) a moratorium on claims related to pre-existing conditions.
As mentioned above, six months is a common waiting period for most benefits.
However, there is normally no waiting period on claims resulting from accidents. For
obvious reasons, the waiting period for payouts on the birth of a child is usually at least
nine months!
Individual rating is the most common form of rating in personal insurance. At the
underwriting stage we collect information about the insured individual, such as their
age, sex and state of health. We then use this individual-level information to determine
the premium rate that the individual will pay.
A community-rating system does not use individual information. It will only use group-
or community-level information, such as where a person lives or their occupation. All
those individuals that belong to a group, having the same values of these community-
rating factors, will be charged the same premium. In effect no individual proposer that
meets the eligibility conditions will be refused insurance, because there is no
underwriting at the individual level.
The common premium charged may increase from year to year as a result of increases
in claims costs. Sometimes, even community-level information will be ignored and the
same premium will be charged to everyone choosing a particular level of benefits.
The product’s profitability is dependent, inter alia, on long-term policyholder

loyalty, on cost-efficient claims admission procedures and on volumes in force.

Question 4.6
Explain why long-term policyholder loyalty and a large volume of in-force policies help
to ensure the success of a portfolio of cash plan policies.
Question 4.7
(i) Explain how community rating could lead to cross subsidy between
policyholders.
(ii) Cross subsidy usually provides an opportunity for policyholders to select against
the insurer. Explain how this might happen.
(iii) In some countries (eg Ireland) a system of lifetime community rating has been
proposed for PMI. This system allows insurers to charge premiums that vary by
age at entry, but which do not change after entry provided the policy is renewed
each year.
Explain how a lifetime community-rating system avoids some of the pitfalls of a

community-rating system.
2.5 Dental plans
While some comprehensive PMI policies include dental insurance, this cover is
obtainable separately. Insurers 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 pound for pound 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 that expected. The insurer will deal with the administration of the
arrangement, but will often only cover the cost of accident and emergency 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 experience risk. This can be on a full
indemnity basis, but often limits, excesses or coinsurance will apply.
2.6 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 Cash Plans or some PMI products, but
may be purchased on a stand-alone basis.
Question 4.8
The following is a possible structure for the benefits under a dental or optical plan.
For all eligible claims you (the insured) agree to pay 25% up to your maximum annual
limit of £500 and we (the insurer) will pay the remaining 75%. Once you have reached
your maximum annual limit, we will pay 100% of your claims until the start of the next
policy year.
State the advantages and disadvantages of this arrangement for the insured and the
insurer compared with a plan that has a fixed excess level per claim.

3 Group business
Group business is defined as any collection of individuals who combine to make
a single proposal for uniform insurance cover. Usually the collected individuals
will be employees in the same company and the employer will pay for the
premiums either wholly or in part. Generally the group will be a discrete
definable unit of individuals and the insurer will look for some minimum take-up
rates of the terms offered, if the scheme is voluntary, in order to limit
anti-selection.
3.1 Group pricing
This section provides a brief introduction to the pricing of group products. Group
pricing will be covered in more detail in Chapter 16.
Individual policy premiums are generally higher than group premiums as the risk
of anti-selection against the insurer is higher when an individual is financing his
own premium.
Expenses also tend to be lower on group policies due to less underwriting and
economies of scale.
Some form of experience rating is usually incorporated in group pricing,

whereas individual business is normally priced on a community rate basis (ie the
premium is assessed with all other lives in the same risk cell without reference
to individual claims experience).
Note that community rating here, in the context of comparing it with experience rating,
has a different meaning from that used when we discussed cash plans in Section 2.4.
Here we are simply referring to premiums being calculated irrespective of the particular
insured’s claims history, and other individual rating factors, such as age, are likely to be
used. (Both definitions of community rating are given in the Glossary.)
For an experience-rated group policy, the premium charged will be a weighted average
of the insurer’s “book” premium for the scheme (which is based on the experience of all
of the insurer’s group policies for the rating factors involved), and a premium based on
the actual claims experience of the particular group. This is explained in more detail in
Chapter 16.
The larger the group size, the greater the credibility that is placed on the group’s
own experience.
So in the extreme, for a very large group, the group premium will depend entirely on the
group’s claims experience. In this case the group’s experience is said to be 100%
credible. (This would be self insurance as discussed before.)

No claim discounts (NCDs) are sometimes used for individual and group
business in order to make some allowance for individual claims experience in
the premium rates.
NCD is a form of experience rating where adjustment (usually a discount) is applied to

future premiums. The level of discount depends in some way on the number of claims
made (or on the time expired since last making a claim). This is similar to the NCD
scales that are used for motor insurance premiums in many countries. For small groups,
often a low claims discount (LCD) is applied. This is similar to NCD, but the premium
discount is based on the total amount of claims rather than the number.
The rationale behind NCD or LCD is that a group or individual that has had good
claims experience in the past is less likely to claim in the future and therefore can be
charged lower premiums.
Additional rating factors are considered when pricing group business

(eg industry, location, size of group, employer’s attitude to his employees’
health).
Larger groups (more than 50 employees) are often flat rated according to benefit
class, whereas individual business is almost always age rated.
So for smaller groups, some individual rating factors (eg age) will be used in addition to
the group rating factors and the group’s experience.
Large groups frequently self-insure up to a point (eg 125% of expected claims

cost), and purchase administration and stop-loss insurance from the insurer.
So the policyholder (ie the employer) meets all claims during the year until, in this
example, they exceed 125% of the expected annual claims cost: after this the insurer
meets all the claims. The insurer looks after the administration for all claims.
The situation could be summarised, using the UK market as an example, as follows:
Individual business Individually priced (ie using rating factors such as age,
etc). May have NCD.
Small groups Premiums based on group rating factors and ages of
individuals; NCD or LCD often applies.
Medium groups Flat-rated premiums based on group rating factors, and
experience-rating using credibility factors.
Large groups Self insure, usually with stop-loss cover and admin from
insurer.

The above table only gives an indication of the size of group most likely to purchase a
certain arrangement. In practice there can be much overlap – for example, a relatively
small scheme may self-insure.
3.2 Group product design
Benefits and exclusions are generally similar between group and individual
products, although pre-existing conditions are more likely to be covered under
group business due to the lower degree of anti-selection likely to be
encountered.
Question 4.9
Explain why we would expect a lower degree of anti-selection on group business, and
why this means that insurers are more likely to cover pre-existing conditions in group
schemes.
There is often greater scope for customising benefits for larger groups to meet
their requirements.
For example, rather than purchasing a “ready-made” product the group may:
● choose specific levels of excess or limits
● choose certain benefits not available on standard PMI products (eg dental cover
or prescription fees)
● exclude certain benefits it may not require (eg psychiatric treatment, certain
complementary treatments).
Question 4.10
The insurer may find it difficult to quantify the effect on the expected claims experience
of changing the benefits from its standard products, eg due to lack of experience.
Despite this, why would the insurer normally be happy to meet the larger group’s needs
for a “tailor-made” product.

3.3 Group product distribution
Individual and small group business is distributed through a wide range of

channels (eg direct marketing, direct sales, IFAs, bancassurance, specialist
medical insurance intermediaries).
Large group business is mainly distributed through intermediaries and is often

“broked” on an annual basis.
The product distribution channels are covered in more detail in Chapter 7.

Chapter 4 Summary
Cover
Private medical insurance (PMI), whether individual or group, is usually an

indemnity-based product that seeks to provide compensation for the cost of private
medical treatment. It provides cover for care and treatment for acute rather than chronic
(incurable) conditions. Usually the insurer pays the insured’s treatment provider
directly.
A policy may typically cover in-patient treatment (acute conditions), hospital

accommodation and nursing. It may include out-patient treatment (including tests and
consultations), day-care treatment, nursing at home, and cash benefits whilst in a
State-funded hospital.
In addition to excluding treatment for chronic conditions, policies will typically exclude
treatment for pre-existing conditions, cosmetic treatment and accident and emergency
treatment.
Premiums
The policy is short-term and usually a one-year renewable contract. Individual

policyholders usually find that their premiums increase at each renewal with increasing
age and due to inflation in the cost of treatments. Some policies have premiums that are
based on age at entry.
Most insurers do not penalise individual policyholders unduly for a poor claims record,
but some operate NCD systems to reflect claims experience in premiums.
Product design
In any market, policies should be designed to complement any health services provided
by the State. In some cases this means providing an alternative to treatment in the State
scheme (eg in a hospital chosen by the insured, at a time chosen by the insured), rather
than providing treatments that are not offered by the State health services.
The overriding criterion is that the policy should offer cover that prospective insureds
would like to buy, for whatever reason, at a “value for money” price.

In order to reduce premiums, there are policies:

● that only provide fixed cash sums for specified in-patient surgical procedures
(MME)
● with a very high excess on each claim
● that will only admit a claim if the required treatment is only available from the
State health service following a long wait (waiting list plans)
● restrict cover to choice of treatment provider (eg to preferred hospitals)
● restrict the availability of out-patient treatment (eg to conditions related to
in-patient treatment only)
Hospital cash plans
These are policies that provide cash benefits designed to meet the unexpected costs of
hospitalisation and healthcare-related events (eg physiotherapy, hearing aids, dental
treatment and opticians’ services). These policies have relatively small benefits and
premiums, and so their success depends on large volumes, high renewal rates and low
cost administration. This means that there is little or no direct underwriting, and
selection against the office must be controlled by the policy conditions (eg waiting
period and moratorium on pre-existing conditions).
Dental and optical plans
These benefits can be part of PMI or cash plan policies or can be stand alone.
The two principal methods of providing dental cover are the capitation bases, where the
dentist is paid an agreed fixed sum per mouth, and an insurance basis, such as where the
insurer provides indemnity cover.
Optical plans provide cover for spectacles, contact lenses, eye tests and optical
treatments.
Group PMI policies
The premiums will usually be rated by the characteristics of the employer and, except
for small schemes, not by rating factors for each individual employee. Selection against
the office will be controlled by the policy conditions (eg compulsory membership or
high take-up rate, a fixed list of benefits that must be offered to all members).

Chapter 4 Solutions
Solution 4.1
(i) Restricted cover
A medical condition is acute if it is expected to be cured (eg 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 necessary, treatment, where the State is unable to provide this. These events
relate mainly to the immediate 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 insured wants most.
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 premiums that make the
policy look poor value, and would be unaffordable by most people.
For the above reasons, PMI policies usually exclude cover for chronic conditions.
So by providing cover for acute conditions only, we are able to offer the cover which
people want to buy, which is in line with the market and at a “value for money” price.

(ii) Acute vs chronic conditions
This is a medical judgement, but the insurer needs to make the final decision.
A very precise definition of what exactly is “acute” and what is “chronic” is required.
Even with this, it can be difficult in practice to make the assessment. Some suggestions
are:
● Require that the insurer authorises a course of treatment before it begins. The
insurer could classify treatments as “active” (ie designed to improve health) or
“passive” (ie designed to alleviate ongoing symptoms). “Passive” treatments
would then only be authorised after further enquires of the insured’s doctor.
● The insurer could ask the insured’s doctor or specialist about the purpose and
likely outcome of a proposed treatment.
● Require that an independent doctor, nominated by the insurer, examines the
insured, in order to ascertain the long-term prognosis for the illness.
Solution 4.2
The qualifying event for major medical expenses is having one of the operations on the
insured list. The operation may be needed to cure a serious illness (eg heart-bypass
operation) or may be to relieve a condition that is serious, but not
life-threatening (eg hip-replacement operation).
Some CI benefits are payable when a specified operation is required – these tend to be
very serious operations (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. 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.

Solution 4.3
(i) Features attractive to the insurer
The policy is relatively easy to understand. This should make it easier to sell, and lead
to fewer disputes about claims and to low administrative expenses.
The requirement for the policyholder to pay for out-patient tests and consultations prior
to treatment is likely to reduce the number of claims the insurer receives (eg many of
these policyholders may choose State treatment instead). This will therefore reduce
overall claims costs and the expenses associated with claims.
The policy allows the policyholder to choose their treatment provider, and all valid
claims for in-patient treatment are subject to coinsurance (ie a percentage contribution
from the policyholder). This encourages the policyholder to think twice about choosing
private treatment and provides an incentive for the policyholder to choose value for
money treatments, thus reducing claim costs (and expenses) for the insurer.
The policyholder handles all arrangements for the treatment. Therefore the insurer is
not party to the supply of treatment and so is not responsible for its quality or timely
delivery, thus preventing any possible damage to its reputation.
The 90-day limit on treatment after leaving hospital is simple and will relieve the
insurer from the long-term costs of (and possible disputes over) what might or might not
be chronic care.
(ii) The policyholder’s point of view
The main advantage is a lower premium. Some policyholders may also like being able
to choose their own treatment providers.
However, others may regard having to arrange for their own treatment as a
disadvantage. Most individuals will have little experience of buying medical care, and
when they need this care because of their condition they may not be able to devote time
and energy to “shopping around” for treatment. Of course, they will have a doctor who
can advise them, and so they may not see this as a disadvantage.
The policyholder will need to fund the up-front costs prior to hospital admission. While
in many cases these will be modest (eg an appointment with a consultant), there could
also be more expensive investigations, such as MRI scans, which may need to be paid
for to prevent delays in treatment. The policyholder will need to have sufficient funds
to pay these “excess” costs. This is a disadvantage compared with more comprehensive
cover.

There is no upper limit to the amount that the policyholder may have to pay. This may
represent a considerable risk for the policyholder.
There is a limit to the amount of post-operative treatment that is covered. This

represents a modest risk for the policyholder.
Solution 4.4
Under PMI, we expect lots of small claims, but relatively few very large claims. This is
because conditions requiring expensive, lengthy treatment tend to be chronic, and are
therefore usually excluded.
The frequency distribution of PMI claim costs will be positively skewed. For example,
a typical distribution might look like the following:
frequency
0.0005
0.0004
0.0003
0.0002
0.0001
1000 2000 3000 4000 5000 6000 7000 8000 Claim cost
Note that the density function is an asymptote to the cost axis. So while the probability
of a claim of more than £5,500 is very small, it is not zero.
As the claim size increases (above the mode size, £1,000 here), we will expect the
number of claims to reduce significantly. The expected value of the cost of claims in
the higher bands (of claim size) will therefore be lower than that of claims in lower
bands, as the claim frequency declines so rapidly.

The saving in expected claim costs of moving to a higher level of excess can be
considered as the expected cost of claims between the two excess levels, ie within a
claim size band. This depends on two factors:
● the probability of a claim in the band, and
● the average claim cost in each band less the claim size at the bottom of the band.
As we move into the right-hand tail of the density function, the probability of a claim in
each band decreases very rapidly. Within each band, the average claim cost less the
claim cost at the bottom of the band increases, but much more slowly.
The overall effect is that the expected costs per claim, and hence the premium discounts
that can be offered, decrease rapidly with increasing excess level.
Here is an example based on the above density function, to demonstrate the above
assertions. This is by way of illustration rather than being part of the answer to the
question.
An estimate by eye of the average height of the density function between £3,000 and
£4,000 is 0.00006. So the estimated probability of a claim between £3,000 and £4,000
is the area under the density function between these values, ie:
0.00006 ¥ 1,000 = 0.060
We can do this for other £1,000 bands to obtain:
Band Estimated probability

£2,000 – £3,000 0.180
£3,000 – £4,000 0.060
£4,000 – £5,000 0.010
£5,000 + 0.001
Given the shape of the density between £3,000 and £4,000, an estimate by eye of the
average claim size is this band is £3,400. So if a policy has an excess of £3,000, the
average saving to the insurer on a claim in this band is £3,400 - £3,000 = £400 .

We can do this for other £1,000 bands to obtain:
Estimated average saving

Band
on each claim
£2,000 – £3,000 £2,200 - £2,000 = £200
£3,000 – £4,000 £3,300 - £3,000 = £300
£4,000 – £5,000 £4,400 - £4,000 = £400
£5,000 + £5,500 - £5,000 = £500
If we multiply the estimated saving by the relevant probability we obtain the estimated
average saving from not having to pay claims in each band.
Band Estimated saving

£2000 – £3,000 £200 ¥ 0.180 = £36
£3,000 – £4,000 £300 ¥ 0.060 = £18
£4,000 – £5,000 £400 ¥ 0.010 = £4
£5,000 + £500 ¥ 0.001 = £0.50
The savings here are £36 per £1,000 between £2,000 and £3,000, and £11 per £1,000
between £3,000 and £5,000.
So the pattern of premiums will reflect the skewness of the frequency distribution of the
claim costs.
.
Solution 4.5
(i) Why is full underwriting not feasible?
Full medical underwriting can make a considerable contribution to initial expenses.

Cash plans have relatively small premiums and are short-term renewable contracts. The
insurer must aim to keep premiums down and to recoup initial expenses quickly, as non-
renewal rates may be significant. Full underwriting would represent a considerable
loading on the premiums. If this results in uncompetitive premiums (for what should be
a “budget” policy) it may mean reduced overall sales, and thus make it more difficult to
cover fixed costs.
Full underwriting can also take some time and so delay the acceptance of a proposal.
This can act as an additional disincentive to potential purchasers.

(ii) Policy conditions
Both measures are designed to prevent selection against the office when the insurer only
undertakes limited underwriting at the start of the policy.
(a) Waiting period before a policyholder becomes eligible for benefits
A waiting period is an initial period at the beginning of the policy, during which
premiums are paid, but there is no entitlement to claim. In the absence of full medical
underwriting, a waiting period discourages people who are aware of their deteriorating
health, but who have yet to receive any treatment, from buying a policy in anticipation
of the need for treatment in the near future.
(b) Moratorium on claims related to pre-existing conditions
During a pre-specified initial period (often known as the moratorium period), the insurer
will not pay claims that arise in respect of a condition that existed, or is related to a
condition that existed, at the time that the policy was taken out. This is established at
the time of claim. If the policyholder has no further treatment for these conditions
during this moratorium period, this exclusion will then be removed.
Full medical underwriting and the moratorium form of underwriting are covered in
more detail in Chapter 27.
Solution 4.6
Cash plans have low premiums and are renewable contracts, usually annual. Both these
factors make the recovery of the initial costs difficult.
If there is a large number of policies, then the fixed initial costs can be spread across
this large number resulting in a small per-policy cost.
If policyholders persist in renewing their policy, it can be treated like a longer-term

contract, and initial expenses can be spread over a number of years. This results in a
much smaller initial expense loading in the premium.

Solution 4.7
(i) How could community rating lead to cross subsidy?
Community rating means that individual rating factors are not used to determine
premiums. To the extent that community factors do not account for all the variation in
claims between policyholders, some policyholders will pay premiums that exceed their
expected claims costs plus expenses, and some will pay premiums that are less than
these costs. To this extent there will be a cross subsidy between policyholders.
(ii) Opportunity for selection against the insurer?
Within each community-rating group it will still be true that premiums should depend
on age, sex and other factors. To the extent that policyholders are aware of these
differences there is the opportunity for selection against the insurer. For example,
younger people in good health will tend to delay buying insurance until they are older
and it appears to be better value.
In addition, if other insurers in the market do not use community rating (assuming this
is allowed), the problems for the insurer who does use it will be exacerbated. Better
risks, such as young people, will buy insurance from the insurers that rate individually,
because they will offer lower premiums.
(iii) Lifetime community-rating system
As we have seen the greatest opportunity for selection against the insurer is the fact that
individual ages are not used in the rating process. If premiums can vary by age at entry,
then the insurer can determine an appropriate level premium to cover the increasing risk
over the expected policy lifetime of the insured. In this case each individual would
have an incentive to renew because they are actually paying a level annual premium for
an increasing risk. There would be no perceived advantage in delaying the purchase of
insurance.
There would still be cross subsidy as the result of not using other individual rating
factors (eg sex), but here the cross subsidy is smaller.

Solution 4.8
Policyholder
+ The policyholder will receive a contribution to the cost of each and every claim.
In addition, his total liability has a ceiling of £500 each year.
+ The fact that there is a contribution to each claim means that there is some
incentive to seek treatment when it is needed. This will be advantageous for the
long-term optical and dental health of the insured.
– Some policyholders may think that the annual excess amount is rather high, as
they may have to pay up to £500 each year. They may prefer to pay a smaller
fixed excess for each claim, of say £50.
– A simple fixed excess may be easier to understand compared with the proposed
structure.
Insurer
+ If the insured receives some benefit each year, no matter how small, they may be
inclined to value the policy more and thus be more likely to renew it each year,
which will improve overall profits for the insurer.
– A major disadvantage is that there is the possibility of many small claims each
year, which will substantially increase the expenses of processing claims.
(However, as each claim only involves a straightforward validation and a
reimbursement, these costs should be controllable.) A fixed excess for each
claim would reduce the number of claims and the associated fixed expenses.
+ The policyholder co-payment acts as an incentive for them to seek less

expensive (or value for money) treatment, as they need to pay 25% of each claim
(up to £500 pa), and so helps to keep claims costs down
+ The encouragement to seek treatment when it is necessary may also be an

advantage for the insurer, as it may reduce the long-term cost of claims.

Solution 4.9
Membership of a group scheme is often compulsory, or a high proportion of those who

are eligible to join opt to do so. Usually, all members of the scheme will receive
benefits that are the same or are determined by a fixed formula.
So group membership should consist of a mixture of good and bad risks. There is less
opportunity for good risks to decide not to join, or for bad risks to buy more cover than
good risks.
The bad risks may include those with pre-existing conditions, but the benefit rules of the
scheme prevent them from selecting against the insurer. So the insurer can be more
relaxed in underwriting pre-existing conditions.
Solution 4.10
Larger groups are likely to be self-insured, or at least experience rated with a high
credibility factor. The scheme will therefore bear a high proportion of the experience
risk, so the insurer will not be too worried about getting its premiums “wrong”.

ST1-05: Product design and stakeholder interests (1) Page 1
Chapter 5
Product design and stakeholder interests
(1) Customer interests
Syllabus objective
(c) Outline the principles by which health and care insurance contracts are
designed and the interests of the various stakeholders in the process:
– customer attraction and clarity
– insurer control and profitability
– regulators' satisfaction
– employer as purchaser
– other stakeholders: equity, guidance notes, sales processes, IT.
The items marked in bold are covered in this chapter.
0 Introduction
In Chapters 1 to 4 we introduced each of the main health and care insurance products.
Our aim was to describe how each product worked (ie why you would want to buy each
product, the benefits provided and how these benefits were paid for).
Each product means something different to each of those involved in buying and selling
the product. So those who buy a policy are interested in exchanging their risk of
discomfort or uncertain cost for the known cost of an insurance premium. The insurance
company is interested in acquiring risks that it can pool and manage so as to make
profits for its shareholders. The government through its regulators is interested in
encouraging and maintaining an orderly market for the product. It is in society’s interest
that individuals have the opportunity to control the health and care risks in their lives. If
this opportunity was not available some individuals might fall on hard times through no
fault of their own, and the government may be faced with increased expenditure on
welfare benefits. There are many other parties with similar interests (eg employers).

Page 2 ST1-05: Product design and stakeholder interests (1)
All these parties (or “stakeholders”) have an interest (or a “stake”) in the market for the
product, so we talk of “stakeholder interests”. Not all stakeholders have the same
interests and objectives. It is a bit like a game where the different stakeholders compete
to achieve their own objectives. The product designs we see are the result of this game.
So if I am a consumer I probably want to be able to buy a policy that I can understand,

that meets my needs for risk transfer, and that I can afford. I probably don’t care
whether or not the insurance company makes a profit (as long as it is not excessive) or
minimises the amount of capital needed to support the product. However, if the
insurance company is not well run then it may become insolvent. I do care about this,
but I am not in a position to do anything directly about it, so through the political
process I “ask” my elected representatives to ensure that the insurance companies are
properly regulated.
At the centre of our discussion in this chapter will be the product. Surrounding the
product are those who have a stake in its success. We will look at each of these
stakeholders in turn and how their particular interests influence product designs.
In summary, design is about “fitness for purpose”. Each stakeholder will have different
purposes. A good design will fulfill the purposes of all the stakeholders in the market.
This chapter examines the stakeholder interests of customers and their influence on
product design. Chapter 6 looks at other stakeholders – ie insurers, regulators,
employers and others (including the actuarial profession).
You may find it helpful to put yourself in the position of each stakeholder and consider
things from their point of view. This should be easy for you to do as a potential
consumer. If you have worked for an insurance company it should also be easy to do
from the point of view of the insurer. The regulators’ and employers’ points of view
may be more difficult to imagine.
Question 5.1
The actuarial body to which you belong is a stakeholder in the provision of health and
care products.
(i) Describe the “stake” that the actuarial body has in the design of health and care
products.
(ii) Describe the ways in which it tries to ensure that this stake is maintained.

1 General
The syllabus objective has identified “attraction” and “clarity” as two important interests
that the customer has in the product design.
A product will be attractive to customers if it offers the opportunity to get rid of a risk
that is a worry to them (ie it threatens their plans for an orderly day-to-day life), at a
price that they think is reasonable.
Even if a product meets this need, it will be unattractive if it is difficult to understand.

Lack of clarity may also hinder the sale of the product.
This section looks at how generic health and care products meet the needs of potential
policyholders. Sections 2 – 5 look at product-specific issues.
1.1 To meet specific needs
Health and care policies must be designed with customer needs in mind. The following
example illustrates how these needs have changed over time.
Example
In the late 19th century in the UK, friendly societies (a form of mutual insurance
company) provided their members with income protection (IP) insurance. Benefits were
limited to a weekly payment during the first (usually) two years of sickness. The
payment ceased on recovery, death, or two years from the start of sickness, whichever
event occurred first.
One hundred years later, IP insurance policies provide no payment during the deferred
period, eg the first 6 or 12 months of sickness, and then payments are made monthly
until recovery, death or on reaching normal retirement age, whichever event occurs first.
Needs of health and care consumers in 1890s
In the late 19th century there was no social security system providing statutory sickness
benefits nor any occupational pension schemes providing ill-heath retirement benefits.
The expectation of life at birth was about 45 years, and preventative and curative
medicine was very limited. There were no antibiotics and surgery was limited. Many
people died as the result of illness or infectious diseases.

There were no National Insurance benefits until 1911, and so if you were a worker, then
illness was a threat to the livelihood of both yourself and your family from your first day
of absence from work. If you became ill then the nature of illness was such that you
could expect to recover quickly or die within a few months.
Needs of health and care consumers in 1990s
Much had changed in 100 years. The expectation of life at birth was now more than 80
years; most people expected to survive to retirement in their late 50s or early 60s. Few
people died from infectious diseases and there were complete cures for many ailments.
Many other ailments were treatable, so that the individual remained alive but not fully
fit to work for many years.
Statutory welfare schemes and employers provided benefits for at least the first six
months of sickness. The employee faced the risk of long-term sickness absence and the
inability to work for several years, perhaps up until normal retirement age. Many
employees were paid monthly rather than weekly.
How policies matched the needs in the 1890s
As a worker you faced the risks of short-term sickness absence that would mean no
weekly wages, or death that would leave your family destitute. Friendly society sickness
schemes covered the first of these risks.
There were no national insurance benefits for dependants, but the Poor Law provided
some state cover for the consequences of the risk of death. Employers, charities and
some friendly societies provided additional cover for the risks following death.
Friendly society sickness schemes on their own were a poor match for needs.
How policies matched the needs in the 1990s
There was a well-developed national insurance scheme that provided cover for the
(smaller) death risk.
IP policies with long deferred periods and monthly payments until the first of death,
recovery or reaching normal retirement age covered the residual sickness risks faced by
the employee.
IP schemes together with statutory sick pay, welfare benefits and ill-health retirement
pensions were a good match for needs.

Health and care insurance products are designed with many functions in mind.
In particular, they meet four specific needs:
(1) Healthcare insurance products can repay loans. Under a critical illness
policy, level or reducing, the amount of outstanding loan can be repaid at
the time when the critical illness is diagnosed. Equally, an income
protection policy can be used to meet interest and capital repayments,
when the disability sets in and the policyholder is unable to work. For
many, the comfort that insurance will provide protection against the
inability to meet major financial outgoings of this type is a foremost need.
Being unable to work and earn enough to pay off a loan is a worry for the
customer. An easily understood policy that gets rid of this risk will be attractive
to customers.
Some IP policies have been designed specifically to meet this need. Accident,
sickness and unemployment (ASU) insurance (described in Chapter 1) is an
example of this. Mortgage payment protection insurance is a similar product
designed to cover the risk of not being able to make the repayments on a
mortgage. This is described in Section 2.1.
(2) Healthcare insurance products can replace income. By its very name and
nature, income protection insurance is fundamentally geared to provide a
source of regular income for policyholders who can no longer work
through disability. In order to provide the claimant with an incentive to
return to work, the benefits are often limited to a fraction (usually 60% –
75%) of gross salary, so this is not replacement in full.
As we saw in Chapter 1 some individuals have jobs that provide generous sick
pay for, say, the first six to twelve months of sickness absence. So employees
face the risk of much-reduced income in the event of long-term sickness absence
from work. A policy designed to pay a large proportion of pre-sickness income
in the event of being unable to do your usual job in return for a small regular
premium while you were healthy would be attractive and easy to understand.
Provided individuals were able to recognise this risk in their working lives, the
product should sell well. However, in some countries, the evidence is that
individuals are not very adept at recognising this risk.
Notice how the interests of the insurer as a stakeholder are recognised in the
product design. Restricting benefits to 60% – 75% of pre-sickness salary
provides an incentive for the insured to return to work and helps in claims
management.

(3) Healthcare insurance products can finance medical treatment bills. In

some territories, the State provides only limited medical treatment, if any
at all, for its population. Insurance is a means of funding these bills when
healthcare treatment is required.
In territories where the State offers a health service to all, some

individuals will still feel the need to seek faster access to treatment or a
higher level of treatment. Insurance is a mechanism to make this more
affordable. Private medical insurance is a contract that focuses on
normal hospital needs (though it can also cover private doctor charges,
primary care).
Primary care refers to the advice and treatment provided by a general practitioner
(see Chapter 29, Glossary).
Question 5.2
Products need to be designed so that they are easily understood.
Describe two common misunderstandings among consumers about PMI insurance

products.
(4) Long-term care insurance seeks to cover medical and domiciliary needs
under more chronic conditions, usually at older ages. Here, however, the
insurer’s liability is often couched in cash terms without directly meeting
the needs of claimants that are expressed in years of relevant care.
Here we have a conflict between the individuals’ needs (they would like a policy
that provides care as and when it is needed) and the insurers’ needs (they are
reluctant to provide care because the amount needed and its cost in the future are
very difficult to forecast).
Some insurers in the market may offer care benefits, but for a high premium.
Other insurers may offer cash benefits but for a more modest premium. The
reluctance of consumers to pay high premiums then results in a predominance of
cash provision in the market.

1.2 To provide cash
Private medical insurance is unique in being both an indemnity product (the

benefit is normally no more nor less than the cost of the required treatment) and
providing an amount which is generally paid directly to the provider of the
treatment – the policyholder will not see the money. It should be noted that
some PMI products have excesses or upper limits and hence will not provide full
indemnity.
Question 5.3
(i) What is the principle of indemnity?
(ii) Give an example of a LTCI product with indemnity benefits and a similar
product with non-indemnity benefits.
Other products provide cash and leave it to the policyholders to decide, within
reason and subject to IP replacement ratios, what level of cash benefit meets
their needs. The underwriter will watch carefully for over-insurance. The broker
or other financial intermediary will advise the purchaser on benefit levels to
satisfy certain needs and will review these amounts periodically as needs and
financial circumstances change.
Question 5.4
(i) What is meant by over-insurance in connection with IP insurance?
(ii) How does an insurer check for over-insurance?
(iii) For what type of policyholder are these checks difficult in practice?
The insurance product can provide a lump sum (CI) or income stream (IP), on
satisfaction of the relevant claim conditions. On the one hand, cash provides
the policyholder with choice as to how best to expend this to meet ongoing and
changing needs – the principle of customer choice. On the other hand, cash
shifts the burden of choice to individuals who may be less skilled to exercise it
in medical fields (where the benefit is needed to meet medical expenses) and at
a time when, being recently sick, they may not be in the best mental shape to
make decisions. Additionally insurers may be able to exact better bargains from
providers due to their size and experience.

Question 5.5
“Cash or care” is a continuing debate among those designing insurance products.
For a pre-funded LTCI policy suggest, giving reasons for your choice and without
looking back in these notes, which form of benefits is best from the point of view of:
(i) the insurer
(ii) the insured?
One of the attractions of critical illness insurance, over income protection

insurance, is the receipt of a lump sum, as opposed to an income stream where
the insurer can withdraw the benefits. A lump sum could be converted to
income by the purchase of an annuity or by placing the cash on deposit; but the
policyholder must be aware of the different conditions required to claim under
each contract – the advisor must make it clear that the two policies are not
direct substitutes. It is worth noting that the CI lump sum is often used to pay
off a mortgage and so is effectively converted into an income stream.
We discussed some of these issues in Chapter 2.
Some products go further than the attempt to meet financial outgo when
disabled or receiving treatment.
Being unable to work because of long-term sickness is not a happy state to be in, and
many policyholders find the offer of personal support, advice and counselling attractive.
Extra benefits like this are often valued highly by prospective policyholders yet add little
to the insurance company’s costs. They can be important in increasing the attraction of
a product and thus increasing sales.
Many companies have strong marketing messages that their products also
provide cash to finance recuperation needs, before the policyholder is fit to
return to full employment:
(1) IP products may provide a rehabilitation or proportional benefit to those

who return to work on a part-time basis or in a less strenuous (and lower
paid) role. This can benefit both the insurer (as return to work is
encouraged) and the policyholder (whose path to full recovery is
hastened).

(2) Critical illness policies too will often pay out more than the cost of
immediate care; the surplus is then available for recuperation/
rehabilitation treatment. This additional amount could be used, for
example, to finance a change of lifestyle where necessary to improve the
claimant’s health; this might include moving to a less stressful (and
lower-paid) job following a heart attack.
However, not all medical interventions, by any means, will encompass a

payment under a CI policy.
So while a CI policy will probably pay out if you need a kidney transplant, it is
unlikely to pay out if you need your appendix removed or need intensive care
after a road accident.
(3) The standard PMI plan often provides a cash benefit to the policyholder
where he or she has chosen to be treated in a State-funded
establishment. The benefit is pre-advertised to encourage individuals to
reduce the insurer's claim outgo in this way, by taking advantage of
State-provided treatment, where available.
(4) Hospital cash plans provide cash for policyholders on the occurrence of
certain health-related events such as a stay in hospital, the undergoing of
dental treatment and the provision of spectacles. The benefits under
these plans are deliberately designed to provide a contribution to
policyholders’ medical costs, and not to provide indemnification of these
expenses; in this way the risk of anti-selection is much diminished.
1.3 To allay fears
You can only be afraid of something if you are aware of it. So customers’ fears only
relate to those risks that they recognise.
Customers are more aware of some risks in their lives than they are of others.
Individuals may be aware that the State may provide treatment if you fall ill, but that it
does not provide lump sum payments when this happens. However many individuals
believe that if you are unable to work the State will provide generous sickness benefits.
In most states short-term benefits are related to income, but long-term benefits are not
income related and are designed to maintain a minimal acceptable standard of living.
The result is that many consumers have little fear of being without an income if they are
unable to work for an extended period because of sickness or injury.

In many cases individuals are very bad at estimating the size of the risks they face. It is
a commonly-held belief that you are more likely to get a serious illness than to
experience long-term sickness that prevents you from working.
So in some markets CI sells much better than IP.
Question 5.6
(i) Why do many people think that they are more likely to get a serious illness than
to experience long-term sickness absence?
(ii) Explain why long-term sickness absence is actually often more common than
serious illness?
Ill health is unknown territory to many people and can be an area of much
concern. Individuals, especially those who have others financially dependent on
them, will wish to minimise the risk that a breakdown in healthcare will disrupt
their financial well-being. Disability and sickness are often unpredictable and
treatment bills can be of unknown size. Many value the insurers’ willingness to
provide financial comfort in these circumstances. The psychological effect of
knowing that you are protected from the financial consequences of ill health is
very definitely a policyholder need.
However, in many territories, the insurer is unwilling to indemnify all future

outgoings in all products. For example, few are willing to guarantee the cost of
long-term care in old age, preferring to estimate and fund for an appropriate
amount of cash.

Example
Here is a description of a LTCI product sold in North America.
The New York State Partnership for Long Term Care is a public-private partnership,
which links Medicaid and private long-term care insurance. Medicaid is the State
healthcare provider.
The private part of these policies is the insurance coverage for long-term care. The
public part is Medicaid extended coverage for long-term care and other Medicaid
services, eg primary medical care. Both parts help to protect an individual’s assets.
The private part of Long Term Care Partnership policies must cover at least three years
of nursing home care, six years of home care or an equivalent combination of both.
This is the minimum benefit duration. Once the minimum benefit duration is reached,
regardless of whether the policy's benefits have been exhausted, the policyholder will be
eligible for Medicaid extended coverage for the remainder of his or her life without
consideration of his or her assets.
Comment
There are three main stakeholders: the individual, the insurer and the State government.
The individual has a need to provide for long-term care costs in old age, but does not
want to spend all his or her assets on care and so be unable to make bequests to family
and friends. The State would like those who can afford it to provide for their own care
costs and not rely on the State. Insurers find it difficult to forecast the eventual costs of
care and so are reluctant to sell policies that cover all the care that is needed, preferring
to provide cash-limited benefits.
So the State offers to provide for those who need care for an extended period, if
individuals buy insurance that provides care for an initial period. The insurers can now
more easily forecast the maximum cost of the benefits needed and so can provide
competitively-priced insurance. The State will also regulate insurers and approve
qualifying policies, so that individuals find it straightforward to choose and buy a policy
from those available.
All the stakeholders achieve their key aims.

1.4 Simplicity and clarity
Life insurance is relatively straightforward – a sum insured is payable on death,

whereas healthcare insurances cover events that are more complex and have
benefits that can vary according to the severity of the episode.
Critical illness insurance attempted to overcome some of this complexity by

providing a fixed sum insured on certain pre-defined events. But despite its
success in so doing and its comparative attraction to the public, it does not
meet all the ill-health needs of the public.
Question 5.7
Describe two major health care risks that are not covered by CI insurance.
Income protection, in attempting to provide a regular income at a percentage of

a claimant’s pre-disability salary, needs careful wording to avoid a scenario
where the policyholder, supported by his/her doctor and encouraged by
worsening economic conditions, can begin a claim for replacement income and
continue it despite being much recovered. The definition of disability is not
straightforward and must be a balance between the desire to meet the needs of
genuine claimants and the desire to have in place a statistically sound and
controllable insurance risk.
The advantages and disadvantages of the various ways of defining disability (incapacity)
were discussed in Chapter 1.
PMI is simple in its benefits (the indemnification of medical costs), but can be
obscure in some of the exclusions and limits that it imposes. For example, a
condition such as breast cancer may be covered while it remains in an acute and
treatable phase; but the treatment costs may not be covered if the disease
becomes chronic and life threatening.
Question 5.8
You work for a PMI insurer in the customer services department. A customer calls and
asks “What’s the difference between an acute and a chronic illness?”
What are you going to say?

Long-term care, at the moment, falls between many stools. Many policies offer
cash and not care and the adequacy of the cash amount to meet healthcare
needs many years ahead is not guaranteed. Different benefit levels may be
available to help approximate to these potential future expenses; but this can
further complicate the product for a less expert purchaser.
1.5 Guarantees and reviewability of premiums and benefits
Part of the attraction of a traditional life product is the fixed relationship between
benefit and premium. The variable nature and definition problems of healthcare
insurance and the myriad of factors which can influence the experience prompt
a reviewable premium approach, ie the insurer has the right to review the
premium to be charged for benefits in the period ahead. The policyholder then
has the option to accept or decline the proposed terms.
Uncertainty as to the amount of future premiums is rarely what the policyholder

will choose to meet needs. However when given the alternative, a higher
starting premium to encompass the cost of guarantee, the applicant can make a
more informed choice. Unfortunately, guarantees are not always available in
some forms of healthcare insurances and not all insurers will offer both for
immediate comparison.
It is nonetheless very important that, where a reviewable policy is being advised

to a customer, that the latter is clearly aware of this fact and has some
understanding of the potential for premium change over the policy term being
considered.

2 Income Protection
2.1 To meet needs
The main needs that an income protection policy meets are:
(1) Replacement income when the policyholder is unable to continue in

his/her own (or possibly any) occupation, and cannot earn income.
In the short term after the onset of the illness or disability, the employer
will typically retain responsibility for the employee’s continuing income.
This may last three months, six months or possibly longer, depending on
the employer’s generosity and the nature of local employment law.
Thereafter the sick person is dependent on any State welfare benefits, on

personal financial resources and on insurance. Insurance is crucial as, in
most countries, State welfare benefits are unlikely to maintain the
individual in his/her prior state of comfort, and personal financial
resources will often be limited in sustainability.
IP insurance is often arranged by the employer on behalf of the workforce

or it may be down to the individual worker, particularly if self-employed,
to purchase the insurance.
Question 5.9
Describe briefly how the IP needs of a clerical officer employed by a government

department might differ from those of a self-employed veterinary surgeon.
(2) An income stream designed to match the policyholder’s monthly

loan-servicing costs.
The service of loans, such as a mortgage, can prove a major outgo from
an individual’s disposable income. This is particularly so when the loan
in question is the mortgage on one’s own house, for some the largest
single financial transaction that they ever make. Because of this fact
many lenders are keen to ensure that mortgage payment protection (also
known as waiver of mortgage) insurance is in place when the loan
agreement is being negotiated. This safeguards their loan from the peril
of borrower incapacity.

The benefit will be structured to cover both the interest on the loan and
the vehicle used to cover the repayment of capital. A rider to the policy
may also cover the peril of unemployment. Again, it may be the
individual’s responsibility to organise the cover or be faced with meeting
the loan outgo from a much-reduced monthly income. The benefit level
may need to be restructured in the face of fluctuating loan interest rates.
Earmarked policies like this are often a requirement of the financial

arrangement. The individual pays the premiums and the benefits are assigned to
the financial institution.
The policyholder may also need a regular income stream on incapacity to cover
premiums that he/she is paying for other types of insurance policy
(eg endowment assurance or insured pensions arrangements). Because of the
small size of the premium and the virtual absence of anti-selection, the cost is a
small one; it is often an automatic rider on the insurance contract itself. It is
rare to effect such cover on a stand-alone basis, except possibly to cover
substantial pension-premium contributions
Many small professional practices (doctors, dentists, vets) are dependent on

each other’s support to provide full services to their clients. The disability of
one such partner could seriously impact the fee stream from the partnership and
provide a risk of client loss. For these reasons, the professionals purchase a
form of income protection insurance on each other, called Locum Protection
insurance. The benefit provides for the salary and other employment costs of a
temporary replacement professional, so that the practice can continue to
provide services to all. A short deferred period would be applicable.
In summary, the two groups who perceive the greatest need for income
protection insurance are:
(a) The employer who is keen to pass on the financial responsibility for sick
employees to an insurer after a limited period of invalidity (group IP).
There may be legal requirements to do this.
(b) The self-employed person, who does not have the comfort of an
employer-sponsored scheme and who must purchase individual IP cover.
2.2 To provide cash
In certain circumstances the IP benefit may be commutable to provide a lump sum, but
this is not generally the case. The insurer must assume that the claimant is not
anticipating a long period in benefit and will value the commutation accordingly.

2.3 To allay fears
The individual with dependants (spouse and/or children) needs the comfort of
knowing that there will be an income stream into the long term to provide for
their upkeep and welfare, if the individual is unable to work, or must take a
lower-paid job, due to ill health. This is the fear that encourages purchase of
income protection insurance. State sickness or disability allowances are often
insufficient as replacement income and employment benefits are often only
available in the short-term.
Repayment of high-cost loans such as mortgages is another serious

consideration when the normal income supply dries up. The policyholder needs
to examine all potential outgo when choosing a benefit level.
The concept is simple and appealing – a replacement income at a time of great

need. But there are several issues that the insurer must consider to protect
against greater than expected losses:
(1) Benefit limits must be applied (usually defined with reference to

pre-disability salaries) to ensure that the individual has an incentive to
return to work. Policies will often have a maximum replacement ratio
specified in the contract conditions; this will be expressed in terms of
salary at the time of claim and State benefits at the time of claim. The
actual replacement ratio will vary depending on salary and individual
circumstances.
For example, the benefits payable might be restricted to the smaller of the sum
insured or to 60% of income immediately prior to the period of illness. Any
other benefits – such as State benefits – that the policyholder might be receiving
while unable to work, would also be deducted from the payments made under
the policy.
(2) The definition of disability is not always open to objective assessment,

eg inability to perform one’s normal occupation.
(3) Payouts are not always linked to current salary (especially for individual
IP policies where benefits are often expressed as a cash amount rather
than as a percentage of salary) and this should prompt an annual review
of benefit levels prior to disability occurring. However, this is more an
issue for policyholders and their advisers.

(4) Underwriting can be complex. Certain occupations are difficult to cover

because of the high potential disability risk. Some individuals may have
difficulty getting accepted for insurance because of their own medical
experience or because of family medical history.
Question 5.10
(i) Insurers are often reluctant to offer IP policies to manual workers in the building
trade. Why is this?
(ii) Discuss how you could modify an IP policy so that this risk was acceptable to the
insurer and the policy was also attractive to the customer?
(5) Exclusions can be rife. These may include residence abroad, certain
pastimes, failure to seek and follow appropriate medical advice and
others that may not always seem logical to the policyholder (eg claims
arising from participation in an illegal activity).
(6) It is difficult to find objective criteria to determine fitness to work. The

failure of activities of daily living may be deemed an objective test of
incapacity but in many territories, inability to continue in one’s own
occupation and trade may be difficult to prove.
Insurers have tried to make the criteria more objective and more focussed on
work by developing and adopting other tests. ADWs (activities of daily
working), FATs (functional assessment tests) and PCAs (personal capability
assessments) were mentioned in Chapters 1 and 2.
Question 5.11
(i) List six items that might be in a typical PCA test.
(ii) What advantages do the use of tests like those listed in the last paragraph have
over occupation-based definitions of disability?

The cost of guarantees must be funded. The insurer’s claim experience is

subject to many influences totally outside the insurer’s control (eg economic
and social influences such as unemployment trends). Even if experience is
proceeding as expected, the guarantees are expensive because the insurer will
have to set reserves to ensure that benefits will still be met if experience
deteriorates.
Guarantees provide consumers with the comfort of known future premium outgo
but that comfort comes at a price.
Index-linking can provide something of an off-set for both parties since

premiums and benefits may rise in times of inflation, which may match
worsening experience. But the connection is tenuous and adds to the
complexity of the product.
With reviewability the insurer has the comfort of knowing that premiums may be
adjusted in the light of emerging experience, although in practice there will be a
limit as to how far increases may be imposed. A doubling of premiums for
example may dissuade the lives with better experience from renewing their
policies, leaving the portfolio top-heavy with claimants or potential claimants,
prompting an even bigger premium increase. Capping increases at new
business rates should reduce lives that exit – if they still want cover, they can’t
go elsewhere more cheaply and hence are more likely to stay.

3 Critical Illness
3.1 To meet needs
A variety of needs are met by a critical illness policy:
(1) Income can be provided from the lump sum via an annuity when the
individual cannot work as a result of his critical illness.
(2) Medical costs can be funded when the critical illness requires surgery or
other expensive treatment.
This was the purpose of the original CI policies issued in South Africa.
(3) The benefit can be designed to repay a mortgage or other loan when the
policyholder’s health is in question following diagnosis of a critical
illness.
(4) Business partners can purchase CI policies on the lives of each other
such that the benefits will fund the buyout of the stake in the partnership
when critical illness arises.
This is sometimes known as Keyman cover.
(5) Fund a change of lifestyle where necessary to improve the claimant’s

health; for example, moving to a less stressful (and lower-paid) job
following a heart attack.
(6) Other needs suggested include recuperation after illness, taxation

planning, medical aids (for example, the installation of specialist
equipment in the home to enable the claimant to remain in his/her house).
The student should consider whether a critical illness policy is actually the best
means of meeting these needs and whether other insurances may be more
focused or comprehensive.
Question 5.12
In what sense could you argue that PMI is more focused, and IP more comprehensive,
than CI?

3.2 To provide cash
One of the major policyholder attractions of this policy is that it provides a lump
sum cash benefit that is not normally dependent on the severity of the medical
condition. This benefit cannot be reclaimed by the insurer in the event of
recovery. This is also an attraction for purchasers.
This contrasts with an IP policy where benefit stops on recovery and a partial recovery
might result in the insured working part-time and receiving a proportionately reduced
benefit.
Cash gives the policyholder choice. It can be directly applied to meet personal
needs, without being earmarked for particular purposes or can be converted to
produce income (with or without capital protection).
The conversion into income could be achieved by purchasing a life annuity. Normally
impaired life terms would be available. These would give an enhanced income
compared to a purchased life annuity. The annuity could be capital-protected, ie include
a balancing payment on death equal to the purchase price of the annuity less the annuity
payments received.
It can represent a windfall to the policyholder, in that the amount of money

produced can far outweigh the immediate medical costs or the longer-term
damage to quality of life (although this is inherently difficult to quantify, and
some policyholders may deem any such damage to be worthy of a very high
compensation). In this way, it is not directly related to needs. This can cause
anti-selection problems and conflicts with one of the basic principles of
insurance: the matching of loss to benefit.

Example
Angioplasty is an invasive procedure performed to reduce or eliminate blockages in

coronary arteries. Opening a blockage in a coronary artery typically involves the use of
an angioplasty balloon. Often a “stent” is implanted after angioplasty to keep the artery
open and prevent blockage occurring again.
The arteries are usually accessed through a needle puncture (the “keyhole”) made in the
groin (femoral artery). In simple cases the procedure can take just 30 minutes.
Before the development of keyhole surgery the treatment of this condition required
major surgery and was a critical illness. However advances in surgical techniques have
made the treatment a minor procedure.
As the sum assured is much larger than the costs of the treatment and any losses
resulting from the condition, windfall gains have resulted.
There may well be a temptation for the insured to undergo treatment of marginal
necessity in order to benefit from the policy.
Several insurers have now removed angioplasty from the list of insured conditions.
Question 5.13
Suggest how the terms and conditions of a CI policy might be amended so that the same
range of illnesses and procedures were covered, but the problems highlighted in the
example above are avoided.
3.3 To allay fears
Critical illness is based on the diagnosis of a certain number of headline

diseases or on the occurrence of number of dreaded surgical procedures. It
thus certainly allays some of the financial and medical fears of individuals.
However, it is not comprehensive in the diseases and procedures covered. A
combination of IP and PMI might be better targeted and more comprehensive.

CI is a theoretically simple product. This is part of its attraction to consumers.

The lump sum payout (which cannot subsequently be withdrawn by the insurer)
has a powerful draw for purchasers who are wary of insurers’ promises to look
after them. The claims trigger of diagnosis or procedure is easy to explain and
adds to the attraction of the product.
However, the insurer needs some controls in place to ensure fair play. The
product is still subject to exclusions and point-of-claim underwriting.
Definitions (of heart attack, for example) may differ between insurers in the
same market (though in some territories work has been done to standardise
definitions) whether for marketing or cultural reasons. This may serve to muddy
the otherwise clear waters at claim time.
Question 5.14
Why is underwriting at the time of a claim needed?
In addition, certain definitions may require evidence such that the actual
condition covered is more severe than the colloquial understanding of the term
used in the headline title of the condition.
When CI was launched, many markets prudently kept the benefits reviewable,
understanding the unknown nature of future risks. In some of these territories,
competition pushed insurers into offering guarantees on benefits or premiums,
at little extra cost. Possibly only now, the true cost of reserving for those future
risks is being estimated and, where guarantees are still offered, a more
appropriate differential is charged.
With trends in incidence for each of the various critical illnesses covered
moving in different directions, the increases on future reviews are difficult to
predict. It is possible that ongoing enhancements to reserves for guaranteed
products may be significant.
Question 5.15
If premiums are guaranteed, how is the insurer going to find these additional reserves?

The customer is probably not aware of this potential downside for the insurer.
Competition for new business and policyholder retention have not deterred
insurers in many markets from making significant increases in premiums.
Insurers’ previous generosity in adding further diseases or benefits to existing
policies at no additional cost is disappearing.
The future is uncertain. It may bring about a situation where the insurer is
forced to continue to offer coverage even though illnesses, by the progress of
medical science, are no longer critical and where the insurer is forced legally to
cover less severe incidences of named conditions than was assumed in the
calculation of current premiums.

4 Long-term care insurance
4.1 To meet needs
Long-term care insurance usually aims to provide financial protection when a

person becomes unable to look after him or herself. Typically this arrives in old
age; this at least is where the purchaser of LTCI will be focusing attention.
An individual will purchase LTCI with a view to financing the provision of care
and assistance in old age. There may be uncertainty as to the role of the State in
the future in paying for care – it will provide comfort to the person to know that
there is an independent source of cash which will be triggered when severe
incapacity sets in.
With changing social and demographic circumstances some individuals might be

worried about the reduction in informal care as well as in care provided by the State.
Claimants’ needs at the time may entail domestic support (eg a nurse or other
carer visiting the patient’s home periodically to monitor well-being). This may
progress to live-in care as the claimant becomes more incapacitated.
Alternatively, residential care may be sought in establishments that can provide
various levels of care and vigilance.
In some countries continuing care retirement communities (CCRCs) have become

popular. People join a community usually by paying a lump sum, often raised from the
sale of their current house. Within the community they receive accommodation and care
appropriate to their needs in return for a regular service charge. More comprehensive
care (eg 24-hour nursing) may entail extra charges that could be funded from a LTCI
policy.
Finally, there may be a need for medical care, where physical (or possibly
mental) breakdown requires the intervention and supervision of doctors and
nursing staff. This last stage will generally be the most expensive.
Question 5.16
Discuss whether a PMI policy would be appropriate insurance to cover the medical care
described in the last paragraph?
At the early stages of incapacity, family or friends can provide some of this care
and attention. However, for many, LTCI is bought to avoid dependence on the
loyalty of unpaid care in this way.

Even though informal carers do not usually receive wages there will be extra expenses
connected with their caring that could be met from a LTCI policy with cash benefits. In
some countries, the State may also provide other benefits for carers (eg paying an
allowance or paying tax relief for payments to carers).
4.2 To provide cash
Long-term care insurance generally provides cash income, triggered by the

onset of incapacity. The benefit level is chosen at the time of purchase to meet
estimated levels of assistance at the time of need, in accordance with the
policyholder’s means to pay (estimated income).
This describes a pre-funded policy.
Alternatively, an immediate needs policy converts a lump sum into a lifetime

income, dependent on level of disability, at the time of need. Here also the level
of benefit may increase with deepening incapacity.
Few insurers, if any, will fund for care, ie will promise to indemnify the
policyholder’s residential and medical costs from incapacity in the future for the
balance of lifetime. This is deemed to be too uncertain a liability to entertain.
The insurer will generally take a longevity (annuity) risk and may additionally
promise to increase benefit levels in line with a suitable objective index of costs
– but this is far short of indemnification.
4.3 To allay fears
The fear of individuals is that they will not have sufficient funds to pay for their
care in old age and that the care available from the State is either not available
or inadequate. Possibly they do not want to rely on family and friends to provide
help.
People who wish to fund for the care of elderly relatives and friends may also
purchase policies. Their fear is not having enough money or time, when the
need arises, to look after an elderly person for whose welfare they feel (or are)
responsible.
Long-term care insurance goes some way to allaying those fears; but the
policyholder is left with the concern that the funds which the insurer will provide
are not enough to provide the care at the level deemed appropriate in the future.

Policies that only provide cash benefits create another uncertainty for the insured. When
they are in need of care, despite the fact that they have the cash benefits from the policy,
they and their relatives will have little or no experience of buying care services
(eg judging price and quality of the services offered, knowing how State-provided care
interacts with privately-purchased care). Some insurers have addressed this fear by
offering a care management service to provide help and advice without charge.
The fear and need for long-term care insurance is often one of priority. While in
employment, other needs such as mortgage repayment and pension funding
take a higher priority. A growing awareness for LTCI is often felt after
retirement, at which point the funding for long-term care becomes that much
more expensive.
The concept of LTCI is straightforward. However, the simplicity at the surface

disappears when one considers that the contract is at best an approximation to
the wishes of the policyholder. There is a big danger that the purchaser of
long-term care insurance may believe that care is being bought and may later be
disappointed with what the plan provides.
The trigger points for long-term care benefit are generally defined in terms of
Activities of Daily Living (ADLs). These need to be explained to the applicant, to
avoid the belief that payment will follow a doctor’s referral.
Question 5.17
One of the difficulties with PMI is that policyholders believe they are covered for all
medical treatment (ie for both acute and chronic illnesses, for both preventative and
curative treatment). This is, in part, the result of the belief that a PMI policy replaces
the medical treatment provided by the State.
Describe how similar difficulties might arise for LTCI, and how these might be
addressed.

Immediate needs LTCI
Immediate needs plans present no problems of premium guarantees. An income

stream is bought by a single premium. The income stream may move to
different levels with increasing disability and may be linked to some index. It
will be guaranteed to continue for the beneficiary’s lifetime and there may be
some capital protection
Pre-funded LTCI
For other types of plans, reviewable products predominate. The degree of

premium variation at renewal will depend mainly on the past and future expected
claims experience of the insurer and on estimated trends in the index (if any) to
which the policy is linked.
Question 5.18
(i) Why might reviewable premiums for LTCI cause more difficulties than
reviewable premiums for IP insurance?
(ii) How could insurers modify the review procedure so that some of these
difficulties were avoided?

5 Private medical insurance and related products
5.1 To meet needs
Private medical insurance will meet needs strictly only where there is no State
alternative available to the policyholder – either because a State alternative does
not exist, or because personal wealth levels may preclude his/her participation,
above eligibility criteria. In many territories, the State will provide some level of
healthcare to all; PMI is then bought when the individual wants a higher level of
care, such as:
• medical attention without waiting
• medical attention in higher standard of accommodation, eg private room
• medical attention with doctor of choice
• medical attention in a local hospital.
If no State-funded healthcare exists, PMI will usually pay for all forms of
healthcare needs on an indemnity basis. It will cover primary care (such as
visiting the family doctor or nurse) and hospital care for all forms of chronic and
acute illnesses.
5.2 To provide cash
Private medical insurance is normally an indemnity product – it pays the medical

treatment costs actually incurred by the policyholder and in many cases the
insurer settles with the provider of treatment directly. Only under special
circumstances will the plan provide cash.
Hospital cash plans are special arrangements designed to provide cash when
certain medical events take place (eg physiotherapy, new spectacles).
Question 5.19
Outline the key differences between the cover provided by a PMI and a Hospital Cash
Plan.
In territories where the State offers an alternative, the insurer may pay a daily
benefit in cash for time spent by the policyholder in a State hospital, which does
not otherwise incur cost for the insurer.
This can act to keep claims costs down by encouraging the policyholder to use State
facilities where these are available.

5.3 To allay fears
Where the State does not offer medical care for an individual, the fear is the
basic one that the cost of treatment may exceed disposable funds or may be at a
level to cause financial discomfort.
Where the State does provide the alternative, the purchaser may buy PMI
because he/she fears they may not be able to work and generate income while
waiting for State medical treatment. They may also fear the quality of treatment
and/or accommodation in the State sector and therefore be prepared to pay for
better medical treatment.
Question 5.20
Who else might share the fear of being “unable to work and generate income”?
The concept is clear and simple – indemnification of medical costs incurred

while insured. However the conditions that may be imposed may complicate
matters.
Underwriting and acceptance process can be misunderstood. The process by

which an individual becomes accepted for insurance will vary by market and
often also by insurers within the same market. This is particularly relevant to
the applicant’s medical history.
Medical underwriting is covered in Chapter 27.
Limits/exclusions can further confuse. Plans are seldom identical across a

market. The process of indemnification may be subject to certain upper limits or
excesses where the patient has to meet part of the cost. Certain treatments may
be excluded from coverage.
Limits may be imposed on the total payments or the number of treatments for an episode
of illness or on the total payments in each policy year. These limits may apply to each
benefit – for example up to £3000 for physiotherapy in any policy year or up to 10 days
of home nursing following a spell in hospital. Alternatively they may apply in the
aggregate, ie for all benefits in the period. These limits are designed to cut off the long
right-hand tail of the claim cost distribution.

The treatment of chronic conditions, pre-existing conditions identified in the initial

proposal for insurance and treatment designed to improve the insured’s lifestyle rather
than treat a medical condition (eg cosmetic surgery) would usually be excluded.
Pre-authorisation
The insurer may require the patient to receive authorisation (from the insurer)
before treatment begins, both to ensure that the procedure is covered and the
medical facility is appropriate under the policy. This may be deemed to restrict
freedom and may not have been understood at the outset.
However, this procedure should reduce the number of disputed claims, ensuring that
policyholders understand the extent of their cover before treatment begins.
Hospital bands/networks
Some policies provide cover explicitly only in certain types of medical

establishments (where costs are cheaper or where the insurer has a special
arrangement with the provider and this has been reflected in the premium
charged). Again this might not have been fully appreciated at purchase.
In many markets, the insured’s doctor acts as an initial “gatekeeper” in that treatments
covered must be recommended by the doctor or by a consultant to whom the doctor has
referred the insured.
Pre-authorisation by the insurer is an additional step. This ensures that the policy covers
the recommended treatment and the circumstances in which it is going to be provided.
Some policies will restrict cover to a hospital with which the insurer has negotiated
special prices for treatment.
This procedure also gives the insurer some control over the standard of treatment and
care that the hospital will provide. This may help to minimise the chance of complaints
by the insured about the treatment received.
Cost sharing
Policies will sometimes have intricate member cost-sharing arrangements,

which are not always well understood by the policyholder. For example, policies
may have one or a combination of individual service coinsurance and
deductibles/excesses by policy year.
Recall that coinsurance is where the policyholder pays a percentage of every claim cost,
while an excess/deductible is the amount of loss that the policyholder has to incur before
the insurer will pay anything on a claim.

Private medical insurance is almost invariably a one-year product and as such is

annually renewable. There are some instances of products with premium
guarantees for very limited periods (maybe three or five years), available at times
when rates of medical inflation are deemed calculable. The indemnity nature of
this product, uncertainty over future trends and the lack of control over the
costs charged by the supplier of the service in some markets, make guarantees
very difficult. As a one-year general insurance product, the insurer may refuse
coverage in any future period; but in practice this rarely happens.
A product called major medical expenses was developed in the UK to enable

long-term insurers to participate in the medical insurance market. This product
offers fixed pay-outs for medical expenses rather than indemnity and gives
guaranteed renewability for the term of the contract, but not guaranteed
premiums.
Question 5.21
Some PMI insurers charge premiums that are determined by the policyholder’s age at
entry provided that the policy is renewed each year. The premium charged each year is
the current premium for the policyholder’s age at entry.
Contrast the pattern of annual premium payments you would expect on one of these
policies with that you would expect for a policy where premiums were determined using
the policyholder’s current age rather than the age at entry.


Chapter 5 Summary
Customers are among those who have a stake or interest in the design of health and care
insurance products.
The primary interests of customers are to have products that appeal to them and that are
simple, easy to understand and affordable.
The products are designed to meet the need for customers to transfer risks that they face
to an insurance company. They provide cash or care for the policyholder and allay the
policyholder’s fears.
Income protection
IP policies are designed to meet the need for an income during injury or sickness that
prevents the insured from working. The product provides a cash rather than an
indemnity benefit. The policyholder chooses the amount of benefit. The benefits
payable are subject to limits imposed by the insurer so that the insured has an incentive
to return to work.
The policy benefits should be chosen to match the policyholders’ needs for income
(eg benefits for the self employed should be different from those who are employed and
can expect to receive support from their employer). Some policies may be earmarked to
meet particular expenditure (eg the repayments on a loan).
Benefits must be limited to ensure that the insured has an incentive to return to work.
Occupation will influence the length of a period of disability (eg some jobs are more
arduous). This means it is difficult for the insurer to draft readily understood policy
conditions, particularly in regard to the definition of the kind of occupation that the
insured is prevented from doing as a result of injury or sickness.
Some occupations have particular risk characteristics which mean that, in order to
control the risk, the insurer can only offer a restricted choice of policies.
Policy restrictions (eg on residence) are essential to control risks.
Premiums may be guaranteed or periodically reviewable. Selective lapsing will act to

limit the size of any premium increase.

Critical illness
CI policies are designed to provide a lump sum cash benefit on the diagnosis of any
serious injury or illness specified in the policy.
A variety of needs are met by a critical illness policy:

• Income can be provided from the lump sum via an annuity when the individual
cannot work as a result of his critical illness.
• Medical costs can be funded when the critical illness requires surgery or other
expensive treatment.
• The benefit can be designed to repay a mortgage or other loan.
• Business partners can purchase CI policies on the lives of each other such that
the benefits will fund the buyout of the stake in the partnership.
• It can fund a change of lifestyle in order to improve the claimant’s health.
• Other needs suggested include recuperation after illness, taxation planning,
medical aids (eg the installation of specialist equipment in the home).
Policy benefits are not related to the actual loss incurred by the insured and they can be
used for any purpose.
These policies have had an instant appeal to consumers as they are readily understood
and cover a risk that customers can recognise readily.
What are serious illnesses and how they are treated changes rapidly with medical
advance. This has made it difficult for insurers to assess the risks they face. More
recently insurers have tackled this problem by steering away from policies with
guaranteed long-term premiums and offering policies where the premiums are subject to
regular reviews.
Long-term care
In the past, LTCI has had less appeal to consumers than other health and care products.
In part this is because it is not clear to consumers the role that the State plans to take in
providing care in old age, and because for most consumers it is a risk that is many years
away and that comes low down on their list of priorities.
Long-term care insurance generally provides cash income, triggered by the onset of
incapacity. Pre-funded products are paid for by regular premiums. Trigger events are
usually defined in terms of ADLs, which need to be explained to an applicant.

While consumers may prefer indemnity benefits, insurers have found it increasingly
difficult to assess these risks and prefer to offer products with cash benefits.
Immediate-needs products present no problems for premium guarantees. For other

products reviewable premiums predominate. However, the scope for insurers to offer
pre-funded products with reviewable premiums is limited, as the incomes of older
policyholders are usually fixed.
PMI and related products
If they are to appeal to consumers, PMI products should be designed to complement or

augment the care offered by the State. This means that different designs will be needed
in different markets. The policies are normally written on an indemnity basis.
Policy conditions can complicate the product and lead to misunderstandings by

policyholders, eg:
• pre-existing conditions are often excluded
• cover is only usually provided for the treatment of acute conditions
• claims may be required to be pre-authorised
• the choice of hospitals or other establishments in which treatment can be
provided may be restricted
• there may be complicated arrangements for sharing the risk between the
policyholder and the insurer.
In addition, PMI is short term and usually annually renewable, and so premiums (and
sometimes policy terms and conditions) can be changed each year.
Hospital cash plans provide cash, rather than indemnity benefits, and are designed as a
budget-priced add-on to State provision. The benefits often extend to non-hospital
based services and routine preventative care (eg dental and optical care).


Chapter 5 Solutions
Solution 5.1
(i) Stake in product design
The actuarial body will aim to serve the public interest and also the interests of its
members. The public interest includes the regulation of products.
In the public interest it will want to ensure that there are a wide range of health and care
products available to cover the risks faced by individuals and organisations. It will also
want to ensure that its members use the best methods in the design of these products.
These methods will be up-to-date (they reflect current research and thinking), so they
will satisfy regulations, make efficient use of capital etc.
(ii) Actions to achieve its aims
Through education and examination it will ensure that its members are trained in all
aspects of the design of health and care products. It will encourage discussion of
product design through meetings, journals, conferences etc.
It will aim to provide its members with the most up-to-date education, advice and
guidance about health and care products.
It will make public statements and contribute to public debate about the design of health
and care products (eg press releases, evidence to government bodies). In particular, it
will want to help to ensure that products are regulated effectively, so that public
confidence in health and care products is maintained.
It will maintain standards through the issue of guidance notes and other advice to
members. It will help in design by collecting and publishing up-to-date tables of
morbidity and mortality rates.
It will maintain public confidence in actuarial advice about health and care by having a
disciplinary code that is mandatory on all members.

Solution 5.2
Consumers believe that PMI policies will pay for all medical care and not just for care
related to acute conditions.
Some consumers may believe that PMI is a long-term policy with guaranteed premiums
like life insurance, and not a one-year policy with reviewable premiums like motor
insurance.
Solution 5.3
(i) Principle of indemnity
Indemnity is “protection against loss”. So the insurance company will do whatever is

necessary to return the insured to the state they were in immediately prior to the event
happening.
The insured should not profit from the insurance (ie be better off after the event than
before it).
(ii) LTCI products
A policy that promised care in a residential home approved by the local authority
whenever your general practitioner recommended this would be an indemnity policy.
Your loss would be met exactly by the policy.
A policy that promised £500 per week whenever you were living in a residential care
home would not be an indemnity policy. £500 may or may not restore you to the
financial position you were in prior to needing residential care.

Solution 5.4
(i) Over-insurance
Over-insurance means that at the date of claim the policy benefit is greater than the
proportion of salary appropriate to maintain an incentive to return to work.
So, for example, an IP policy may limit claim payments to 60% of your salary
immediately prior to the period when you were unable to work through sickness or
accident. However, just to be on the safe side you chose and paid premiums for a
benefit equal to 100% of your salary.
(ii) Checking for over-insurance
The insurer checks for over-insurance through financial underwriting. Part of the
proposal form asks questions about current basic salary, overtime payments, bonuses,
tips etc. Proposers might be asked to provide an official tax or other document to verify
their income (eg a copy of their last P60 tax form in the UK).
(iii) Policyholders for whom these checks are difficult in practice
Over-insurance is more difficult to check for those who are self-employed or who have
an irregular income (eg plumbers, authors). The assessment is often complicated by the
fact that their income sources may include dividends as well as salary. A copy of a
recent tax assessment or a certificate from an accountant are possible sources of
information.
Solution 5.5
(i) The insurer
The insurer is likely to prefer cash benefits.
LTCI events will usually not happen for a considerable time. This makes the estimation
of the probability of their happening and the claim size when they do happen very
difficult.

The type of illnesses that are prevalent in the future and how these illnesses are treated
will influence the probability of needing long-term care. For example, Alzheimer’s
disease occurs relatively frequently at the moment and is likely to require expensive
care. However, advances in medical and related technologies in the future may see the
disease prevented or alternative less expensive ways of providing care for those with
cognitive impairment may be developed.
There may be other diseases as yet unknown that will present similar problems in the
future to those presented by Alzheimer’s disease today.
A cash benefit only requires the insurer to estimate the probability of a claim. This
presents fewer problems than also having to estimate the claim size.
Premiums for care policies would be very high compared to premiums for cash policies
(because of the substantial contingency loadings needed for care policies), and so they
may be more difficult to sell.
Policies with care benefits will require larger reserves. This effect is bigger if premiums
are guaranteed rather than reviewable. This may cause problems if the insurer has to
find additional capital should the experience turn out to be much worse than that
assumed in the premium basis.
(ii) The insured
The insured is likely to prefer care benefits.
By buying a care policy the insured will achieve his or her aim of removing the risk of
having to pay for care throughout their life. A cash policy has the residual risk that the
cash available will be insufficient to pay for the care they would like.
Cash brings another problem for the insured. At a time when their life has been
disrupted through illness or accident that needs long-term care, they or their immediate
relatives will need to find and purchase care. Aside from the time and trouble involved,
those buying the care will have little or no experience of buying products in this market
before. They will have little idea of the options available, what is a fair price, how to
judge quality etc. With a care policy experts from the insurers will have addressed all
these issues.
However, the premiums for care policies are likely to be much higher than those for
cash policies, so the insured may opt for a cash policy, particularly if the insurer offers a
“free” advice service for the purchase of care.

Solution 5.6
(i) Why does serious illness appear more common?
Serious illnesses and accidents (in a CI sense) have a high profile in people’s minds
because of their consequences, particularly the threat to life. However, long-term
sickness is much less noteworthy, particularly as it is often not a threat to life (ie people
are less “afraid” of it).
You tend to hear about nearly all the serious illnesses of people you know, but only a
small proportion of their long-term sickness events. So serious illness appears to be
more prevalent than long-term sickness.
Serious illness is restricted to a few diseases (eg heart disease, cancer) that tend to affect
people of particular ages. However, long-term sickness includes a wide range of
illnesses and injuries (eg work-related stress, serious bodily injury) that affect people of
many ages.
People are not very good at averaging out the effect over all ages. When critical illness
events occur they appear to affect a large proportion of people.
However, when long-term sickness events occur they appear to affect only a small
proportion of people.
(ii) Why is long-term sickness actually more common?
Long-term sickness is the result of a wide range of accidents and illnesses, many of
which are not life threatening (eg back pain, stress) or “serious” enough to result in a CI
claim, but are sufficient to prevent you doing your normal job. These accidents and
illnesses occur over a much wider age range than the serious illnesses.
So long-term sickness affects a greater proportion of the population than serious illness.
Solution 5.7
Two examples of risks not covered by CI insurance are:

• the result of serious accidents (eg injuries following a car accident), unless these
result in permanent disablement
• psychiatric and similar illnesses (eg stress), unless these result in permanent
disablement.

Solution 5.8
Points you might make to the caller are:
If you have an acute illness or accident then you expect that, after an operation or a
course of treatment, your condition will improve so that your health gets back to where
it was before your illness or accident.
However, there may come a time during your treatment when your condition does not
seem to be getting any better. Medical treatment makes your life more comfortable and
enables you to enjoy life, but the effects of your illness or accident are unchanged. You
are now suffering from a chronic condition.
Even though you have a chronic condition, it is possible that you may become acutely ill
again either through an illness related to your chronic condition (eg severe breathing
difficulties if you are suffering from asthma) or through an unrelated illness (eg a fall
resulting in a hip fracture).
The definitions of acute and chronic in the Glossary (Chapter 29) are:
Acute illnesses are illnesses or conditions of a non-degenerative nature where a cure is a

reasonable prospect. PMI generally only covers surgery and other treatment for illnesses
deemed acute.
Chronic illnesses are degenerative and/or generally incurable. The purpose of any
treatment is palliative. PMI does not generally cover treatment for chronic illnesses.
Solution 5.9
Clerical officer
The clerical officer will receive a monthly salary, and will probably receive full salary
during an extended period of absence from work as a result of accident or sickness
lasting for six or possibly twelve months. So a policy with a long deferred period would
be appropriate.
There will be lots of opportunity for work in clerical or related areas. These jobs are not
very physically demanding. So, rather than choosing a policy with an own-occupation
benefit definition, a definition based on the occupation to which the insured is suited by
way of education or training might be more appropriate, and it should be cheaper.

Veterinary surgeon
The veterinary surgeon will receive fee income, and so no work means no pay. So a
policy with a very short (eg one week) deferred period would be appropriate.
Treating animals is a demanding job and there will be few opportunities for equally
well-rewarded work that is less arduous. So the insured’s preference would be for an
own occupation benefit definition.
There would be little to distinguish between the needs of these two individuals on other
characteristics of the policy design (eg waiver of premium, benefit escalation).
Solution 5.10
(i) Manual workers
Manual work in the building trade is very arduous, and even a minor accident or illness
might prevent someone from working at his or her normal job. Also, despite health and
safety rules, accidents are relatively common. So the probability of a claim is very high.
For similar reasons, if a claim occurs, then the period of disablement may be longer than
for other occupations because complete recovery will probably be necessary before the
insured is able to work again.
These two features will mean that, if cover can be offered, premiums will be very high
compared to benefits, and so the policies will not be very attractive to consumers.
(ii) Policy modifications
Only selling policies with a long deferred period would reduce the risks for the insurer.
However, workers would find this unattractive because most employers only offer a
short period of full pay during sickness absence and any State benefits after this may be
seen as inadequate. Many building workers are self employed and would need a short
deferred period. This would not be a good modification.
Changing the occupation definition from “usual occupation” to “occupation to which

the insured is suited by education or training” after, say, six months of benefits would
act to control the risk. Workers might find this acceptable because if they had been
unable to work for six months, they might see a change in occupation as a natural way
of coping with their illness.

Only offering short-term sickness benefits with short deferred periods, eg 60% of
pre-sickness earnings for 12 months, then 40% for a further 12 months is another
possibility. This would go some way to controlling the risks and be attractive for
similar reasons to those for changing the occupation definition. The period of benefit
could be tailored to the cause of the sickness.
Solution 5.11
(i) Items in a typical PCA test
• Getting up from a chair.

• Standing.
• Walking.
• Lifting and carrying.
• Walking up and down stairs.
• Bending and kneeling.
• Using your hands, manual dexterity.
• Transport: the ability to travel, eg getting in and out of a car unaided.
(ii) Advantages of tests
The tests are independent of occupation and concentrate on generic skills, so they will
be easier to apply on a consistent basis. Claims staff only need to be familiar with one
system.
The tests are more objective, and may be easier for the insured to understand. There
will be less possibility of disputes about claims.

Solution 5.12
CI pays a cash sum on the occurrence of one of the serious conditions listed in the
policy, irrespective of the actual loss suffered by the insured.
PMI is an indemnity product that pays for the actual medical treatment expenses
incurred as a result of sickness or injury. The size of the payment is related to the actual
loss, and so it is more focused.
IP provides benefits when the insured is unfit to work in their usual occupation
(although other definitions can be used). So, for example, a broken arm may prevent a
carpenter from working normally and result in an IP payment, but the injury would have
been treated in an accident and emergency department with no PMI payment and no CI
payment (because the injury was not serious enough). So IP is often more
comprehensive than CI.
Solution 5.13
The policy could recognise that not all serious injuries and illnesses are equally serious.
There could be a sliding benefit scale related to the seriousness of the condition. So, for
example, a malignant tumour that has invaded adjacent tissue might pay 100% of the
sum insured, while angioplasty might pay 25% of the sum insured.
We would need to change the policy conditions so that the first claim did not terminate
the policy. Second and subsequent claims for a different condition or a worsening
condition, would be allowed. Only once 100% of the sum insured had been paid would
the policy terminate.

Solution 5.14
In effect all insurance policies involve underwriting at the time of the claim (eg for life
insurance, checking of the death certificate for the life insured).
The insured events for a CI policy are complex. These events are carefully defined in
the policy conditions and may not correspond exactly to the events described using the
same words in everyday speech. So we need to collect information about the medical
events surrounding the illness, and the results of tests that show whether or not the
insured event has occurred.
Sometimes a policy excludes specified pre-existing conditions that were identified when
the policy was issued. Claims underwriting will allow us to identify and exclude events
relating to these pre-existing conditions.
In some markets, insurance companies have cooperated in the use of standard policy
definitions. This helps to prevent misunderstanding of claim events by policyholders
(eg common documentation, industry advertising to give information and raised
awareness). It also helps in improving the quality of information provided by medical
advisors because there will only be one set of criteria used by all insurers.
Solution 5.15
In a proprietary company the shareholders will provide the additional capital.
In a mutual company the other policyholders who are members of the society (ie entitled
to a share of its profits) will provide the additional funds needed.
However, in either case, other sources of capital may be found, eg from reinsurance
arrangements.
Solution 5.16
Treatment that involves long-term care is by its definition the treatment of a chronic
condition. Payment for the treatment of chronic conditions is normally excluded from a
PMI policy, so most conditions would not be covered. However, the treatment of acute
episodes, while the insured is receiving long-term care, is covered by a PMI policy.

Solution 5.17
Policyholders may believe they are entitled to care as soon as they feel they would
benefit from it. This may be for social reasons (eg their informal carer cannot continue
to provide care) or for medical reasons (eg they have become forgetful). However, the
policy sets out precise conditions for benefit entitlement (eg failing 3 out of 6 ADLs).
In the policyholder’s eyes these criteria may appear to be very severe. Insurers have
used other criteria (eg personal capability assessment (PCA) – see Chapter 1) that are
more specifically related to being unable to do things for yourself. Policyholders may
find it easier to understand these tests and relate them to their need for care.
Solution 5.18
(i) Difficulties
IP policies are usually written for a term that is related to a person’s working life. A
review of premiums that results in an increase may be unwelcome, but the insured is
likely to have an increased income to meet these new premiums.
Pre-funded LTCI policies are usually written on a “whole of life” basis. So

policyholders will be expected to pay premiums after retirement. Retirement income
usually increases at a maximum of the rate of price inflation, rather than the usually
higher rate of wage inflation.
If reviewable LTCI premiums increase more rapidly than general price inflation, then
reviewable LTCI premiums are likely to take an increasing proportion of the insured’s
income in retirement. There may come a point at which the insured feels unable to pay
the increased premium and so will be left without insurance.
(ii) Modifications
A common solution is to have reviewable premiums until the insured is aged, say, 80
but guaranteed premiums after this.
This provides reassurance to the policyholder. Also, the extra risk is limited for the
insurer because only a relatively small proportion of the policyholders will survive to
take advantage of the guaranteed premiums.

Solution 5.19
A PMI policy is an indemnity policy. A cash plan is not an indemnity policy, but pays
fixed cash benefits.
The policyholder must incur costs to claim most benefits under a PMI policy. Provided
an insured event has occurred (eg hospital admission) the cash plan will pay benefit
whether or not the insured has suffered any loss.
A PMI policy usually only covers the cost of acute treatment. A cash plan has benefits
that extend to regular treatment (eg optical or dental check-ups).
Cash plans usually have much lower premiums, have simpler benefit structures and use
only straightforward underwriting procedures.
Solution 5.20
Your employer might be particularly concerned if you were unable to work, particularly
if you fulfil a vital role in the business. This might be especially important for a small
business where roles in the business are not duplicated (eg one bricklayer in a small
building business) or where each person generates fee income for the business
(eg partners in a veterinary practice).
Solution 5.21
Premiums for PMI policies using age at entry can increase if claims costs increase
because of inflation in medical costs. So we would expect the age at entry premiums to
increase each year at roughly the inflation rate for medical costs. The inflation rate for
medical costs is often much higher than general price and wage inflation.
Premiums for PMI policies using current age will increase by the inflation in medical
costs, together with the increase in expected claims costs as the result of increased
morbidity because the policyholder is older.
So age-at-entry premiums will rise more slowly than current-age premiums.
In life insurance we also charge a premium based on the age at entry, but we also
guarantee that this premium will not increase.

Chapter 6
Product design and stakeholder interests
(2) Other stakeholder interests
Syllabus objective
(c) Outline the principles by which health and care insurance contracts are
designed and the interests of the various stakeholders in the process:
– customer attraction and clarity
– insurer control and profitability
– regulators’ satisfaction
– employer as purchaser
– other stakeholders: equity, guidance notes, sales processes, IT.
The items marked in bold are covered in this chapter.
0 Introduction
In Chapters 1, 2, 3 and 4 we introduced each of the main health and care insurance
products. In Chapter 5 we introduced the idea of a stakeholder, and discussed the
interests of the customer in the design of products.
You may find it useful to have the summaries of Chapters 1, 2, 3 and 4 to hand to
remind yourself of the key features of each product as you read this chapter. It would
also be useful to re-read the Introduction to Chapter 5, in particular the discussion of
what is meant by a stakeholder interest.

As it was in Chapter 5, the health insurance product will be at the centre of our
discussion in this chapter. Surrounding the product there are the customers and other
groups who have a stake in its success. We have already looked at customer interests;
now we will look at each of these other groups of stakeholders in turn, and discuss their
particular interests.
We will look at the following stakeholder interests:

● Insurers in Sections 1 – 5.
● Regulators in Section 6.
● Employers in Section 7.
● Everybody else (eg actuarial profession) in Section 8.
The insurer is an important stakeholder. Most other stakeholders will be external to the
insurer’s organisation, but in a large organisation there will also be stakeholders who are
internal to the organization, eg the IT department.
You may find it helpful to put yourself in the position of each stakeholder and consider
things from their point of view. If you have worked for an insurance company it will be
easy for you to view things from the point of view of the insurer. The regulators’ and
employers’ points of view will be more difficult to imagine.
Question 6.1
Why is it important for the insurer to take account of the customers’ interests in the
design of a product?

1 Insurer as a stakeholder
The insurer is primarily interested in ensuring that it remains profitable, but also needs
to maintain control of the risk-management process. Various aspects of product design
will impact on these stakeholder interests.
In this section, we look at the general issues in which the insurer has an interest when
designing health and care insurance products. Sections 2 – 5 will then look at
product-specific issues for the insurer.
1.1 Product design
The insurer will design the health insurance product to meet customer needs
and/or provide some element of customer gain (the perceived value of the
benefit exceeds the cost of premiums). To be attractive, it must be clear about
both:
(a) the benefits provided in terms of the claims triggers and cash values
(b) the amounts and variability of premiums.
The product must offer sufficient benefits to justify the price charged.
On the other side of the coin, the clarity must extend to a legal set of conditions
that provide a framework for statistical costing, by being able to predict future
outgo. It must be concise enough to prevent anti-selection and moral hazard.
Question 6.2
Explain the difference between anti-selection and moral hazard.
The product must be capable of being distributed through the insurer’s normal
sales channels. Consultation with their representatives will normally be a vital
part of contract design.
The product must be designed to meet customer needs. Many insurers do not sell
directly to the public, but market their products through intermediaries (the insurer is the
producer and the intermediary acts as the retailer). Because insurers are not in direct
contact with customers, they may learn little about customers needs. Intermediaries can
help provide this information. Some insurers will also use market research to help in
the design of their products (eg sample surveys or focus groups of customers or
potential customers).

Finally the local regulators may have certain requirements to be met in the way
in which healthcare products may be designed.
This is discussed further in Section 6, when we look at the regulators as stakeholders.
In some territories, new contracts have to be approved by the regulators before

they can be launched and premiums may need to be filed with the regulators to
prevent excessive charging.
This will be particularly important in markets where there are only a small number of
insurers and the insurance product is bought by almost everybody (and so is in effect
compulsory).
1.2 Risk pricing
The actuary or other risk-costing analyst will attempt to estimate the likely
benefit outgo from the contract design. In order to do this, he or she will seek
the most up-to-date relevant statistics. The availability of suitable statistics will
vary by territory and by product. Reinsurer assistance will often be a key factor
in the provision of statistics, as well as in the contract design and the
mechanics of pricing.
We will discuss the requirements for data, particularly in relation to pricing, in Chapters
10 to 12.
Question 6.3
Consider the following two products:

● a special CI policy that pays £10,000 on the diagnosis of the failure of a kidney
● a special PMI policy that pays for treatment following kidney failure.
Describe briefly the statistical data that you would need in order to estimate the cost of
the benefit outgo on each policy.

Product design and pricing will often be an iterative procedure as each is

adjusted in turn so that all the various targets can be met:
● customer acceptability
● regulator requirements
● needs of distributors
● price competitiveness
● adequate profitability/return on capital
● company culture in product style and price
● systems and other internal constraints
● underwriting methodology.
The specifics of the pricing of healthcare products are covered in

Chapters 10 to 20.
So in designing the product the insurer needs to pay attention to the needs of the other
stakeholders (the first three targets listed above). The last five targets reflect the
insurer’s stake. But some of them relate to aspects of the insurer operations in which
the actuary will not have direct involvement. So within the insurance company there
will be other stakeholder interests, which the actuary must take into consideration.
1.3 Medical underwriting
The rationale for medical underwriting and policy acceptance is such a

fundamental element of product design and pricing, that it may dominate many
of the conditions within the contract and be a key determinant of the premium to
be charged. For example in private medical insurance, the decision to employ
the technique of moratorium underwriting (where the applicant is not asked any
medical questions at the outset and can claim for any condition other than those
pre-existing in a defined period before acceptance) has impact on every aspect
of product development and on all internal systems of control thereafter.
The process of medical underwriting will be described in Chapter 27. It is the process
by which we collect data about the proposer’s current health and their medical history in
order to assess the risk we are being asked to insure, and using this information we
decide whether or not to accept the risk and on what terms.

Importance of underwriting
Underwriting is more important for long-term policies with guaranteed premiums,

benefits or terms. In these cases the insurer has no opportunity to revise any of the
terms and conditions of the policy.
Some policies will have guaranteed long-term benefits, but their premiums are subject
to regular review (eg IP policies might have premiums that are reviewed every five
years). However, the insurer is obliged to offer to renew the policy and so does not have
the opportunity to exclude those with a poor claims record. Premium review is for the
portfolio of policies, and so it is not possible to impose special premiums on those with
a poor claims record. So underwriting will be important for these policies as well.
Even a one-year renewable policy, where both benefits and premiums (for each portfolio
of policies) can be reviewed every year, still needs underwriting to prevent the office
accepting sub-standard risks when the policies were originally issued. Assuming that
initial medical underwriting applies, this would be undertaken when the policy is first
taken out, and so the underwriting terms would apply for as long as the policyholder has
the contract, ie there would be no further underwriting at subsequent renewals.
Long-term policies provide the insurer with the opportunity to recover the initial costs of
underwriting over the first few policy years, and so the impact on premiums of
underwriting expenses will be modest.
One-year renewable policies provide less opportunity to spread expenses over many
years. This is because non-renewal rates for one-year policies tend to be higher than
lapse rates for long-term policies, and so the expected duration for one-year renewable
policies is much shorter than for long-term policies. These expenses can have a
significant impact on premiums. So there is pressure to use alternatives to initial
medical underwriting that involve minimal expenses. Moratorium underwriting, where
medical evidence is only collected once a claim has been made, is one of these
approaches. This is described in more detail in Chapter 27.
1.4 Premium or benefit change on renewal or review
A large measure of insurer control under healthcare products is exercised at

renewal and/or review. Because of the potential volatility of experience, most
healthcare insurance products are annually renewable or periodically
reviewable. At this point, the insurer will compare past experience to that
expected and project likely experience going forward.

The result of this analysis, which will identify the cause of the deviations from
expectation, will prompt the extent to which changes in premiums and benefits
could or should be made and may prompt the nature of these changes that are
possible (or necessary). Benefit changes may entail product redesign, such as
amendments in range of critical illnesses covered, or the redefining of private
hospital bands.
Where analysis indicates that expansion of cover is possible, this may be viewed
as a reward element for good experience and to encourage persistency or
renewal.
Where analysis indicates that benefits must be reduced or premiums increased,

the insurer must be wary of resultant selective lapsing (the better risks choosing
to leave), which will exacerbate the problem that the changes were trying to
solve. Alterations of this type will necessitate a monitoring of current
competitors’ pricing and practices in this regard.
Question 6.4
Why should you monitor competitor’s prices in this instance?
1.5 Claims procedures
The claims procedures that the insurer intends to utilise will be another
important consideration in the pricing and product design process. It is
imperative that these are consistent with the underwriting criteria which accept
policyholders and important also that they are consistent with the data
underpinning the pricing calculation (or that adjustments are made accordingly).
Claims procedures should match policyholder expectations in the length of time

prior to claim settlement and the amount of information required. They should
be roughly on a par with the practices of competitors to avoid anti-selection and
an upsurge of business for the insurer with the weakest claims requirements.
Question 6.5
What are the causes of delay in the settlement of claims for CI policies?

1.6 Reinsurance
The decision to reinsure (what method, how much and with whom) will certainly
be part of the pricing process and may well impact too on the product design.
For example, it may influence the policy limits that should be included. An
inexperienced insurer may rely heavily on a reinsurer for local and/or product
knowledge to help with contract construction, suitable clauses, the needs of
regulators and the pricing implications of each of these considerations.
The training and resourcing of different functions within the insurance operation
may also involve reinsurer co-operation if not management.
Question 6.6
Why is reinsurer expertise more important for health and care insurance products than it
is for life insurance protection products?
These and other aspects of reinsurance are covered in more detail in Chapter 26.

2 Insurer as stakeholder: income protection

In Section 1 we discussed general issues that might be important for the insurer’s stake
in a health and care insurance product. In Sections 2 to 5 we highlight some important
ones for each of the four main products.
The first challenge of insurer control will be applicant underwriting/acceptance

and the charging of appropriate premiums. This will necessitate splitting
applicants by risk factor (by occupation, area of residence, age, sex) and
requesting adequate information prior to acceptance such that the risk can be
properly estimated.
Similarly, the appropriate information has to be requested to substantiate a

claim, checking that this information is consistent with that provided at the time
of policy application. The level of benefit will be checked against current salary
to ensure that the policyholder retains an incentive to return to work.
Once the claim is approved, a claims counsellor will normally be allocated to:
● provide advice for the claimant in coping with the disability and
● provide for the insurer a likely duration of the illness (establishing such a
date of return to work in the mind of the patient).
Question 6.7
Most IP policies have a deferred period before the payment of the benefits begins. How
do insurers make use of this period to ensure that claims are processed efficiently?
Thereafter the insurer will put in place a procedure for monitoring the ongoing
claim, with periodic visits and continuing medical certification. The frequency of
these will depend on the severity of the complaint. The monitoring process
increasingly these days focuses on the rehabilitation of the claimant and is
performed where appropriate by specialist nurses.
Question 6.8
Describe the policy conditions that are designed to help the insured back to work.

3 Insurer as stakeholder: critical illness

Critical illness insurance provides a lump sum benefit that, by definition, is not
intended to indemnify the claimant against medical costs or other financial
needs. The insurer must be on guard against anti-selection and non-disclosure
by effective use of its underwriting and claims processes.
In offering standalone products, the insurer will be keen to avoid paying out
unnecessarily on death (which is not priced into the product) and hence the
wording and management of the survival period, typically 28 or 30 days will be
key to profitability.
So, a critical illness claim that satisfies the listed conditions in the policy, will only be
paid if the insured survives a period of time from the date of diagnosis of the condition.
Control will also necessitate an adequate financial reserve to cover late notified
claims that arise, maybe up to five years after the original incidence.
Question 6.9
Explain the difference between incurred but not reported (IBNR) claims and reported
but not settled (RBNS) claims.
Some insurers will attempt to control the risks presented by the late notification of
claims, by imposing a notification period, such that only claims submitted within, say,
two years of the qualifying event are eligible for payment.
The process of dealing with these claims is covered under “Claims – late notification” in
the Glossary (Chapter 29). Reserving for late notified claims will be discussed in
Chapter 21, Reserving.
Proper control will also have to be exercised in managing the expectations of

both policyholders and distributors when new diseases are “discovered”. The
practice in some territories has often been to include these at little or no extra
cost. All must be properly costed and advice (from reinsurers or others) taken
when the insurer cannot easily estimate the implications. Similar situations
arise with other market moves to extend or restrict cover such as the
introduction of certain guaranteed insurability options.
Question 6.10
Describe a guaranteed insurability option (GIO) that could be used to allow a

policyholder to increase the sum insured on a 20-year stand-alone CI term insurance.

4 Insurer as stakeholder: long-term care insurance

In many countries, the well being of individuals in their old age, and the funding
of the finance required to provide care, are political hot potatoes. The insurer
needs to have flexibility in contract design and the provision of benefits such
that future changes in State attitude to long-term care will not cause loss that
has not been costed.
So, for example, the State might to decide at some time in the future to charge for
nursing as well as personal long-term care. An insurer providing care benefits will face
increased costs unless this can be controlled by virtue of the product design (eg by
reviewing benefits and premiums)
Also the policyholder perception that the contract provides care not cash, and
the regulator’s interpretation of this promise may warrant margins in the future
potential claims outgo. The insurer must be aware of such future dangers.
In other words, the insurer should allow prudently for possible extra claims outgo, if the
regulators insist that benefits are enhanced beyond those intended by the insurer. This
may result from disputed claims, where the regulator rules in favour of the policyholder.

5 Insurer as stakeholder: private medical insurance

The insurer exercises a great deal of pricing control in that these are short-term
contracts and generally they can be repriced annually.
However, the insurer lacks a certain control over benefit payouts since these
indemnify the charges of a third party (usually a hospital plus surgeon plus
anaesthetist). The insurer may be able to agree fees for certain procedures with
some providers in advance; the larger the insurer the more possible this is.
However, the patient is usually free to receive treatment wherever he or she
decides (subject to policy limits); this will restrict the insurer’s ability to control
costs. The insurer sometimes attempts to limit costs after the treatment has
been carried out if the bill received is deemed unusually high for a particular
treatment.
For example, it is common for PMI policies to restrict claim payments to those that are
“reasonable and customary”.
Alternatively, an insurer can put in place a requirement of pre-authorisation

where the policyholder is required to get both his or her treatment protocol and
place of treatment approved before care begins. This is not always in keeping
with market practices and may infringe the freedom of choice expected with this
policy.
In most countries, medical inflation has far outstripped the rate of consumer
price inflation with which customers may be more familiar. This makes it hard
for the insurer to convince the policyholder of the need for the annual price
increases that the insurer needs to impose to maintain profitability. The rate of
medical costs inflation may be a function of many things, including:
● an ageing population of policyholders
● lack of sufficient supply of hospital beds or professional medical
practitioners forcing up prices
● the move to newer and more expensive treatments or drugs for certain
conditions
● a greater propensity for policyholders to claim following a perceived
deterioration in State-provided healthcare.
In addition, medical costs will increase as a result of increases in the salaries of medical
staff and the cost of equipment.

6 Regulators as a stakeholder
The regulator’s priorities are:
● that insurers remain solvent
● that consumer detriment in sales, administration and claim payment is
minimised if not totally eradicated
● that the insurer files adequate and accurate reports to enable the
regulator to assess the insurer’s probity (how deserving of trust the insurer
is) and solvency appropriately.
The issues of solvency and reporting are considered elsewhere in this course.
To protect consumers, the regulator will be keen to see that the policy has clear
and unambiguous wording, and that it offers a range of benefits that a
purchasing customer might expect (from its title or from similar products in the
marketplace). The interpretation of the titles “critical illness” and “long-term
care” have been flagged as potential danger areas.
The regulator is concerned that consumers are not misled. This can be achieved by
regulating the sales processes. The insurer (or the agent acting of behalf of the insurer)
is usually required to discover exactly what risks the consumer wants to insure, and then
to explain clearly how the product being recommended meets these needs. The
regulator will often insist that the consumer is provided with a written document that
explains clearly the key features of the policy that is being recommended.
The product should represent reasonable value for money, relating premium to
benefit and comparing costs with others available in the market.
The sales processes will be monitored to ensure that an appropriate product is

sold at the right level, taking into account customer needs and ability to pay,
that there is no undue pressure to purchase (cooling-off periods, where the
purchaser may change his/her mind, may be in place) and that promises made
as regards the product are in keeping with the policy conditions.
Question 6.11
In most countries the sale of cars is not regulated, so why is it thought necessary to
regulate the sale of health and care insurance?
In some countries, the regulator may require premium increases on health

contracts to have regulatory approval prior to implementation.

This will be particularly important in countries where insurance is, to all intents and
purposes, compulsory, and there are only a limited number of insurers.

7 Employer as a stakeholder
The employer has a stakeholder interest as the purchaser (or sponsor) of group health
and care schemes, particularly IP and PMI.
Certain different considerations apply to product design and control when

considering healthcare protection packages sponsored by an employer.
Differences will arise in the underwriting and acceptance procedure, in the
methodology for pricing (see Chapter 16), in the purposes of the product and in
its manner of distribution.
Group products can arise:

● where the employer pays the whole premium on behalf of the employees
● where the cost is shared between the two parties (the employer may pay
part or all of the employee cost, but the member must pay for any
coverage desired for spouse or children)
● where the employer collects premiums (eg by payroll deduction), but the
employee pays all costs.
Other groups are not employment based, but based on a common affinity. The
members of such a group may all belong to the same club (eg motoring
organisations, trade unions) or all have the same credit card.
The more tightly defined the eligibility for membership and the closer to
compulsion the participation, the more relaxed the insurer can be towards
underwriting and pricing.
A tightly defined group will be more homogeneous (eg nearly all the same social class,
all working in the same industry, all living in the same area), and so apart from
individual risk factors (eg sex, age), risks will not vary and members can be charged the
same premium. Compulsory membership will mean that the insurer obtains a spread of
good and bad risks, and selection against the office will not be a major problem.

7.1 Underwriting and acceptance
There are special considerations that apply to the underwriting and acceptance of new
group business.
The insurer underwrites to ensure that on average the risk represented by the
lives accepted for cover matches that expected when the premium rates were
produced. When presented with a body of risks applying together, the
underwriter can afford to take a more global view in assessing whether the
experience of the group as a whole will approximate to that in the premium
basis.
Some lives in poor health may be accepted because they are balanced by lives in
very good health within the group. The group’s own experience suggests the
premiums that might be charged, if the quantum of risk experience is such as to
ascribe a certain statistical credibility. Thus, unless there has been a significant
change in the make-up of the risk components, the lives within the group can be
accepted as they stand. However, special consideration may still need to be
given to any IP, PMI or possibly CI claims that are in payment or about to be
paid, if they would fall to the new insurer as a liability.
When a group policy moves to a new insurer, the insurer might take on responsibility for
all the current as well as the future liabilities of the scheme. In such circumstances, it
would be desirable to assess the costs of all these current liabilities, particularly those on
which lots of information is available.
The underwriter for group IP and CI may still require individual underwriting for
the largest cases. Persons seeking cover above the “free cover limit”, because
of their salary or status entitlement, would be assessed on their own merits and
terms decided appropriately.
Question 6.12
Describe what is meant by the free cover limit.

7.2 Purposes of group insurance
Group arrangements may be devised because it is a legal requirement

(eg income protection insurance in some territories).
It may be a positive message to prospective employees at the recruitment

process or to existing employees at a certain stage of promotion; critical illness
or private medical might apply here.
The employer may want a package that appeals to all employees or just a small group of
employees (eg departmental managers).
It can act for both parties to promote health and ensure a speedy return to work
following an operation (private medical insurance). It can act as a mechanism to
smooth the process of early retirement on grounds of ill health, when an
employee is in continuing poor health (group IP).
Group covers may have tax advantages over individual insurances in some
territories.
In this case the employer can offer the employee a benefit that has a greater perceived
value to the employee than its cost to the employer.
Quite often, the employee will have the choice of which benefits to select from a
range of alternative provisions which the employer is prepared to make, some of
which will require staff contribution; these are commonly known as
cafeteria-style or flex-style benefits. Each benefit brings its own tax
considerations, either of the premiums as contributed or on the benefits when
paid.
Sometimes a benefit that is provided to the employee without charge is regarded as a

form of salary, in which case the employee will be taxed on the cash equivalent of the
benefit provided, eg the premium on a PMI policy.

7.3 Distribution of group products
In some territories, such as the UK, the largest group arrangements are almost
exclusively in the hands of certain independent financial advisors (brokers) who
specialise in the business. These 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, eg by introducing a new sickness absence policy.
In other territories, and with smaller groups, products may be distributed

through insurance brokers, other intermediaries or may be sold direct to the
client. The ability to introduce risk husbandry may thus be greater.
When the insurer is in closer contact with the employer there will be a much greater
opportunity for the 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.

8 Other stakeholders
This section looks at the interests of other stakeholders. We examine:
● The importance of equity between different groups of policyholders.
● The role of professional guidance notes.
● The stakeholder interests of those who sell the products.
● The stakeholder interests of those who provide the information systems to
administer the products.
● The stakeholder interests of the actuary involved in the product design.
8.1 Cross subsidies and equity
Product design and pricing will inevitably involve parcelling of risks and
averaging of premiums. Indeed it may be imperative to align one’s price to fit
current market processes. However, it is important that products match needs
as individually as possible and that profitability is assessed by using
homogeneous risk cells as far as possible.
In order for certain product lines to sell in a particular market, it may be

necessary to spread expense contributions and other considerations across
product lines. This must be monitored with a view to establishing a more exact
code of product pricing in the medium term, with each contract making its own
share of company-required profit. Such complications can arise initially where
certain distributors are responsible for more than one product type and
subsidies are inevitable.
Circumstances where a product is sold at a price that does not satisfy the required profit
criteria can be sustained in the short term by cross-subsidies from other products.
The actuary will need to ensure that the rights of different classes of
policyholders to security of benefit are not transgressed by cross-subsidies.
These rights will encompass reasonable expectations of bonuses if with-profits
contracts are entitled to share in the surplus of health and care business.
Question 6.13
Why might an insurer want to subsidise a heath and care product in the short term?

8.2 Cost of guarantees
The difficulties of writing guaranteed benefits or premiums in health and care

insurance have already been mentioned.
In particular, we have discussed:

● the difficulties of guaranteeing premiums on long-term IP, CI and LTCI policies
(Chapters 1, 2 and 3 respectively)
● the difficulties of keeping the insured conditions up-to-date on long-term CI
policies (Chapter 2).
There are certain guidelines that should be followed in deciding whether or not to offer
guarantees.
In summary here the rules are:

● ensure there is a customer need. This may be difficult in an
intermediated market where the broker will have a large say in the
interpretation of client needs and in the recommendation of guaranteed or
reviewable formats
● price as accurately as possible by projecting the range of potential
outcomes
● charge the cost of capital to the product, if possible
● obtain sound reinsurance, building the cost into the product if necessary
● ensure that marketing and other policy literature is clear in its description
of the guarantees
● ensure that adequate reserves are in place when the business is written.
Question 6.14
The monthly premium for a 20-year stand-alone critical illness insurance on the life of a
42 year-old male with a sum insured of £100,000 is £32. The premium is subject to
review every five years.
The guaranteed monthly premium for the same policy is £62.
Explain why the policy with the guaranteed premium is so much more expensive.

8.3 Guidance notes
The description of the professional guidance that applies to the actuary is

outside the scope of this course (but see Chapter 8 Section 5). The actuary must
comply with actuarial guidance in the territory of operation. Both the actuarial
body to which the actuary belongs and the body presiding over the territory in
which he or she is operating are stakeholders in the exercise of his or her
judgement.
Guidance covers all aspects of the actuarial function, including the pricing of contracts,
reserving and reporting to others on the state of a block of business.
8.4 Stakeholders interests of those involved in selling products
Products which sales channels can sell
The sales channels for selling health and care insurance are described in Chapter 7. The
mains channels are:
● independent intermediaries (IFAs)
● tied agents (agents with links to particular insurers)
● an insurer’s own sales force
● direct marketing by the insurer to the consumer.
The people responsible for selling the insurance products, that the actuary is
designing, are important stakeholders in the process.
The actuary should involve sales people early in the design project. Not only
will this give the actuary a better feel for what might sell in the market place, but
he or she will also get insight into customer needs in appropriate segments of
the population and a view of what competition is doing in these fields. The
iterative process of benefit and premium adjustment may give the salesperson a
better understanding of the value and cost of aspects of the product’s package.
The actuary may also be involved in sales training, explaining the main features
of the new product, the needs that they address and the important messages to
impart in the sales process. This will ensure a greater clarity of the product’s
purposes. The product’s commission and clawback structures will also be
explained, as will the scope for premium review. The extent to which the
product must fit with local regulatory sales and disclosure rules must also be
clearly described.

The different types of commission and clawback structures will be discussed in

Chapter 8.
Balancing commission, competitiveness and profitability
The product must:

● have sufficient sales incentive to encourage distribution
● be priced to attract customers (in preference to competitors)
● retain sufficient margins to ensure an adequate return on capital.
The balance between these competing forces is a fundamental task for

management.
Question 6.15
Describe what will happen if a product fails to satisfy each of the above criteria.
8.5 Stakeholder interests of those providing information systems
Systems implications
Systems can be a positive source of information for the actuary, but often, in the
product development process, they act as a constraining influence. The actuary
must be aware, when proposing a new contract, of what existing systems can
accommodate and what can be changed, at what cost and in what timescale.
The key considerations are these:

● computer systems must record all processes of insurance
● they must provide information to enable profitability to be assessed
● new products will require systems’ reorganisation
● any launch or redevelopment will require a reappraisal of priorities
● the expenses of IT changes must be included in the product costing
● time must be allowed for development and testing
● continuing dialogue with a key systems decision maker will be important
in the process.

Data collection
The capture of data is crucial to the management of the business, initially in the
administration, but latterly in the monitoring of own company experience, and
subsequently in the use of these data to re-price the products on a more relevant
basis.
The information technology must:

● capture individual policy details at inception
● align or link these to claims information as it unfolds
● combine the policy and claims data to monitor profitability
● group by risk characteristics – the lower the level of detail, the more
specific the remedies available
● be able to add external data as appropriate
● be able to model and project, including other aspects of company
cashflow.
8.6 Stakeholder interests of the actuary
We now consider the factors that an actuary will consider when determining the
suitability of a proposed contract design, not all of these will necessarily apply
in every situation.
The factors which apply to a completely new product will be equally relevant in
assessing both the continuing validity of an existing product, and the appropriateness of
any proposed modification to existing products.
Profitability
A company will want to ensure that the premiums charged for contracts will be
sufficient to cover the benefits provided and the expenses in most foreseeable
circumstances, with, for proprietary companies, a surplus to reward
shareholders whose capital has been risked in support of the company.
At a general level, a healthcare insurance product can be broken down into two
components: protection and administration. This brings into focus the true nature of a
product: it is the provision of certain services to the policyholder by the insurance
company.

What is important is that the product be profitable in its entirety, but ideally every
product should be profitable in each of these dimensions:
● Protection: the premium basis morbidity and mortality assumptions should cover
the risk involved. This risk will be gradually changing and this future change
should be allowed for if appropriate, eg by projecting the incidence rates of
different critical illnesses.
● Administration: the expense loadings must cover the marginal acquisition and
administration costs for each individual policy. Further to this, the company will
require that its total expenses are covered by total expense charges (subject to
any conscious cross subsidies). Each policy should therefore also contribute to
the fixed costs of the insurance company.
For unitised contracts, eg some LTCI products, it will want to ensure that overall the
charges will be sufficient to cover the expenses.
The risk to profitability is lower (than for non-unitised products) because investment
risk is largely borne by the policyholder and the morbidity and mortality charges may be
variable at the company’s discretion.
The most critical influence on profitability will therefore be the adequacy of the expense
charge. This charge may also be variable. But, for most product types, undercharging
for expenses for one year is likely to have a greater impact on profitability than a slight
undercharging of the morbidity and mortality risk for the same time period.
There is a full discussion of pricing issues later in the course.
Marketability
The benefits offered need to be attractive to the market in which the contract will
be sold. Innovative design features may make a contract more attractive as may
the addition of options and guarantees. The charging structure for risks and
benefits needs to be attractive to the potential market and consideration needs
to be given to whether the charges should be guaranteed. More generally, it
needs to be considered what guarantees should be given with regard to
premium rates.
In the context of marketability the actuary should ensure that the product is
understandable. Special features will only be a good thing if the customer being
targeted understands and appreciates them. This aspect is very sensitive to the
distribution channel we intend to use for the product. For instance, an insurer would not
attempt to sell a complicated product by direct marketing methods.

Competitiveness
A company will not want the structure, level of the charges and resultant
premium to depart too far from those of competitors, although this may depend
on how it will market the contract.
Financing requirement
Unless the company has substantial capital resources, it will want the benefits
and charges to be designed to minimise its financing requirement. There is
more scope under unit-linked products to adjust the design to achieve this than
under non-unit-linked products; unit-linked versions can, for example, vary the
nil-allocation period to reduce the length and amount of financing strain.
Guarantees may have a big influence on the level of reserves that have to be
established at the outset and hence the financing requirement.
This is a particularly important criterion for new (or recently established) healthcare
insurers because of the small amount of free assets that they have available to finance
new business.
Risk characteristics
Consideration will need to be given to the acceptability of the level of risk

associated with a proposed contract design. The level of risk acceptable will
depend upon the company’s ability or willingness either to absorb risk internally
or to reinsure it.
This is unlikely to be a problem for the mortality risk, since it is such a well-studied and
quantified risk both at industry level and at company level, though for a company
entering a new market for that company (perhaps using a new distribution channel) the
mortality risk would still be relatively large. However it is a big problem for entirely
new risks, ie those risks whose incidence is relatively unknown.

Example
Many companies have had to confront this problem in developing critical illness
insurance products when they first appeared in a particular market. At best, the data
available would have been population statistics covering the rates of incidence of the
various ailments concerned, along with critical illness experience data of insured lives
from more mature markets.
Companies in such a situation will invariably have used at least one of the following
methods, to reduce the risk inherent in launching the product in those circumstances:
● offer the contract with a reviewable premium
● reinsure a large part of the risk
● incorporate large margins in the premium rates
● offer the contract as an addition (rider) on a term insurance policy, so that the
critical illness claims are effectively accelerated death claims.
Onus of any guarantees
The company will need to consider the onus of any guarantees, including
renewability on pre-fixed terms.
Offering guarantees results in two problems:

● possibly having to suffer a cost that you did not fully expect; and,
● probably (depending on the supervisory reserving regime) having to reserve for
this possibility from the outset – thereby increasing the capital strain of the
product.
The extent of the onus of any guarantee is a function not only of how likely or how big
an adverse change in some variable might be, but also on the financial impact that the
change in the variable might have.
Hence, a health and care insurer may not find its guarantees so onerous if it can reduce
the financial impact of those guarantees. In the case of investment guarantees, the
company can reduce the financial impact by immunising itself against these guarantees
by the choice of suitable investments. For instance, with immediate needs LTCI it is
theoretically possible to invest so as virtually to eliminate the investment risk, though
there are many difficulties (such as a shortage of suitable investments) that can prevent
this happening in practice.

Sensitivity of profit
Under a unit-linked contract, it may be possible to have a charging structure that

reduces the sensitivity of the contract’s profitability to variations in future
experience.
There is considerable overlap between this and the last point about the onus of
guarantees. They are closely related because products are more likely to be sensitive to
particular types of risk the more onerous are the guarantees on charges or other aspects
of the contract.
The important variables that might impinge on profitability are:

● morbidity or mortality rates
● expenses, including expense inflation
● withdrawal rates
● investment return.
The product design for a unitised contract can minimise the sensitivity of profitability to
adverse experience of these factors by:
● Morbidity or mortality: make the charge for this variable at the company’s
discretion.
● Expenses: make the charge for this variable at the company’s discretion.
● Withdrawal rates: don’t offer any guaranteed surrender values.
● Investment return: if there are no investment guarantees (for example, where
payment at maturity is simply the value of the unit fund, with no specified
minimum value) then most of the investment risk is borne by the policyholder.
● Matching: try to match income (the charges) with outgo (expenses and benefit
costs) as closely as possible by duration, especially with regard to the initial
expenses.
Extent of cross-subsidies
A company needs to decide on the extent of any cross-subsidies between, for

example, large and small contracts. The marketing advantage of a simple
premium or charging structure may conflict with a desire to avoid cross
subsidies.

Administration systems
The system requirements of a new product may limit either the benefits to be
provided or the charging structure to be adopted.
For example, if the company’s computer policy administration system cannot cope with
administering a waiver of premium option, the product should not have one (unless it is
so important that it is worth spending money on enhancing the system).
The issue of compatibility with the administration system can also be extended to cover
the aspect of simplicity: it is in the interests of the administration system, policyholders,
agents/brokers and the company’s staff that the product be simple. Thus any
complications must be warranted by some significant advantage in terms of the
marketing of the product.
Consistency with other products of the company
The company may wish to ensure that the charging and benefit structures of a
new policy are at least similar to any existing business.
The key reason is that a major change will result in significant systems development,
which will take time.
There are benefits in terms of saving time and cost with such things as training
administration and sales staff, printing marketing literature and so on.
There is also a possibility that a design, which appears much more attractive or
favourable to policyholders, may seem unfair to existing policyholders and may lead to
some dissatisfaction and possible marketing risk. For example, it may cause many
policyholders to surrender their policies over a short period of time and the company
may be unable to recover all of its expenses from them (particularly its fixed expenses).
Conflicts between product design factors
These factors are not necessarily independent. Meeting one objective may
prejudice the meeting of another, and so a compromise must be struck.
These all represent interests that the actuary has in the design of a product. However, in
some cases these interests coincide with those of other stakeholders (eg administrative
systems), and so the legitimate interests of other groups will influence the eventual
decisions.

Question 6.16
Describe the stakeholder interests of the shareholders of an insurance company in the

design of a product.


Chapter 6 Summary
Insurers
The actuary working for insurer should consider the following when determining the
suitability of a contract design:
● Profitability – The premiums charged must be sufficient to cover benefits and
expenses, and meet the required profit criteria.
● Marketability – The products must meet customer needs and be attractive to the
market in which the contract will be sold.
● Competitiveness – The structure and level of premiums or charges should not
depart too far from those of competitors.
● Financing requirement – Products will be designed to minimise this.
● Risk characteristics – Consideration will need to be given to the acceptability of
the level of risk associated with a proposed contract design.
● Onus of any guarantees.
● Sensitivity of profit – Product designs should minimise sensitivity of profit to
variations in future experience.
● Extent of cross-subsidies – For example, between large and small policies, or
between different products.
● Administration systems – The system requirements of a new product may limit
either the benefits to be provided or the charging structure to be adopted.
● Consistency – The product design should be consistent with other products of the
company, and the company’s culture.
● Regulation – Product designs must comply with the relevant regulation, guidance
notes and accepted professional practice.
There may be conflicts between the above product design factors.

The insurer will wish to ensure it has efficient control of the risk management process.
This includes:
● ensuring there are clear definitions of insured events
● having sufficient and relevant data for pricing and subsequent monitoring
● medical underwriting
● premium reviews for reviewable or renewable policies
● efficient and effective claim procedures
● appropriate reinsurance.
Each of these factors can influence the product design. For example, the form of
underwriting used can significantly influence the conditions and premiums of a product.
Reinsurers may assist in the provision of statistics, contract design and the methodology
for pricing.
The decisions made by the insurer will be influenced by the interests of other
stakeholders (eg customers, regulator).
Product-specific control procedures
Income protection:
● checking current salary against the level of benefit in the policy conditions
● claim monitoring and rehabilitation services.
Critical illness:
● effective underwriting and claims control to protect against anti-selection and
non-disclosure
● adequate reserves to cover late notified claims
● managing policyholder expectations in the light of new diseases and market
changes
● imposing a survival period on stand-alone policies (to avoid “death” claims).
Long-term care insurance:

● policy designs that are robust to changes in the provision of care by the State.
Private medical insurance:

● control of claim costs by agreeing and monitoring provider prices
● control of claim costs through pre-authorisation of benefits.

Regulators
The regulators’ main objectives are:

● ensuring that products are clear, fair, good value and appropriate for customers
● monitoring solvency (and sometimes premium rates).
Employer as purchaser of insurance
In sponsoring healthcare products for employees, the employer is motivated by legal

requirements and human resource issues, such as ensuring a speedy return to work
following illness and helping to recruit and retain staff. There may also be tax
advantages.
Underwriting and pricing can be more relaxed compared to individual products,

especially for groups where the take-up rate is close to 100%.
Large employers usually use specialist brokers to search for the best deal, and so the
insurer’s ability to influence the employer is often limited. The market is very
competitive.
Other stakeholders
A good product design will be compatible with the interests of all stakeholders
involved. Some of these are internal to the organisation (eg sales, IT), and some are
external (eg actuarial bodies).


Chapter 6 Solutions
Solution 6.1
If the product does not meet the interests of the customer then:
● it will not be attractive, and so is unlikely to sell many policies
● it may lead to customer dissatisfaction, and so the insurer may get a bad
reputation resulting in loss of future sales
● the regulator may impose restrictions or penalties on the insurer (eg if the
product is not seen as being fair to customers).
These are all likely to have an adverse impact on the insurer’s profits.
Solution 6.2
Anti-selection by the customer against the insurer arises because the customer has some
knowledge about the insured risk, which the insurer does not have. For example, the
customer may know that he or she has a dangerous occupation, which increases the
likelihood of illness or accident, which will result in an IP claim. However, if the
information collected by the insurer during the proposal process does not pick this up,
then the insured pays a premium that does not reflect the increased risk.
Provided the insured has completed the proposal form honestly, there is nothing illegal
about this. The anti-selection has occurred because the insurer’s procedures are
deficient. There is a definition of anti-selection in Chapter 29: Glossary.
Moral hazard can be defined as the risk that an insured’s behaviour changes, as a result
of having insurance in place, such that the risk and/or cost of claims increase in
consequence.
So moral hazard can arise because the insured is reckless, or takes less care than usual as
a result of having insurance cover. Most insured health and care events are unpleasant,
and so the insured may want to avoid them. However, someone with a personal
accident insurance may be inclined to take greater risks (eg driving too fast).
Another example of moral hazard occurs with IP policies. A claimant in receipt of

income benefit is likely to be in less of a hurry to get back to work or seek alternative
employment compared with someone who does not have that income.
Submitting false or exaggerated claims are further examples of moral hazard.

Solution 6.3
Special CI policy
We need data about the incidence of the diagnosis of kidney failure in the insured
population by age and sex. Such data may only be available for the population at large,
and we will need to make adjustments so that it relates to the insured population. The
claim cost is fixed, and so we do not need data relating to claim cost.
We would also require data on mortality following the diagnosis of kidney failure. This
is because the policy is likely to have a survival period, and so claims by policyholders
that do not survive this period after diagnosis would not be paid.
Special PMI policy
We will need the same data as that required for the CI policy. However, the claim cost
is now variable, so we will need data relating to claim cost.
Different individuals will be treated in different ways. We will need data about the
proportion of claims that result in different types of treatment, eg dialysis, transplant.
We will need data about the components of the average treatment of each
type (eg number of days in hospital, number of dialysis treatments etc). To complete a
claim cost calculation we will need to know the unit costs of each of the types of
treatment (eg £350 for each overnight stay in hospital, £1,200 for each dialysis).
Some treatments, eg kidney transplant, carry a significant mortality risk. Death would
reduce the expected claim costs, and so information about the survival rates of those
having different types of treatment would be relevant.
Solution 6.4
When premiums are reviewed upwards, healthy lives will often look for insurance
elsewhere and not renew their policy.
The extent of this selection against the office will be very much influenced by the
alternatives available in the market. So if all products provide approximately the same
benefits, then policyholders considering changing insurers will be driven by price.
If the company’s premiums are not competitive, then the selection against it will be
extensive. So monitoring competitors’ premium rates is essential to guard against this
risk.

Solution 6.5
There are two possible factors that may influence the time to settlement.
First, claims underwriting will cause a delay. The claim events are precisely defined in
the policy, and to validate a claim (eg for a heart attack) we will need medical evidence.
This may involve special tests, investigations and reports. There will be a delay while
these are completed, and a further delay while the office evaluates them.
Second, on a stand-alone CI policy, the conditions may require that the insured survives
for, say, 28 days after the diagnosis of the critical illness, before the sum assured is
payable. This will lead to a short delay in payment.
Solution 6.6
A product needs to be designed, priced and sold, and subsequent claims need to be
managed. A life insurance protection product is designed to pay a sum insured when the
policyholder dies, in return for a regular premium until death. The design of the product
and the policy wording is straightforward. There is a wealth of statistical information on
mortality, and so pricing is relatively straightforward. Claims management merely
requires the proof of a death and the payment of the sum insured.
For IP, CI, LTCI and PMI, the insured events require careful definition. The most
appropriate benefit structure needs knowledge of what customers want, and what
competitors are offering. Products can be more complicated and varied with different
benefits being offered (eg different CI conditions, or deferred periods and definitions of
disability in IP insurance). Morbidity data, particularly data relating to specific risks in
the insured population, are not readily available, and so pricing is not as straightforward.
Claims management requires expert knowledge for the evaluation of detailed medical
information.
An insurer is unlikely to have the time or the resources to become expert in all these
areas, nor would it be cost effective for the insurer to do this alone. Access to reinsurer
expertise is therefore more important for healthcare insurance.

Solution 6.7
It is common for IP policies to include a clause that requires the insured to notify the
insurer when he or she has been sick for a short period (eg 4 or 13 weeks), even when
the deferred period of the policy is much longer.
This allows the insurer to maintain contact with the insured, while he or she is sick.
This will enable the insurer to offer rehabilitation advice, which may facilitate a prompt
return to work and avoid the need to pay a claim. The cost of providing this advice will
often be less than the claims that would otherwise have been paid.
At about. say, four weeks before the end of the deferred period the insurer will begin the
claim validation process. The aim is to establish the validity or not of the claim, so that
income can be paid promptly from the end of the deferred period.
Solution 6.8
An early notification of sickness will enable the insurer to offer rehabilitation services.
This is discussed in Solution 6.7.
These rehabilitation services would continue after a claim was being paid.
The policy will usually include a restriction on the maximum benefit that is
payable (eg 60% of the pre-disability income). This will maintain a financial incentive
for the insured to return to work.
The policy will usually include a linked-claims period. So if the insured returns to work
and falls sick again within this period, the two periods of sickness will be treated as one.
Any deferred period before benefits become payable will be ignored for this second
period of sickness. This would also apply to any subsequent periods of work. This has
the effect of encouraging the insured to try to return to work, because the penalties of
falling sick again have been removed.
The policy will usually include a condition so that a proportionate benefit is paid if the
insured returns to work part-time. This will encourage the insured to try working again.
If the insured has been sick for a lengthy period (eg two years), then the policy may
revert to a less stringent sickness definition based on being able to do any job, rather
than the job he or she was doing immediately before the current period of sickness. At
this stage the insurer might encourage the insured to retrain for a new job, perhaps
offering financial support for this training.

Solution 6.9
There are three key dates in a critical illness event:

● the date on which the event occurred (usually the date of diagnosis)
● the date on which the insurer was told of the event
● the date on which the sum insured was paid and the claim was settled.
Claims that are between the first two dates are IBNR claims. The insurer does not know
of these claims, but will still need to estimate the cost of these claims for the purposes of
reserving. These are the late notified claims referred to in the Core Reading.
Claims that are between the second two dates are RBNS claims. The insurer knows of
these claims. However, it may be that the survival period has not expired and so the
claim has not been paid, or it may be the insurer is still collecting or processing evidence
to validate the claim. The insurer will need to estimate the proportion of these claims
that it expects to pay, in order to estimate the cost of these claims for the purposes of
reserving.
Solution 6.10
The GIO could give the policyholder the right to increase the sum assured on the 5th,
10th and 15th policy anniversaries without providing any evidence of health. The
premiums charged would be the then current rates for the policyholder’s age.
Alternatively, the GIO could give the policyholder the right to increase the sum insured
whenever a qualifying event listed in the policy occurs (eg birth of a child, taking up a
new job at a higher salary).
The insurer must ensure that the opportunity for selection against the office is
minimised. This could be done by limiting the option (eg the additional sum insured
cannot be greater than 25% of the original sum insured) or by restricting its use (eg only
those taking up the option on all previous occasions can exercise the option on the
current date).

Solution 6.11
If you buy a car you can always test-drive it to see if you like it. It is essentially a
short-term purchase; you can always sell it again easily and get some of your money
back. You can see a car, so it is a tangible purchase that you can check before buying.
Much of what you buy when you buy a health and care product is unseen, and it cannot
be tried out, eg benefits you will get when you claim. It is (usually) a long-term
purchase and the policy usually does not acquire a surrender value, so it is difficult to
get any of your money back, if you don’t make a claim.
So the regulator helps to ensure the quality of what you are buying.
Solution 6.12
Free cover means free of underwriting. So applications up to the free cover limit (eg a
certain sum insured for a CI policy or a weekly benefit amount for an IP policy) will be
accepted, without any investigations beyond the completion of a proposal form or an
application to join a group scheme. The application may include a simple health
declaration, eg continuously at work for the last three months.
Solution 6.13
This may be desirable in order to maintain or increase market share, or establish a new
product in a market.
It may be a short-term response to aggressive price cutting by a competitor. Cross

subsidy will enable the insurer to maintain current business levels, with the prospect of
making this business more profitable later.
Alternatively, it may be the insurer who is the aggressor, and hoping to increase market
share or establish market share for a new product against established rivals.

Solution 6.14
There are two sources of the difference:

● actual costs
● competitive pressures in each market.
Actual costs
This is a stand-alone critical illness policy for a relatively long term. The claim cost is
fixed (sum insured) but the claim incidence over a 20-year period will be very hard to
predict. This means that the contingency loading in the guaranteed premium will need
to be high. If reinsurers take the same view, then the costs of reinsurance will be high as
well.
The contingency loading reflects the need for large reserves, and hence a high cost of
capital backing for the product.
Insurers may not see this as an efficient use of capital, and so may quote less
competitive premiums to discourage business. This is seen as better for company image
than withdrawing from the market.
Competition
The fact that guaranteed products are so much more expensive may cause some
consumers to decide that the guarantee is not worth the extra premium. This will result
in falling demand for guaranteed products, and increased demand for reviewable
products.
Competition in the reviewable market will result in aggressive pricing. There will be
little price competition in the guaranteed market. The effect will be to increase the price
differential.

Solution 6.15
Sufficient sales incentive to encourage distribution
If the incentives are not sufficient then sales volumes will be low.
The allocation of expenses in the pricing of the product will have assumed certain sales
levels. If these levels are not achieved then the total premium income will be
insufficient to meet the aggregate claims and expenses, and give the required level of
profit.
Priced to attract customers (in preference to competitors)
If prices do not attract customers, then market share and volume will fall. The
consequences will be similar to those for having insufficient sales incentives.
Sufficient margins to ensure an adequate return on capital
If margins are not sufficient this may mean that our prices are very competitive (because
they are artificially low), and sales volumes will be much higher than expected. This
will mean that we need more capital than we planned to use, and so even more of the
insurer’s capital will be earning a lower rate than it would be otherwise.
This may be sustainable in the short term. If we can increase prices in the future (eg on
reviewable or renewable policies) then we may be able to make up for the earlier
shortfalls. For long-term policies with guaranteed premiums, this is not possible.
(However, we may have established a dominant position in the market for these policies,
and be in a position to make enhanced profits on future new business.)

Solution 6.16
The shareholders are primarily interested in increasing the market price of their equity,
which in turn depends on the future dividend payments.
These will be secure if the company has a regular profit stream. To ensure regular
profits the company will need a good reputation, which will help in keeping up sales
levels.
The company should sell products that contribute to the profit stream, and make
efficient use of the company’s capital, whilst ensuring that the company remains
solvent.
The shareholders will want to be satisfied that all the products have an acceptable
balance between risk and return.
The shareholders will want to have confidence that the directors and managements are
competent and capable of running the business from day to day.




using the course.

ST1-07: The general business environment (1) Page 1
Chapter 7
The general business environment (1)
Syllabus objective
products and services are traded:
– propensity to purchase versus drive to sell – meeting customer needs
– methods of sale
– remuneration of sales channels
– types of expenses and commission
– influence of inflation on benefits, premiums and expenses
– regulatory environment on sales and reporting
– professional guidance constraints and opportunities
– role of IFA in the group risks market.
(The items marked in bold are covered in this chapter.)
0 Introduction
When studying the actuarial control cycle in Subject CA1, you saw that it was important
for the actuary to be aware of the general business environment. In this chapter and the
next we shall be studying some aspects of that environment.
In this chapter we look at how health and care insurance companies go about selling the
products they have to offer through the various distribution channels that are available,
and the ways in which the choice of distribution channel affects the insurer.
We also consider the role of the intermediary in the running of group insurance
schemes.

Page 2 ST1-07: The general business environment (1)
The distribution channels we shall be studying are:

● independent intermediaries, who select products for their clients from all or most
of those available on the market
● tied agents, who offer the products of one insurance company or a small number
of insurance companies
● 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.
In addition we look at worksite marketing, which is a means by which insurance

distributors can gain marketing access to all the individual members of a particular
group, such as the employees of a particular company.

1 The main distribution channels
1.1 Insurance intermediaries (brokers)
Insurance intermediaries are independent of any particular life insurance

company. Their aim is to find the best contract, in terms of benefits and
premiums, for their clients. Usually they are remunerated, via commission
payments, by the companies whose products they sell, but they may
alternatively receive a fee from their clients.
It will certainly be the case that most professional intermediaries will seek the best
contracts for their clients. But 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 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.
Question 7.1
Mis-selling has been a problem for several life insurance products. Why is it less likely
to be a problem for most health and care insurance products?
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 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.

1.2 Tied agents
These are insurance intermediaries 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.
Question 7.2
What might be the key advantage for a healthcare insurer of linking up with a bank in
this way?
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”.
A bank is not the only possible type of tied agent. In Continental Europe the traditional
distribution method is through individuals who act as tied agents. Legally they work on
behalf of the insurance company, without being employees. This contrasts with
independent 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.
Question 7.3
Suggest why this is the case.
Tied agents are remunerated via commission payments from the companies to
which they are tied.
Often the prospective policyholder will initiate the sale, but some tied agents
may actively engage in selling.
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.

1.3 Own salesforce
Members of an own salesforce 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.
It will usually be the salesperson who initiates a sale, making use of client lists.
However, once he or she has built up a rapport with a particular 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 (who might, for example, provide a list of, say, 5,000 people who have
moved house in the last 12 months).
1.4 Direct marketing
At present this takes three main forms:

● mailshots
● telephone selling
● press advertising.
It remains to be seen how successful the Internet will be in marketing health and
care products – we discuss this further below.
To send out a mailshot, the life 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.
In the case of mailshots, arguably the insurance company initiates the sale.

In the case of telephone selling, it could be either the prospective policyholder

or the insurance company that initiates the sale.
Thus 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.
In the case of press advertising, it is debatable who initiates the sale. If a

company advertises and someone responds, who is “initiating the sale”?
Press advertising may take various forms, for example:

● 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 may be obtained
● it may give a telephone number to call for the sale to be completed on the
telephone, as described above.
There is now considerable use of the internet, both for marketing and for selling
products. It is usually possible to get a quote on line, and some sites offer a choice of
companies (for example, giving quotes for the 10 cheapest premiums available for the
policy requested). The facility to apply on line for a chosen quote is then usually
provided.
Internet quotes and applications can take into account basic underwriting information,
also requested on line, such as age, sex, height, weight, smoking habits, and a few brief
questions about health and family history.
Question 7.4
Who initiates the sale when the internet is used?
If you have access to the internet, then just search under “health insurance” or “critical
illness insurance” and you will see examples of what’s available.

2 Worksite marketing
This is a process whereby a broker or insurer representative obtains permission
from the employer to address the workforce en masse and sell health and care
products.
For example, the insurer might be given the opportunity to send mailshots to all of an
employer’s workforce or to advertise in the employer’s staff newsletter.
The intricacy of the cover suggested depends on the sophistication of the staff
being targeted; but generally the intention is to offer simple products with a view
to attracting those who have not made their own insurance provision for
healthcare needs.
Question 7.5
Explain the difference between the situation described above and typical
employer-sponsored group healthcare insurance products.
There are benefits to this form of marketing as the prospect of engaging a large
number of employees may enable the insurer to reduce the risk premiums, on a
credibility basis.
Question 7.6
Explain this sentence of Core Reading.
Against this would be the necessity of keeping the underwriting process simple.
Question 7.7
Why?
There may be expense savings, especially if the employer permits the premiums
to be deducted from the payroll; but again, the average premium size may be
small and other administration costs need to be met as usual, which limits the
potential for expense savings.

Question 7.8
Explain what these expense savings are, and why a small average premium size might
be a problem to the insurer.
This form of distribution is unlikely to be undertaken for LTCI. It is already part

of the hospital cash and simple PMI product markets. Similarly, there is scope
to sell CI and IP insurances in this way.
Question 7.9
Suggest two reasons why long-term care insurance is unlikely to be sold this way.

3 The effect of different channels
3.1 Demographic profile
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 lives taking out
contracts through each channel – that is, there will be class selection.
Question 7.10
Comment on likely differences in financial sophistication and income levels between

the following:
(a) Customers of an independent intermediary.
(b) Customers of a major bank acting as tied agent for an insurance company.
(c) Customers reached by advertising in “The Slum”, a downmarket tabloid

newspaper.
One cannot be too dogmatic about levels of income and financial sophistication
associated with a particular distribution channel. For example, an own salesforce might
be targeted specifically at professional people or at people in the lower socio-economic
groupings.
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 that the target markets are reached and
certain channels will tend to be associated with particular target markets.
The levels of income and financial sophistication of the customers will tend to be
correlated with their mortality, sickness and withdrawal experience.
Question 7.11
Consider sickness experience on income protection insurance contracts. How is this

likely to differ between customers of an independent intermediary and those of a direct
salesforce targeted at a broad range of society?

The answer to the previous question illustrates the “class selection” referred to in the
Core Reading. “Class selection” simply refers to the fact that people can be usefully
classified by certain attributes that affect their mortality or sickness experience. For
example, smokers exhibit higher morbidity than non-smokers do. In the situation we
are considering here, the class selection factor at work is the distribution channel by
which the business was acquired.
The sales channel can have a direct effect on the withdrawal (or renewal) 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-sold” their
policies are most likely to cancel. Lowest withdrawal / highest renewal rates should
then be associated with independent intermediaries, especially through the effect of
client-initiated selling and the sophistication of the client base, although there can be
many exceptions (eg where an own salesforce channel targets a sophisticated market and
adopts a carefully focused customer-needs based approach).

3.2 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.
Question 7.12
The following table tabulates some healthcare insurance products against possible
distribution channels. Place a tick in boxes where you think the product is suitable for
sale through that distribution channel, and a cross where it would not be. In some cases
you may feel that things are not so clear-cut. If so, explain why.
Distribution Channel
Independent Own salesforce Telephone selling

intermediary
Conventional
accelerated critical
illness
Conventional
Product
immediate needs
long-term care
annuities
Regular premium
unit-linked long-
term care insurance
The dynamics of selling via the telephone or press advertisements mean that the
products sold this way will almost inevitably be quite simple. (This confirms the
answer to the previous question, but we wanted you to think about it for yourself first.)
Perhaps the most important thing is that the product should appear simple to the
prospective policyholder, even if, in actuarial terms, it is quite complex. In particular:
● 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.

3.3 Contract pricing
We shall consider two aspects of the effect of distribution channels on contract pricing:
● the effect on demographic assumptions, including the effect of underwriting
● the effect on the need for competitive terms.
The effect on demographic assumptions
The level of underwriting will depend on the marketing strategy used.
Business from intermediaries is likely to be subject to most underwriting.
Question 7.13
Suggest why this should be the case.
One reason why sales through direct marketing may have relatively simple underwriting
is that in many markets the levels of benefit on offer have been relatively low. Where
this is not the case, quite stringent underwriting would be necessary. Another reason for
simple underwriting is that complex application forms with lots of underwriting
questions are a major barrier to sales.
The level of underwriting will then be reflected in the demographic assumptions,

other than withdrawals, used for pricing. The class selection mentioned above
will also affect these assumptions.
All other things being equal, the more stringently an insurance company underwrites its
potential customers, the better its morbidity experience is likely to be.
In the same way, the better the morbidity experience assumed by the insurer in its
pricing basis, the more detailed its underwriting will need to be.
However, not all things are equal. The underlying health of those applying for
insurance is also important, and as we have seen this may vary by distribution channel.
This therefore interacts with the insurance company’s efforts to improve its experience
through underwriting.

Question 7.14
A life insurance company markets a regular premium stand-alone critical illness policy.
It places advertisements in a newspaper read mainly by manual workers. The contract
offers guaranteed acceptance of all applications subject to a declaration of current good
health, but if disease is diagnosed in the first twelve months of the policy the benefit is
only a return of premiums paid.
Comment on the likely claims experience under this contract.
Given that the insurance company expects experience to differ depending on the types
of customer it reaches and the extent of underwriting used, it is clear that it will wish to
reflect this in its assumptions when it prices contracts.
Withdrawal rates are likely to be affected by the level of financial sophistication

and whether it was the policyholder who initiated the sale.
A major reason for customers withdrawing from contracts, particularly at early

durations, is the realisation that what they have bought was not suitable for their needs
in the first place. This is the key to both of the factors mentioned in the Core Reading
above.
An unsophisticated customer is more likely to have bought an unsuitable product, either

because he or she has not sought appropriate advice or as a result of deliberate
mis-selling. Also, if a customer has actively sought out a product to meet a perceived
need it is more likely that the product is suitable, compared with, say, an aggressive
sales push for a particular product.
The effect on the need for competitive terms
The competitiveness of premium rates is, in broad terms, likely to follow the
order of the methods in Section 0 above.
That is:
● independent intermediaries
● tied agents
● own sales force
● direct marketing via press advertising or over the telephone.
However, as we shall see below, direct marketing will not always be subject to the least
competitive pressures.

Insurance intermediaries will recommend to their clients the companies with the
most competitive rates, other things being equal.
Things that might not be equal include:

● the reputation the company may have for paying claims
● the company’s financial strength
● differences in policy conditions.
In some markets, particularly those that are not well regulated, the most important thing
that might need to be equal would be commission. It may be more important to offer
good commission terms than competitive premium rates in order to secure business.
This may not be ethical, or good for the long-term reputation of the insurance industry,
but it can happen.
A bank will want the products sold by its employees, as tied agents, to be
reasonably competitive or they could damage its good name.
However, there is not the same direct comparison with other companies that exists with
intermediaries.
Members of an own sales force will not usually be in a competitive situation.
For example, a salesperson may correctly recommend that a client needs a 15-year critical
illness insurance contract. It may well be that most or all of the clients who decide to take
out such a contract do so without looking round the market for a better deal. That may not
be very bright, but that’s the way it is.
It is not clear where direct marketing should fit into this picture of competitiveness. It
really depends on the target market. For example, press advertising in a financial
magazine or heavyweight newspaper may reach financially sophisticated customers who
are keen to compare rates. Advertising in a more downmarket newspaper and to the
financially unsophisticated may involve much less competitive pressure.
Selling on the internet may present viewers with a comparison of different companies’
prices on the same screen!

Having competitive rates or charges is not the be-all and end-all for every product, even
when selling through intermediaries. For example:
● Products may be differentiated from the competition through innovative features

or attractive options.
● More complex products may be difficult to compare across companies. This is

true for many health and care insurance products where there may be (deliberate)
non-uniformity of claim definitions.
● Unit-linked products may compete as much on past investment performance as

on premium rates or charges.
● Some products may compete on the level of customer service or admin support –
eg on admin for group products, or on claim servicing for income protection
products.
Question 7.15
A life insurance company markets the following contracts through independent

intermediaries only:
(a) conventional stand-alone critical illness insurance
(b) unit-linked income protection insurance.
Comment briefly on the need for competitive rates / charges for these two contracts.

4 Group risks
As with most other financial services purchases, the corporate buyer purchases
health and care insurance through independent intermediaries. The employer
purchases group covers on behalf of the employees. There are generally both
tax and risk-pooling reasons why this is an efficient way of arranging insurance.
The size of the contract and the need to be seen to be providing the most
appropriate protection available in the market have created this predominance of
trading via intermediaries.
Question 7.16
Explain how this “need to be seen” requirement comes about.
For the employer, he is assured of a significant 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 comparative analysis of
the market’s providers in terms of security, products available and price, and
administration (often down to the level of employee details and the issue of
coverage notices).
The insurer is assured of a selection process which befits a national broker

organisation and the achievement of a legal contract with minimum additional
administrative expenses.
However, the insurer may thus be limited in other ways: in the opportunity to
build a relationship at first hand with the purchaser of the insurance, in the
chance to influence the retention of this business with the quality and speed of
service, and, most importantly, in the opportunity to engage directly with those
responsible for the lives insured to improve risk management.
So two key issues here are service and risk management.
Question 7.17
Explain how these issues differ, if at all, when we are considering an insurance company
selling group business through independent intermediaries, as opposed to individual
business.

5 Distribution channels and the actuarial control cycle
Question 7.18
How can the different stages of the actuarial control cycle (see Section 0) be used in the
management of a health and care insurer’s sales distribution?


Chapter 7 Summary
Distribution channels
Distribution channels are the routes through which insurers sell their products. The
main distribution channels are:
● independent intermediaries, who select products for their clients from all those
available on the market
● tied agents, who offer the products of one or a small number of insurance
companies
● own sales force, usually employed by a particular company to sell its products
direct to the public
● direct marketing via mailshots, press advertising, over the telephone or internet.
Independent intermediaries may be rewarded by commission from the companies whose

products they sell or by fees from their clients. Tied agents are usually rewarded
through commission. The company’s own salesforce may be rewarded by salary or
commission or a mixture of the two.
Worksite marketing
Opportunities may exist for insurers to market products to individuals through their
employers. This can save the insurer on marketing and administration costs.
Products tend to be simple and to need less detailed underwriting and processing.
There may be problems with small premium sizes.

Effects of distribution channels
Different distribution channels tend to reach different types of people. The customers
may differ in levels of financial sophistication, keenness to take out a contract and levels
of income. Consequently the claim and withdrawal experience of business secured
through different channels may not be the same.
The level of underwriting, which may also vary by distribution channel, will also affect
this experience.
These differences in expected experience should be reflected in the assumptions used in

contract pricing.
The need for competitive terms varies by distribution channel, with the greatest degree
of competition being in business sold through independent intermediaries. The
importance of this varies by type of contract. Covers can vary considerably between
insurers and this can make the business rather less price sensitive than, say, a life
protection product.
Where a channel tends to reach a more financially sophisticated target market then more
complex product designs are possible. However, contracts sold through press
advertising, telephone selling or the internet have to be fairly simple, even when selling
to a sophisticated market.
Group risks
Employers usually obtain their group insurance policies from brokers. This is driven by
the need for the employer to be seen to be getting good products for its staff.
The broker provides considerable administrative support for group policyholders.
The insurer saves on marketing and claim administration expenses in securing and
retaining the business. But doing group business through a broker has disadvantages for
the insurer, as it is unable to:
● build up a relationship with the client
● influence persistency through service provision, except inasmuch as it may affect
brokers’ decisions to use the insurer
● influence directly a client’s approach to risk management.

Chapter 7 Solutions
Solution 7.1
Mis-selling in life insurance has been most common for certain types of savings
contract, for which different companies’ products can appear very similar at the time of
sale but end up achieving very different investment returns for policyholders. In such
cases the initial choice of provider made by the intermediary may have been
unreasonably influenced by the commission level, as all other features could appear
equal, at least to the client.
Most health and care insurances, on the other hand, are primarily protection products.
The policies offered by different companies are likely to differ in material ways, in
particular concerning the types of diseases covered, or whatever defines the conditions
for determining if and when a claim is payable. There is therefore more scope for
judging the suitability of products on the basis of differences in the benefits provided,
rather than on commission levels.
Nevertheless, commission is still an important factor in the selling of health and care
insurance.
Solution 7.2
This gives access to the “warm” customer base that can be accessed through the bank’s
branches or through mailshots, and hence result in increased sales. (“Warm” customers
are those with whom the company (bank) already has an established relationship, and
who are likely to be favourably disposed to the company and to buying its products.)
The bank has information on the personal and financial circumstances of its customers,
which can be used to target marketing effort appropriately.

Solution 7.3
It might be difficult to keep all the insurance companies satisfied that their products are
taking a “fair” share of the agent’s sales.
The agent would be faced with a difficult situation if the products of one company were
evidently better value than those of another company.
(It could be argued that independent intermediaries face the same problem, but the
investment of an insurance company in a tied agent may be much greater. Also, the
independent intermediary is working on behalf of the client, and so is under less
pressure from any insurance company.)
Solution 7.4
It depends! It may be the customer – eg by searching deliberately on the internet under

“health insurance”. On the other hand, the internet can be used to find out more
information, eg by someone looking up the insurer’s website after seeing a press
advertisement. In this case, it may be more accurate to say that the insurer initiated the
sale (although even this is debatable – see our earlier comments about press
advertising!).
This example also illustrates how the distinctions between the various types of direct
selling are often not clear cut.
Solution 7.5
Employer-sponsored group insurance involves the sale of a single policy to the

employer. The employer, as policyholder, purchases the insurance protection for the
employees, on their behalf.
In worksite marketing, the workplace is being used as a convenient way of accessing a

large number of potential individual clients. As a result of the marketing effort, the
insurer hopes to sell a number of products to some of those individuals. Those who do
buy policies will then have individual contracts with the insurance company: they will
pay the premiums and the contract will exist independently of whether or not they
remain in that particular employment.
(Under a group scheme, it is unlikely for any employee to remain covered by the
insurance once they have left that employment, although sometimes the cover can be
converted into an individual contract without additional evidence of health.)

Solution 7.6
This is saying that the large number of lives insured enables the company to charge
lower premiums to cover the pure claim risk. There are a number of reasons for this.
● The “credibility basis” is referring to the reduction in error in assessing the risk
premium when the company is dealing with a large group of relatively
homogeneous lives, as here. This will enable smaller risk margins to be included
in the rates.
● If a large proportion of an employer’s staff can be sold policies, then the risk of
anti-selection is reduced, reducing expected claim rates.
● People at work must be well enough to do the work, and so the condition of
being actively employed will help to ensure the company is dealing with a
largely healthy group of lives (provided, again, that a large proportion of staff
take up policies).
Solution 7.7
This is because of the particular intention stated earlier: a key factor in the success of the
marketing will be how simple the product is, and so a lengthy underwriting process may
well put a lot of people off.
Solution 7.8
The insurer can reduce the total cost of collecting premiums by having the employer
collect the individual premiums on the insurer’s behalf, and then pass them on to the
insurer in one go.
Small premiums usually involve small expense loadings, in absolute size. These
loadings are less likely to meet the per-policy costs (which, by definition, are the same
whether a policy is large or small), leaving less contribution to the company’s overheads
and profit.

Solution 7.9
Possible reasons include the following:
● It is too complex for the target market.
● The other products provide forms of insurance that protect policyholders from
contingencies that can arise during their working lives – ie they address
immediate needs in relation to their job. Long-term care insurance 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 too expensive for the target market.
Solution 7.10
(a) Those seeking the advice of an independent intermediary may tend to be more
financially sophisticated and wealthier on average than the public as a whole. As
such they will tend to seek out advice in managing their more complex financial
affairs.
(b) A major bank would reach a broad cross-section of people with different levels
of financial sophistication and income. A certain minimum level might be
implied by their having a bank account. It may still be those at the upper end of
this range who seek further advice, or who are specifically targeted by the bank
for insurance sales.
(c) Readers of the “The Slum” would probably be the least sophisticated (financially
and otherwise) of the three groups, and have relatively low levels of income.
(Although perhaps in some less developed countries the ability to read at all will
indicate some level of education, and perhaps therefore relative wealth.)

Solution 7.11
If the customers of intermediaries are generally wealthier than average then this might
lead to lighter sickness experience for a range of reasons:
● better living conditions and lifestyle (although too much claret can be bad for
you)
● better access to health care
● more likely to be professional / managerial than manual work, and so less risk
from work-related hazards
● a correlation with education, in that wealthier people tend to have had a better
education and so be more aware of health issues (this is linked to the lifestyle
aspect of the first point)
● a different impact of the effect of sickness on the ability to work, eg a broken
wrist will make a bricklayer unable to work, but will not prevent a university
professor from working.
(As we shall see later in this chapter, there may also be more stringent underwriting on
business placed by independent intermediaries.)

Solution 7.12
Don’t treat the following table as definitive, but a sensible answer would be:
Distribution Channel
Independent Own salesforce Telephone

intermediary selling
Conventional
accelerated critical
9 9 9
illness (Note 1)
Conventional
9 9 r
Product
immediate needs
long-term care (Note 2)
annuities
Regular premium
unit-linked long-
9 ? r
term care insurance (Note 3) (Note 4)
Notes
(1) Although products can be complex when sold to a sophisticated target market,
they don’t have to be.
(2) This is more complex than critical illness insurance, involves much larger
amounts of money, and is only relevant to people who are at the point of
requiring long-term care. This makes cold calling extremely unlikely to yield a
sale, and it wouldn’t be attempted.
It might be possible for the telephone sale to follow a client response to a press
advertisement, but people would be very unlikely to commit themselves to
parting with so much money solely on the basis of a telephone conversation.
Face to face contact is basically essential here.
(3) I was tempted to put a tick here, and it would perhaps be equally reasonable to
do so. Once a salesperson and potential customer are face to face almost
anything could be sold.
(4) This is also almost certainly too complex for telephone selling.

Solution 7.13
Independent intermediaries are representing the interests of their clients, not a particular
insurance company. The insurance company needs to be aware of the possibility that an
intermediary might encourage anti-selection.
It should also be borne in mind that it is the intermediary or his / her customer who is
“initiating the sale”, which may also increase the risk of anti-selection, compared with,
say, when the customer is targeted by a company salesperson.
Also, independent intermediaries are more likely to have customers with high net worth
(rich people), with consequent need for higher insurance cover.
Prices will need to be competitive, as intermediaries have access to, and in theory
knowledge of, the whole market. This may only be achievable by careful selection of
good risks through stringent underwriting.
(One factor working against this is that there will be competitive pressures not to make
underwriting too stringent for business sold through intermediaries, for fear of
discouraging business. In other words, if too great a proportion of applicants are refused
acceptance at standard rates by a particular company, the intermediary will stop
recommending that company for most of his or her clients.)
Solution 7.14
Experience would probably be poor. The target population may experience relatively
poor health and the only underwriting is a statement of good health. High risk
individuals would be able to take out the contract, and as a result experience might be
worse than general population morbidity in the first few years, until the effect of this
anti-selection has diminished.
The low benefit in the first twelve months would at least discourage fraudulent claim
attempts by those who are initially seriously ill, although twelve months may not be a
sufficiently long period.

Solution 7.15
Selling through intermediaries generally requires competitive terms. In particular:
(a) Critical illness premium rates are easily compared (for policyholders with
particular ages, policy terms, smoker status, and sum assured). Products can be
differentiated by the cover provided – having different definitions of diseases
covered, for example – but the scope is fairly limited. (Indeed there is likely to
be competitive pressure to provide at least as much cover as the market “norm”,
which may further be set out as industry-wide codes of practice.)
It is very important for an insurance company to have competitive rates if it

wishes to sell large volumes. Companies may increase competitiveness in other
ways, such as by including renewal or conversion options or other kinds of
benefits, but this can only be of limited effectiveness (eg not all policyholders
require these add-ons).
(b) Competitive expense and other charges are important. However, competition
will not only be on charges but also on past investment performance, as this can
affect the total premiums that have to be paid by the policyholder. Some of the
competitive pressure can be avoided by varying product features, eg having more
frequent reviews, having caps on benefit levels, having stringent claim
definitions or more effective claims underwriting.
Solution 7.16
Group insurance represents a benefit in kind provided by employers for their employees.
Employers that offer better benefits are more likely to be able to recruit and retain good
staff than others, all else being equal. So it is in the employer’s best interests to provide
appropriate products for their staff.

Solution 7.17
Service
There is very little administrative service to provide to individual policyholders, and so

policy retention of individual business will be less influenced by this.
Claim servicing is an issue for both types of business. However, if the broker gives
poor claim service to the insurer’s group clients, and a client decides to take his business
to a different broker, then the insurer has lost its exposure to many good risks (the
employees who weren’t claiming). So the effect of poor claim servicing by the broker is
likely to be more keenly felt by the insurer in its effect on group as opposed to
individual policies.
Group business tends to be of the recurring single premium type, whereas much
individual business is long term. Retention of existing business is therefore much more
of an issue for group than for individual policies.
Risk management
Risk management is an important issue for group schemes, as claim experience can be
reduced by the employer adopting suitable precautionary measures in the workplace
(eg preventing accidents at work, encouraging recovery from sickness and a return to
work). Risk management (in this sense) is not an issue for individual business.
Solution 7.18
At a “macro” level a company needs to decide which distribution channel or channels it

should use (specify the problem). The company needs to choose a distribution strategy
that should help it to meet its targets for future profitability whilst maintaining an
acceptable level of risk. An analysis of the possible channels available in the market
(and those being used by the company’s competitors) should indicate the methods that
are most likely to be successful (general commercial environment).
The choice of distribution channels will affect a number of important assumptions in the
company’s projection models (developing the solution). These will include:
● the volume, types and mix of business likely to be sold in the future, including
contract design, pricing (ie profitability) of those contracts, and policy size
● the mortality, morbidity and withdrawal rates likely to be experienced by the new
business.

The strategy that best achieves the company’s aims, according to these modelling
exercises, might be adopted. However, in these models, the costs and risks involved in
making major changes to the distribution system at the macro level should be fully taken
into account. It would be vital to test fully the impact of variations from central
assumptions before adopting a new strategy, particularly in terms of volume, type and
mix of business, which are extremely uncertain.
The impact of the sales distribution strategy being used at the moment must be
continually analysed (monitoring and feedback). Have the levels, type and quality of
new business (including the resulting mortality, morbidity and lapse experience)
materialised as expected in the models used? If not, then the assumptions may need to
be changed, and this in turn could affect the ongoing decisions being made.
At a micro level, the company should always be striving to make improvements within
its overall chosen sales distribution strategy. Analysing the experience from individual
sales outlets, such as from individual independent brokers, tied agents, sales persons or
direct marketing routes, can point to areas of poor and good performance. Poor
performance might then be improved by adopting better training or administration
procedures, or by providing better sales information, for example.
A professional approach to sales distribution is necessary (professionalism). The

consumers’ interests should be borne fully in mind. Selling methods that are considered
to be unethical should be avoided, and individual examples of poor practice need to be
identified and rectified. Good practice should be fostered.
One thing you should observe from this example is that, whilst the actuary has some
interest in the company’s sales distribution strategy, he or she may have little personal
involvement in the decision making process. This shows how the ethos of the control
cycle should be embraced by all decision makers in a company, and is not something
that just the actuary has to follow.

Chapter 8
The general business environment (2)
Syllabus objective
products and services are traded:
– propensity to purchase versus drive to sell – meeting customer needs
– methods of sale
– remuneration of sales channels
– types of expenses and commission
– influence of inflation on benefits, premiums and expenses
– regulatory environment on sales and reporting
– professional guidance constraints and opportunities
– role of IFA in the group risks market.
(The items marked in bold are covered in this chapter.)
0 Introduction
In this chapter we describe the main kinds of commission structures involved in
remunerating sales. We then consider, for each of the main classes of business, the
degree to which:
● people deliberately seek to buy health and care insurance products
● insurance companies have to take their products to their clients in order to
market them.
Finally we study some of the main regulatory, fiscal, professional, economic and
political influences that may affect the way that health and care insurance companies do
business.

1 Different types of commission

An important aspect of the general business environment is the way that intermediaries
are remunerated for the business that they sell on behalf of insurers.
In the last chapter, we discussed how commission almost inevitably influences the sale
of health and care insurance products. Here we look at the different commission
structures that might be in place.
1.1 Initial and renewal commission
Initial and renewal commission is a common remuneration structure for the sale of
long-term healthcare insurance products. It involves two levels of payment: a high
level, paid for a certain initial period from the start of the policy (eg 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 products, eg by policy term.
In a similar way, short-term healthcare 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.
Indemnity commission
Indemnity commission indicates that the insurer is willing to pay the distributor
commission in respect of premiums which the insurer has yet to receive. This
will generally involve the insurer in some form of new business strain.
By “distributor” we simply mean the intermediary who sells the insurance policy on the
insurer’s behalf.
Indemnity commission involves the payment of the initial commission immediately the
policy has been 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.
Question 8.1
Why will this cause new business strain for the company?

If the policy lapses early, and indemnity commission has been paid, then there is a
requirement for the “unearned” commission to be repaid to the insurer. This repayment
is often called clawback.
The insurer will make some form of credit check on the distributor.
Question 8.2
Why?
This commission style provides a very strong incentive for the salesman to sell
and tends to produce “hunters”, those that attempt to sell one product only to a
customer, rather than “farmers”, those who believe in the value of a long-term
relationship and building up a stream of recurring commissions.
Intermediaries can be influential in nurturing existing clients, by providing a good

service and building up relationships with them, thereby improving the proportion of
policies that are renewed each year.
On the other hand, a remuneration (commission) system that is heavily biased towards
rewarding first sales to new policyholders, will encourage intermediaries to seek new
clients and as a result to spend less effort on keeping existing ones.
The insurer’s commission structure is therefore an important aspect of its new business
and marketing strategy.
Question 8.3
Which strategy is better for the insurance company: hunter or farmer?
The commission agreement between insurer and intermediary will specify the precise
rules according to which indemnity commission is deemed to be unearned, and has to be
paid back. Naturally enough, the longer a policy remains in force, the less commission
has to be ultimately repaid.
Earnings periods are the numbers of months over which the indemnity
commission is earned, and after which a policy lapse would not entail clawback.
The earnings period is the same as the period of time for which the initial commission
would have been payable.

Clawback is a process by which initial commission is reclaimed from a

distributor if a policy lapses before the commission is fully earned. The extent
of clawback is calculated by a formula specified in the commission agreement,
such as the proportion of the initial commission which the number of premiums
actually paid bears to the number expected during the earnings period.
Example
Earnings period: 24 months.

Initial commission: £60.
Assuming the policy lapses after 9 months, and ignoring any discounting, the clawback
would be:
60 ¥
(24 - 9) = £37.50
24
Indemnity commission may be paid to any distributor who needs cash “up-front”
to develop his/her business, eg to support the cost of marketing ahead of commission
from resulting sales.
This is subject, as always, to the insurer being satisfied as to the credit-worthiness of the
intermediary.
1.2 Alternative commission structures
Level annual commission is an alternative commission method whereby every

premium paid by the policyholder entitles the distributor to a set proportion of
that premium.
Question 8.4
List the advantages and disadvantages of level annual commission compared with high
initial and low renewal commission.
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
contribution to profitability more appropriately.

So this is part of the solution to Question 8.4 above, which we have already discussed.
Between level annual and indemnity commission, is the system of initial

commission spread over a limited number of years, eg four.
This is simply the initial and renewal commission structure we described at the
beginning of Section 1.1.
Commission is sometimes paid in proportion to the sum assured in some

territories. This would reflect an insurer’s preference for higher sums at risk
than premiums as sources of profit.
This might be appropriate, for example, if an insurer has a strategy of trying to attract
business from younger policyholders, where its pricing strategy is such that per-policy
profits are higher on such policies. This assumes that, for a given premium, benefits
would be higher on policies taken out by younger policyholders.
Where there is commission paid as a large initial amount (such as indemnity

commission), there is often a lesser amount payable as renewal commission, for
the balance of the policy term, to encourage the distributor to promote
persistency.
Question 8.5
The initial commission is often a function of the premium-paying term of the policy.
Explain the likely reason for this.
There are therefore two main ways in which we can pay commission that reflects the
profitability of the whole contract to an insurer:
● 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).
The potential therefore exists for there to be a lot of variation in commission structures
between insurers, and getting the balance right between initial and renewal commissions
can be a key element of an insurer’s marketing strategy.
However, many of the above structures and formulae will be market norms
established under law by the regulators or accepted as codes of practice by the
insurers under the guidance of industry bodies.
So the variation in structures seen in practice, within markets, tends to be more limited.

1.3 Other expenses
There are many types of expenses other than commission that are incurred by health and
care insurance companies.
These are dealt with in Chapters 11 and 28, both in their application to premiums
and the analysis of their experience.

2 Propensity to buy versus need to sell

In order to succeed in the business of health and care insurance a company needs
customers. In this section we consider the driving forces that lead to insurance policies
being bought by consumers and sold by the insurance companies.
2.1 What makes a policy sell?
An insurance contract will be taken out by an individual for any one or several of the
following reasons:
● it is a legal requirement to do so
● the person wants the contract sufficiently to outweigh the cost and inconvenience
of taking it out
● the person is persuaded that he or she wants the contract sufficiently to outweigh
the cost and inconvenience of taking it out.
Some elements of insurance are legally necessary (eg third party motor
insurance). These insurances are bought rather than sold – although insurers
advertise to raise brand awareness so that at policy renewal, motorists will ask
for a quote. Other insurances are not legally necessary to buy – these policies
therefore have to be sold.
Question 8.6
Health and care insurance is often described as being sold, not bought. Explain what
you think is meant by this, and why.
Where there is no legal requirement to buy a product, we might have:

● products that meet overwhelming personal needs, and are deliberately sought
after and purchased by consumers (so the consumers have recognised their risk)
● products that meet needs that do not feature as high priority for consumers at the
present time, and would not be actively sought for purchase (consumers face the
risk but are unaware of it or of its magnitude).
The second of these types can still be sold, provided there is a real underlying need that
the product fulfils. But the insurer (or intermediary) has to go out to the client and make
a case for the sale.

This involves:
● finding a receptive client
● finding out about the client’s health and care insurance needs, if any
● advising the client about possible products to meet any needs, as appropriate
● helping the client to buy the product or products that he or she may now wish to
buy.
So part of the role of an intermediary is to make customers aware that they really do
have a need for a product, and that they need it now (assuming, as always, that this is
appropriate).
Health and care products lie somewhere in between those that are bought and
those that are sold. They represent protection plans and so are designed, in
some cases loosely, to meet needs. They are all to some extent in competition
with State welfare benefits and so the generosity of these benefits will indicate
the extent to which healthcare products are a need or a luxury.
So, at one extreme, a product that is a need is a “must have”. At the other extreme, a
product that is a luxury is something we would like to have if and when we can afford it;
it provides desirable benefits but we can manage without it for now.
2.2 Selling characteristics of different products
Let’s consider how each of the four main health and care insurance products fit within
the various extremes we have described above.
Private medical insurance
If all medical expenses are the responsibility of the individual, then medical
expense insurance is certainly closer to a need. If the State promises free
healthcare at the point of delivery to all, PMI must be sold rather than bought.
Question 8.7
In the UK there is a well-established health and care service provided by the State,
which is free at the point of delivery. Why would anyone buy PMI at all in this country?

Income protection insurance
Limited term IP in many territories is legally binding on employers and is a need

for those who are self-employed. Longer term protection should also be a need
for all but may not be perceived as such.
So there are many people out there who have a real need for income protection, but who
do not feel the necessary urge to seek out and buy the product. This is an example of a
product that falls in the “unaware” category: people may be unaware of the need, or
unaware that there is a product available to meet the need, or just don’t believe the need
is important enough (yet?) to buy the product. Whichever applies, the product basically
has to be sold, not bought.
Long-term care insurance depends directly on the perceived attitude of

governments to the provision of care and individuals’ priorities on long-term
funding for this purpose. There are elements of legal compulsion in some
countries.
The State may provide incentives to buy long-term care insurance in the following two
main ways:
● the level of State provision may be so meagre that people develop a strong desire
to achieve better provision for themselves or for their close relatives
● the State may require a person to use up the greater proportion of their life
savings in paying for their long-term care before the State will provide any
benefits: long-term care insurance is then seen as a way of protecting a person’s
wealth, thus preserving the amount that can be inherited by their children and
others.
Critical illness insurance
Critical illness insurance is not directly matched to a specific financial need.

Instead, it aims to provide a lump sum at a time of crisis. This sum can be used
to meet financial needs (if any) or to “compensate” the insured for suffering a
specified critical event. There is also the attraction of a single big payout – the
lottery syndrome. As a result, it is sometimes bought ahead of being sold.
So, although CI insurance does not directly meet a specific financial need precisely, it
does give people peace of mind to know that they will have a stash of cash available
should they become critically ill. Who knows what they might need this money for?

And if they don’t end up needing the money to pay the mortgage off, or to cover the cost
of medical treatment, or whatever, they still know that we can have a nice holiday and a
big party or two, and that’s going to make them feel better if nothing else will.
So this product removes worry and could even provide individuals with some luxury in
what is otherwise a dire situation – and it’s something for which lots of people feel it is
worth paying premiums.
2.3 Future developments
There is a growing awareness in many countries that the State cannot continue
to provide welfare benefits at the same level, given commitments to low
taxation, ageing populations and a reducing (proportionately) taxable workforce.
This appreciation is increasing the attraction of health and care insurance
products.
So there is an underlying switch occurring from State funded to individually funded

healthcare benefits. An obvious (but not the only) means of individual funding is
insurance, and so the demand for these products can be expected to grow in the future.
Increasing sales regulation and disclosure in many countries are reducing an

insurer’s ability to “create needs” through the sales process, and thus the
distribution of some health insurance products may be made more difficult.
Question 8.8
Is the Core Reading suggesting that this is a good thing?
The growing tide of mis-selling scandals will make some insurers wary of
pushing beyond the obvious needs of the customer.
Question 8.9
Explain briefly how this “less enthusiastic” selling might benefit an insurer.

3 The regulatory regime
3.1 The aim of regulation
Governments may impose restrictions on the way that life insurance companies
operate. The aim of such restrictions is usually stated to be the protection of the
policyholder.
Historical experience has shown that insurance companies could not always be trusted
to manage their affairs appropriately without legislative control.
People who take out long-term insurance contracts, for example, are giving large sums
of money to insurance companies, often over very long periods of time, in return for a
“promise” by the company to pay the contractual benefit at some (often distant) future
date. The public needs to have well-founded confidence that insurance companies will
still be in business and able to honour their obligations when policyholders claim.
Without this confidence people will be reluctant to buy insurance, and will therefore be
denied this essential financial service as a result. Taken to the extreme, the industry will
fail.
Countries have therefore found it necessary to regulate their insurance industries in

order to ensure the security of the policyholders’ interests, thereby achieving the
necessary public confidence in the industry to the benefit of both parties: the public
receive a reliable service and the insurance companies attract business.
Although the restrictions will usually meet this aim, they may also have the
effect of either discouraging innovation or restricting the benefits that could
otherwise be given to policyholders.
3.2 Regulatory restrictions
The following are the more common of such regulatory restrictions.
1. A restriction on the types of contract that an insurance company can

offer.
Example
In Italy, there are six classes of long-term insurance product, based on contract type. For
example, unit-linked business is one class. Companies have to be authorised separately
for each class. Some companies may be authorised to write only one or two of the six
classes.

2. Restrictions on the premium rates or charges that can be used for some
types of contract. (See Section 4 of Chapter 18 for more detail.)
Such restrictions have been common in many European countries and in some
states in the United States. The rates themselves might be restricted, or certain
elements of the premium rate basis, such as morbidity and interest, might be
controlled.
Question 8.10
If policyholder protection were the aim, would you expect restrictions on premium rates
for critical illness insurance to specify upper or lower limits for the rates?
3. Requirements relating to the terms and conditions of the contracts

offered, for example with regard to how paid-up policy and surrender
values are to be calculated.
For health and care insurance, the most important terms and conditions relate to
claim definitions. So there may be regulations governing the claims that must be
allowed under particular contract types. Restrictions may also exist regarding
the extent to which charges under reviewable contracts can be revised upwards,
eg by specifying the maximum percentage increases and the frequency of
increases allowed.
4. Restrictions on the channels through which insurance may be sold or

requirements as to the procedures to be followed or the information
required to be given as part of the selling process.
For example this might involve:

● minimum training requirements for insurance salespeople
● the right of the policyholder to cancel the policy without any loss during
an initial “cooling-off” period at the start of a contract
● the illustration of possible benefits and surrender values (where
applicable), perhaps on specified or restricted bases.
This last point would be appropriate for the projection of surrender values on
unit-linked contracts, for example (assuming surrender values were payable).
5. Restrictions on the ability to underwrite, for example a prohibition on the

use of genetic test results.

Example
In New Zealand, anti-discrimination law prevents insurers from refusing to insure

anyone, whatever their state of health. However, insurers are allowed to charge an
appropriate premium for the risk.
Example
In the UK a code of conduct exists between insurers that prevents them from taking
account of genetic test results for certain types of contract (and for benefit amounts
below a certain level). The code also states that no insurer can demand a genetic test be
taken as part of the underwriting process.
Question 8.11
A genetic test can give information about the inherited risk characteristics of an
applicant for health insurance. One of the most significant risk characteristics of an
individual is sex, and insurers in many countries are allowed to take this into account.
So why shouldn’t insurers be able to request genetic tests in order to find out about other
relevant inherited risk characteristics?
6. An indirect constraint on the amount of business that may be written.
In most countries there are regulations regarding the minimum level of

mathematical reserves that must be held, often combined with minimum
requirements regarding the solvency margin (or capital requirement) of the
company.
We have considered this issue of capital strain elsewhere in the course.
These regulations have the effect of (a) limiting the capital available
within a company to write new business and (b) effectively placing a
minimum requirement on the finance required to write a contract.
The capital that a company has available to write new business is, broadly
speaking, the supervisory value of its assets minus the supervisory value of its
liabilities, including any solvency capital requirements (SCR). This difference is
sometimes referred to as the “free assets”, “free capital” or “free reserves” of the
company.

If the company uses up more than the amount of its free assets in writing new
business, or in any other way, it will be insolvent in the supervisors’ eyes. Quite
simply, the larger the value of supervisory reserves plus SCR that the insurance
company has to hold to satisfy the regulators on the existing in-force business,
the smaller the free assets and hence the capital available for writing new
business.
What is more, the bigger the reserves plus SCR that have to be set up for any
new contract, the greater the amount of the limited capital available that will be
used up when each new contract is written.
7. Restrictions on the types of asset or the amount of any particular asset in

which the insurance company may invest for the purpose of
demonstrating solvency.
Regulators might restrict the types of asset in which a life insurance company
can invest. Alternatively, they may allow considerable freedom over the
investments, but restrict the amounts of certain assets that can be included in the
asset figure used in the supervisory valuation.
Question 8.12
How might such restrictions protect policyholders?
We shall be discussing healthcare insurance company investment, including the possible

effects of regulation, later in the course.
3.3 Regulation on different institutions
The wider regulatory environment in terms of which institutions are allowed to

transact insurance-type business is also important. In practice, insurance
companies are likely to have the monopoly of providing pure protection benefits,
but not of providing savings benefits.
The other institutions offering savings contracts, for example banks, will usually
be subject to different regulatory controls from insurance companies, leading to
a non-level playing field with regard to the terms on which such contracts can
be offered.
However, this is less of an issue for health and care insurance products than for life
insurance.

Question 8.13
Why?
3.4 The effect of the regulatory regime on contract design
The regulatory environment is likely to have a significant effect on the design of

the contracts sold by insurance companies, as the companies will want to make
the best use of any regulatory opportunities available to them. Conversely,
contract design will have to take into account any constraints imposed.
Question 8.14
The regulatory authorities in a particular country have just introduced a requirement for
healthcare insurers to illustrate, to prospective policyholders, the withdrawal values for
each of the first ten years of a contract.
Comment briefly on how this change may affect the contract design and the benefits
paid under unit-linked healthcare insurance policies.

4 The fiscal regime
4.1 Approaches to taxation
Insurance business may be taxed in a number of different ways. The most

common methods are:
● a tax on the annual profits of the business, where profits broadly means
the excess of the change in the value of the assets over the change in the
value of the liabilities
● tax payable on investment income less some or all of the operating
expenses of the company.
In addition, there may be a tax on premium income.
One way of looking at these two approaches is that they recognise different aspects of
the nature of an insurer. The “profits” approach recognises that an insurer, at least if it
has shareholders, is a company trying to make a profit like any other.
The “investment income” approach could be thought of as treating the insurer as a group
of individuals pooling their resources for investment. If the investment return of
individuals is taxed then it is logical that this return should be taxed if it is earned within
an insurance company (provided the policy proceeds are tax-free when they are paid to
the policyholder).
We will now discuss these two approaches in more detail.
4.2 The profits approach
The profits calculation described above essentially measures taxable profit as the
increase in the free assets of the company over the year, where free assets is defined as
the value of assets minus the value of liabilities. Any solvency capital requirement may
or may not be added to the value of liabilities in this calculation; this makes little
difference to our discussion here. Let us define:
A0 = Assets at start of year
A1 = Assets at end of year
V0 = Liabilities at start of year
V1 = Liabilities at end of year

Then profit could be stated as:
1 (A1 – A0) – (V1 – V0) in symbol form, the definition of profit given in the
Core Reading above
2 (A1 – V1) – (A0 – V0) ie increase in free assets over the year.
Generally the reserves used will be the supervisory reserves, because this limits the
insurer’s freedom to manipulate the amount of the reserves and hence the taxable profit.
It would also be unfair to the insurance companies to use reserves in the tax
computation which are calculated any less prudently than the supervisory reserving
basis. This is because the company is only likely to distribute profits that are earned in
excess of the supervisory reserves, so a tax assessment on profits based on smaller
reserves would be asking the company to pay tax on profits before they have actually
been earned.
Question 8.15
Suggest why the profit calculated using supervisory reserves, may give a rather distorted
measure of profit in a particular year, particularly for a rapidly expanding insurance
company.
Question 8.16
Explain whether or not it would be appropriate to base the tax computation on reserves
that are calculated more prudently than the supervisory reserves.
4.3 The investment income approach
First it is worth pointing out that “investment income” is not always the precisely correct
term, although it may frequently be used colloquially. The taxable amount may include
some or all of the capital gains realised, as well as investment income.
Example
In the UK the investment return on equities and property, for long-term life insurance
business tax purposes, includes realised gains but not unrealised gains. In Ireland, on
the other hand, unrealised gains are notionally realised each year and are also included,
albeit with the amount of tax paid spread over seven years.

Allowing a deduction for expenses is reasonable because such expenses must reduce
any returns actually available to policyholders or shareholders.
Question 8.17
How sensible would the “investment return less expenses” approach be as a basis for
taxing regular premium critical illness insurance business?
The argument stated in the solution to Question 8.17 applies to any contract that
provides mainly protection benefits. This means it will apply to all health and care
insurances, except for long-term care insurance, which is likely to have a significant
investment component.
It is also possible for the taxation system to incorporate both methods at the same time.
This usually requires the tax to be the largest of the two calculated values. Therefore
unless a company has large volumes of long-term care insurance, health and care
insurances taxed on this system usually end up being taxed on profits. This is what
happens in the UK.
4.4 Tax on different types of insurance business
Within a particular country, different types of insurance business may be taxed

by different methods.
“Different types” here could refer to various possible classifications of business.

Possible examples include:
● short-term versus long-term
● conventional versus unit-linked
● savings versus protection.
Some classes of business can also be exempt of tax. Where policyholders effectively
gain the benefit of gross investment returns on their insurance policies, the benefits
themselves (or some part of them) are likely to be taxed instead.
Note that it is possible for policyholders’ funds to be credited with gross investment
returns, while profits earned on the business by the shareholders can still be taxed. This
is the system that applies generally in Continental Europe – details are beyond the scope
of this course.
This can mean that it is cheaper for the consumer if certain forms of benefit can
be offered as one type of business rather than another.

Example
To use a life insurance example, in the UK it is possible to offer term assurance as

pensions business (subject to certain limits) as well as life assurance business. Because
of the tax concessions on contributions to pension funds the term assurance cover can be
offered more cheaply as pensions business.
Tax concessions available to individuals may make the sale of certain types of
contract easier.
The tax treatment in the hands of policyholders of policy proceeds can distort
buying habits.
In summary, the overall attractiveness of a particular healthcare insurance product

compared with other products depends on a combination of:
1 the taxation treatment of premiums paid, in particular whether the premiums are
deductible from the individual’s taxable income in full, in part or not at all
2 the taxation of the insurer’s funds during the life of the contract
3 the taxation treatment of the eventual policy benefits.
Example
Fiscal rules permitting, a long-term care insurance might be written as either of the
following versions:
Version 1: taxed benefits

● premiums are tax deductible
● investment return is received gross
● benefits are taxed as income.
Version 2: tax-free benefits

● premiums are paid out of net income
● investment return is taxed
● benefits are free of tax.
Version 1 is likely to be more attractive to a person who is currently paying a high rate
of tax, but who expects to be paying a lower rate by the time benefits might be payable.

4.5 The effect of the fiscal regime on contract design
As with the regulatory environment, product design will want to make the best
use of any opportunities provided by the fiscal environment. On the other hand,
the ability to maximise favourable taxation treatment may force constraints on
product design.
For example, tax authorities may be keen that pure savings business should not be
“dressed up” to look like healthcare protection insurance in order to secure favourable
tax treatment where this exists. If so, they might specify minimum levels of insurance
cover necessary to secure tax concessions.
This would then represent both an opportunity and a constraint. The tax concessions
might allow a competitive product to be produced, but the design would have to include
at least the minimum level of insurance cover.
It should be noted that both the fiscal and regulatory environments are significant
drivers of product design in the insurance industry.

5 Professional guidance
Actuarial associations will often issue professional guidance for actuaries
advising insurance companies. These will typically give such actuaries a
framework of points that they need to consider in carrying out their
responsibilities in order to maintain professional standards.
The extent to which this is considered necessary will depend on the extent to which
actuaries’ scope for judgement is limited by legislation, which will vary from country to
country.
As such, professional guidance should not restrict the actions of actuaries and
may even provide protection against pressure from proprietors to agree to
courses of action that may not be in the best interests of policyholders.
For example, planned new business levels might require more capital than the company
has or can raise, threatening the long-term survival of the company. The actuary would
presumably be arguing for a change in the plans in any case, but the existence of
professional guidance on the matter may strengthen his or her hand in discussions with
the proprietors.
The guidance may typically cover areas such as the following, which are taken
from Guidance Note 1, issued by the Faculty and Institute of Actuaries in the
United Kingdom:
● the matters to consider in determining the suitability of the design and
pricing structure of a new long-term insurance contract
● the matters to consider when determining the value of the liabilities of a
long-term insurance company
● the matters to consider when advising on the suitability of a distribution
of profit (surplus) to with-profits policyholders or shareholders.
Question 8.18
Why are these matters particularly likely to be covered?
Additionally, short-term insurance covers, such as private medical insurance,

are covered by Guidance Note 12.
Guidance Note 12 (GN12) gives guidance to actuaries on the preparation of formal

reports on the actuarial aspects of a general insurance undertaking. You do not need to
know its details for this Subject.

In addition to the above, actuarial associations may issue professional guidance

on the interpretation of Government Regulations. This may typically arise where
the Government does not want to be overly prescriptive in its requirements so
as not unduly to restrict the actions of insurance companies. The Government
will then look to the actuarial profession to set limits, as it were, on what would
be acceptable behaviour.
This is very much the situation in the UK. In some other countries, for example many
of those in Continental Europe, more actuarial matters are specified in legislation, and
less is left to the judgement of actuarial associations or individual actuaries.
Professional guidance and regulations are both ultimately designed for the same end, as
we described in Section 3: to generate consumer confidence and hence create a thriving
insurance industry for the benefit both of consumers and providers.

6 Inflation
6.1 Meeting customer needs
In the design of any contract, the meeting of policyholder needs is paramount.

To this end, the purposes for which the product is sold, ie the protection of
individuals against some potential healthcare event and need, must be met both
in the immediate aftermath of the policy sale and into the effective lifetime of the
contract.
So the first priority is to be sure that a claim payment made in the near future (ie within
one or two years of the policy sale) will be of sufficient amount to meet the loss incurred
by the insured event. This simply means that when a non-indemnity contract is sold, the
insured’s financial needs are appropriately assessed and covered by the chosen benefit.
If the period of cover extends much beyond one year, there should be some means to
increase the benefit payments in line with the increases in the insured loss due to
inflation. The way of doing this depends upon how the policy benefits are defined.
Fixed level benefits
To the extent that a contract offers a fixed benefit, the policyholder must be
encouraged to review the level of cover frequently and reapply if cover becomes
insufficient to meet the purposes for which it was originally effected.
Question 8.19
What is the risk to the policyholder of this approach?
Benefits increasing at a fixed escalation rate
Where cover escalates at a fixed rate, the same process must be undertaken.
The danger here is that the policyholder may believe that he/she has bought
inflation protection.
Question 8.20
So what is the danger here?
It is also feasible for policyholders to become over-insured with such a policy, if

inflation turns out to be lower than the policy escalation rate.

Benefits increasing in line with a national inflation index
Some contracts increment cover amounts in line with national average earnings
or consumer inflation; even here the insured must be encouraged to review
provision against needs. For example, (in the case of LTCI) the increase in cost
of care homes may exceed the rise in retail prices, in which case the benefits
may become inadequate.
It is unlikely for any published inflation index to match exactly the inflation of particular
healthcare costs.
Benefits not fixed but indemnify actual healthcare costs
Where a contract indemnifies the cost of treatment, care provision or other

medical expenses, the risk of covering inflation is passed to the insurer. On
one-year contracts, the cost can be reappraised annually and premiums
adjusted accordingly.
This would be the normal case for private medical insurance and other short-term
medical expense policies, such as dental care funding plans.
On longer-term business, premiums may not be reviewable and the insurer will
need to keep the level of prospective reserves consistent with current and future
expected cost levels.
The worst case scenario here could be a pre-funded long-term care insurance policy,
with guaranteed renewable (but not reviewable) premiums, which provides for the
actual costs of long-term care, whatever they might be.
Question 8.21
The “worst case scenario” we have just described is rather unlikely to be found in
practice: why?
Question 8.22
Suggest two variations of this product design that would be much more likely to be
found in practice.

6.2 Inflation of expenses
Inflationary pressures will also apply to the expenses of policy and claim
administration. Here too the actuary will reflect rising expenses in the amounts
set aside as reserves for future policy outgo.
As well as the reserves, future expenses assumed in the premium basis should also
include appropriate allowance for future inflation, although index-linking or other
escalation of the actual premiums payable can help in this provision.

7 Other economic influences
7.1 Business optimism
In times of business optimism, there is a positive jump in demand for employer

sponsored insurances. This can arise from a need to offer an appealing
employment package to attract and retain the best staff.
Individuals are generally happier to renew/upgrade existing policies and initiate

new covers in buoyant times.
7.2 Employment security
As before, confidence in the continuity of salaried remuneration promotes the

likelihood of insurance purchase.
Lack of confidence in the longevity of one’s employment can produce an

increasing tendency to claim in some lines, eg PMI. It is noticeable that when
there is a danger of a group PMI scheme being withdrawn or when an individual
feels personally at risk of redundancy, there is an incentive to have treatment
under the policy before the cover becomes unavailable.
A similar thing happens under group income protection policies, though for slightly
different reasons, at times when employers are trying to economise on the salary bill. If
there is any possibility of an employee claiming for sickness benefit under the policy
rather than drawing salary, then the employer is likely to encourage this. In effect the IP
scheme is being used to “lay off” employees temporarily. In better times the employer
would be much keener to keep its staff in work.
Question 8.23
What is the disadvantage to the employer in encouraging its employees to claim in this
way?
Equally one might see an increase in IP claims in times of employment

insecurity, through work-related stress or depression.
A person will become more anxious at work if he or she is worried about their job
security. The increased stress can lead to more stress-related absence from work
(which, as mentioned above, might be encouraged by the employer in order to save on
the salary bill).

7.3 Investment returns
An important aspect of the economic environment for insurance companies is the

investment market, and the returns available. We will discuss this under the subject of
setting assumptions, later in the course.
7.4 Political stability
Political stability in itself can indicate national economic well-being. However

some political parties are better disposed towards insurance and hence some
political scenarios are more advantageous to the economic environment for
healthcare insurances than others. This latter fact is especially true for health
and care products where the government’s view of these as alternatives or
complements to the State welfare system can have a dramatic impact on the
public’s keenness to buy.
As we said earlier, the trend in many territories is towards more private healthcare
funding, so the political will (on balance) seems to be favouring health and care
insurance business generally. In the US, private healthcare insurance has been the norm
for many years, whatever the political persuasion of the time.

8 End of Part 1
You have now completed Part 1 of the Subject ST1 Notes.
Review
Before looking at the Question and Answer Bank we recommend that you briefly review
the key areas of Part 1, or maybe re-read the summaries at the end of Chapters 1 to 8.
You should now be able to answer the questions in Part 1 of the Question and Answer
Bank. We recommend that you work through several of these questions now and save
the remainder for use as part of your revision.
Assignments
On completing this part, you should be able to attempt the questions in Assignment X1.
Reminder
If you have not yet booked a tutorial, then maybe now is the time to do so.

Chapter 8 Summary
Commission
Commissions are split into initial and renewal payments. Commission is paid at the
higher initial rate for the first X months of a policy, and at the lower renewal rate
thereafter. The rates are expressed as percentages of the premium payable.
Indemnity commission is where the initial commission is paid in advance of the

premiums that earn it. Clawback is the repayment of any unearned indemnity
commission at the time of policy lapse; the clawback terms are a function of the
earnings period, which would be the same as the value of X above.
Alternatively, commission can be level, or high for a few years and lower thereafter.
Level commission structures encourage renewals but discourage new sales, and lead to
reduced capital strain for the insurer. Level commission defers remuneration for sales
and so is less popular with intermediaries.
Initial commission may be proportionate to (lump-sum) benefits, which better reflects

the total profit contribution of the policy; alternatively commission may be a function of
both premium and policy term.
Propensity to buy versus need to sell
Consumers have a natural tendency to avoid the issue of buying most healthcare
insurance products because the need may seem distant, it may be a taboo subject, or
people are simply unaware that the products exist.
Insurance can be considered as bought or sold. Insurance is bought if:

● it is a legal requirement
● people have an overwhelming desire for the product in order to meet a priority
need.
Insurance is sold where:

● people are unaware that they have a real need for the product
● the product or the needs being met are complex and have to be explained, and/or
advice needs to be given (eg about providers).

A healthcare insurance product is also somewhere between a need and a luxury:

● IP – usually real need but public generally unaware
● CI – need is uncertain but provides peace of mind and windfall opportunity, and
so often bought (desirable luxury)
● LTCI – extent of need is strongly affected by the level of State provision
● PMI – extent of need depends on level of State provision.
The regulatory regime
Governments may impose restrictions on insurance companies, usually with the stated
aim of protecting policyholders. The more common restrictions are:
● a restriction on the types of contract that an insurance company can offer
● restrictions on the premium rates, or charges, for some types of contract
● requirements relating to the terms and conditions of the contracts
● restrictions on the channels through which insurance can be sold, on sales
procedures or on information given at the point of sale
● restrictions on the ability to underwrite (eg to avoid discrimination)
● an indirect constraint on the amount of business that may be written, via
minimum reserving or solvency capital requirements
● restrictions on the types of asset or the amount of any particular asset in which
the company may invest for the purpose of demonstrating solvency.
The wider regulation of the different financial institutions also has an impact on
insurance companies and the products that they sell.
The fiscal regime
The most common approaches to health and care insurance company taxation are:
● a tax on the annual profits of the business
● tax payable on investment income less some or all of the operating expenses of
the company.
The second method often produces zero tax for protection products.
Different tax treatment of different types of insurance contract can make it cheaper to
provide some benefits as one form of business rather than another.

In comparing the tax advantages of different products one must consider:

● the taxation treatment of premiums paid, in particular whether the premiums are
deductible from the individual’s taxable income in full, in part or not at all, and
whether there is a premium tax
● the taxation of the insurer’s funds during the life of the contract
● the taxation treatment of the eventual policy benefits.
Professional guidance
Actuarial associations will often issue professional guidance for actuaries advising
insurance companies. These will typically give actuaries a framework of points to be
considered in carrying out their responsibilities in order to maintain professional
standards.
Actuarial associations may also issue professional guidance on the interpretation of

government regulations.
Inflation
Policy benefits must meet the insured’s future requirements. Inflation will erode a
policy’s ability to do this. Solutions include selling policies to reflect current needs, and
also for long-term policies:
● policyholder buys additional policies in future to make up shortfalls
● policies include pre-determined benefit and premium escalation
● policies include index-linked benefit and premium escalation
● policies provide indemnity benefits.
Inflation of expenses should also be allowed for (in reserves and premiums).
Other economic influences
Business optimism – increases demand for products.
Employment security – high security increases demand for products; low security can
also increase claim incidence (eg IP policies).
Political environment – will affect the economy and hence demand for products; but can
significantly affect demand through national policy on promoting State or private
healthcare provision.


Chapter 8 Solutions
Solution 8.1
New business strain on day one of a policy is:
0 +V + {initial commission } + {initial expenses} - {first premium}
where 0 +V is the supervisory reserve (including any solvency capital requirements) on

day one of the policy.
So increasing the initial commission paid on day one of a policy will increase the strain,
all other things being equal.
Solution 8.2
If the intermediary goes bankrupt it may not be able to repay the insurer any unearned
indemnity commission that arises from subsequent policy lapses. So the insurer wants
to make sure this is unlikely to happen before agreeing to indemnity terms.
Solution 8.3
It depends!
“Farming” leads to high persistency, so fewer new policies have to be sold each year to
maintain a stable portfolio size (ie there is low turnover) and this is less expensive for
the insurer to maintain, provided renewal commission rates are not too high. A key
component of the expense saving is due to the fact that, where persistency is high, the
company’s initial expenses can be spread over a large volume of regular premiums.
However, in order for farming to prosper, intermediaries need to be suitably rewarded

for getting policies to renew. The more effort required by the intermediary to secure
renewals, the more renewal commission needs to be paid. So there may come a point at
which this strategy is not cost effective in terms of the level of renewal commission
required. It then becomes cheaper for the insurer to compensate for lapses by putting
more effort into sales, by paying more initial commission, and so fostering the “hunter”
ethic.

Solution 8.4
Advantages
Level annual commission:

● 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.
Disadvantage
Level annual commission discourages the intermediary from actively seeking new
clients, which requires considerably more effort than achieving a renewal.
So the problem is that level commission does not reflect the work done to earn the
commission. In effect, part of the (higher) renewal commissions represent 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.
Solution 8.5
The profit from a policy would be expected to be broadly in proportion to the total
premiums paid over the term of the contract. So the longer the premium-paying period,
the higher the profit would be expected to be (as a proportion of one year’s premium). It
is therefore sensible for the reward to the intermediary to reflect this.

Solution 8.6
People usually decide to buy something through a feeling of need for, or desire for, the
product (eg food, clothing). With health and care insurance, people will feel the need
for a product if they consider that the risks that they currently face are unacceptable, and
that they would rather incur the cost and inconvenience of taking out insurance, and so
leave themselves with a much lower and acceptable risk.
However, many people may not be aware that they need the product (at least, not until
it’s too late), and so they will not always deliberately go out and buy it. So, much health
and care insurance is sold following approaches made by insurers and intermediaries to
the public, rather than the other way round.
In summary, the reasons include:

● the public are unaware of need, either through ignorance or from a belief that the
event “won’t happen to them”
● serious illness and incapacity may be taboo subjects
● products are difficult to understand, which puts people off
● a difficult marketplace – the presence of many providers makes it hard for
individuals to know which products and companies would be best to meet their
specific needs
● the general need for advice before making long-term financial commitments,
which makes the whole process very time consuming.
Solution 8.7
The State healthcare provision, while adequate (arguably), could be bettered (arguably).
People buy PMI so they can be assured of shorter waiting times to treatment, more
attentive care, pleasanter accommodation (eg private rooms instead of shared rooms),
and can have more choice over where they are treated, who will treat them and in the
way they are treated. In other words, to have the “luxury” treatment.
I guess we should have inserted the word “arguably” after every statement made in the
above paragraph – we hope you get our drift.

Solution 8.8
Yes, because it has put “create needs” in inverted commas. This is suggesting that the
regulation is preventing or reducing sales of products where the customers’ needs have
been mostly or entirely fabricated by the intermediary. Regulation is designed to reduce
the incidence of such mis-selling, in which case it is true that selling will become more
difficult. But rightly so: sales of genuine needs-based products should be unaffected by
the regulation.
The exception to this is the extent to which people may be put off buying: both by the
process itself and as a result of the higher cost involved.
Solution 8.9
Products will be more likely to be sold to meet clients’ real needs. As a result,
persistency of business should improve, and so should the good name of the company.
This in turn should feed back into more sales. So we are into a virtuous spiral of merit
and reward.
Solution 8.10
Theoretically, either would be possible. The authorities may feel that:

● rates that are too low might threaten the financial security of the company and
hence the security of its policyholders
● rates that are too high might give poor value for money.
(Depending on the product, the market and the distribution channel, the authorities
might feel that competition could take care of the second point. On the other hand,
effective competition depends on freely available information which is readily
understood, and this might not be the case: see Solution 8.6.)
Solution 8.11
The reason is a matter of ethics. No-one can fail to know what sex they are (and being
male or female is not all bad, either). But we are all ignorant of these other
characteristics unless a genetic test is taken. People might not want to know, for
example, that they test positive for a potentially fatal genetic disorder such as
Huntington’s Chorea. For a third party (like an insurance company) to require a genetic
test is deemed too great an infringement of personal liberty and therefore unethical.
Hence the ban.

Solution 8.12
The restrictions could prevent or limit investment in very high-risk or volatile assets,
and so reduce the risk of insolvency.
They could prevent over-concentration in a particular:

● country
● asset class
● stock-market sector
● individual asset
which will help to reduce the risk to the policyholder.
Solution 8.13
Because most health and care insurance policies are essentially protection policies, and
the policy reserves at all durations (which form the investments) will usually be small
compared to the sums at risk.
This will not apply to some forms of LTCI that are designed as savings products.
Solution 8.14
The most likely effect is that the insurance company will have to improve early
surrender values, if these have been poor to date. Not to do so might discourage
potential policyholders.
This might mean:

● reducing charges early in the contract, or
● reducing any penalties applied to unit funds on surrender.
All other things being equal, higher benefits paid to surrendering policies will mean
lower benefits for those who don’t surrender. This would come about through a
different structure of charges. Policyholders who surrender will be charged less than
before, and those who don’t will be charged more.
On the other hand, the desire to improve early surrender payments will be (possibly
significantly) constrained by the fear of worsening selection against the remaining
members of the portfolio. Any encouragement to surrender could lead to a
disproportionate increase in the healthy lives that do so.

Solution 8.15
The reserves, being supervisory reserves, will be prudent rather than realistic.
Supervisory free assets may well fall when business is written because of new business
strain, as we have discussed in previous chapters. But later in the term of the contract
profits will start to come through, as experience (hopefully) proves better than that
assumed in the reserves.
This means that the company’s overall taxable profit, measured in this way, would
reduce if it had a sudden surge in new business, although it would all “come out in the
wash” eventually. So the effect is to redistribute the tax paid over time, rather than to
change its total amount (assuming tax rates don’t change in the meantime).
Solution 8.16
This would depend on the way in which the company’s distributable profit was
calculated. For example, if distributable profit were based on supervisory reserves, then
any more prudence in the calculation of tax reserves will defer the tax payments by more
than the profit on which it is based. This would be over-generous to the insurance
company and hence inappropriate.
In general it would seem to be most appropriate to base the tax computation on the same
definition of profit as that used to determine the company’s distributable profit.
Solution 8.17
It would be fine, provided the tax authorities are happy to get no tax! The funds
building up under critical illness insurance are small, as we explained earlier in the
course. This means that very little investment return is earned and may well be smaller
than expenses, depending on how much of an offset for expenses is allowed.
But the business may still be profitable, and so a basis that produces no tax might not be
considered suitable, particularly for companies with shareholders.

Solution 8.18
This is because these are the things that actuaries do! They are key specialist activities
for an actuary working within an insurance company that transacts long-term life or
healthcare business. A very good reason for this is that these areas are important in
protecting solvency, ie in making sure that:
● the company does not sell a lot of loss-making business
● reserves are not understated
● excessive distributions of profit are not made (and, perhaps, that any split
between policyholders and shareholders is fair).
Solution 8.19
Unless there are guaranteed insurability options under the original contract, the
policyholder has to be re-underwritten on every new application. An adverse change in
personal or health circumstances can make it expensive, or even impossible, to increase
cover at a future date.
Solution 8.20
The fixed escalation rate may be significantly lower than the actual inflation rate, so that
the policyholder can still become under-insured if he or she does not review benefit
levels periodically.
Solution 8.21
It is an extremely risky product for the insurer: either the company is risking its
solvency, or it must be charging its policyholders heavily by including large margins in
its premium basis (and so probably not selling much business). It would be much more
inclined not to issue the product in this form at all.

Solution 8.22
We could have:
(1) benefits on an indemnity basis (with a ceiling payment) but premiums regularly
reviewable
(2) benefits fixed – or more likely index-linked; premiums may be guaranteed (fixed
or index-linked) – more likely reviewable, but less frequently than in (1).
Solution 8.23
Group schemes are often experience rated: that is future premiums are in some way
related to the past experience. So if more claims are paid now, the employer will have
to pay higher premiums in the future. However, it does defer the cost, hopefully to
times when finances are not quite so tight. Also, not all of any high claims experience
might be passed on in increased premiums, and so it might still be seen as the preferred
option.

ST1-09: State healthcare provision Page 1
Chapter 9
State healthcare provision
Syllabus objective
(e) Explain the likely role of the State in the provision of alternative or
complementary health and care protection packages:
− lump sums and regular incomes
− flat-rated and earnings-related
− different viewpoints for the retired, for the employed, for children
− simple methods of funding these outgoes.
0 Introduction
The role of the State in the provision of healthcare to its citizens has a large influence on
the market for healthcare insurance in that country. This can be particularly so, given
that often the State is the provider, regulator, financier and purchaser of healthcare, all
at the same time.
This chapter looks at the possible roles of the State and how they influence healthcare
insurance providers.
You are not expected to know the State provisions of any particular country, unless you
decide to study Subject SA1. In this chapter, however, we use the healthcare systems in
various countries around the world to illustrate possible approaches to State healthcare
provision.
Notice that there is a subtle difference between healthcare benefits (ie provision of
medical treatment) and welfare benefits (ie provision of income and other benefits such
as housing allowances) given to those unable to work due to sickness or disability. The
material in this chapter often refers to either or both of these types of benefits.

Page 2 ST1-09: State healthcare provision
1 Objectives of State healthcare provision

When considering a State healthcare system, the Government of a particular country, be
it developed or undeveloped, will have a number of questions it will want to answer.
● Who should get what benefits and when?
● Who pays for the cost of these benefits, when should they pay, and how much
should they pay?
● Who will organise the collection of the payments and the payment of the
healthcare providers?
● How will it be decided how much of the payments collected will be spent on
exactly what services, and who will make these decisions?
● How will patients access the healthcare services provided?
● What risks are there for patients and the State once the system is in place?
There is no “right” answer to the provision of State healthcare benefits. Each country
will have its own objectives, which in turn will depend on items such as:
● its political stance
● the characteristics of the population, eg its wealth and size
● the quantity and quality of medical services and expertise available
● the state of the country’s infrastructure
● the economy
● the country’s overall state of development
● the existence of other State benefits
● the history of State care in that country
● the social and cultural stance of the country.
The overall objectives of any Government’s provision of healthcare might be

considered under four headings:
● protecting the nation’s health
● subsidising the poor
● balancing the budget
● following social culture and/or political promises.
These objectives are now considered in turn.

1.1 Protecting the nation’s health
One of any Government’s primary objectives will be to protect the health of its
population. The extent to which it can do this will depend, of course, on the
nation’s wealth and the other priorities on its budget – but healthcare will always
come somewhere near the top of the list. It starts with the availability of food,
drinking water, nutrition and hygiene. It extends through the provision of basic
medical services and education. The ultimate goal might be a thriving medical
services system which encompasses state of the art medical facilities with a
population taking first-hand responsibility for its own health wellbeing.
By so doing, the Government can safeguard a healthy and productive workforce.

This in turn promotes productivity and a growing Gross Domestic Product
(GDP). The healthy body is more likely to contain an enthusiastic work ethic.
So, in this sense, the State healthcare policy should pay for itself.
The idea here is that healthy workers are happy workers. Happy workers work hard and
help to boost the GDP of the country in which they work. A country with a healthy
GDP can afford to install and develop an efficient State healthcare system. This keeps
workers healthy (and the Government in power!). And so the cycle continues …
The role that the State itself will play in fostering a healthy nation will depend
much on the style and culture of politics within the country, from a
market-centric laissez-faire environment to a more centrally provident system
where healthcare is the State’s responsibility.
Question 9.1
What is a market-centric laissez-faire environment? Do you know of any countries that

have this ethos?
Question 9.2
What are the advantages and disadvantages of a laissez-faire approach?
An example of a country that has quite a different approach is France. Here, the
Government provides a centralised service, making public health insurance compulsory
for all legal residents.
Other countries have a mix, where there is both a significant State-provided component
and a significant private component.

Providing healthcare facilities such as doctors, surgeons and hospitals is not the only
way to protect the nation’s health. There are other ways to do this too:
Education will be a key platform in the structure from children in school to adults
in the workplace and beyond.
Question 9.3
In what ways can the government meet the objective of educating the public?
The Government too will aim to ensure that research and the import of the latest
health technologies are not left exclusively to commercial considerations. The
Government will look to take a longer-term view as to benefits of the latest
scientific advances and find ways to sponsor their introduction to the country.
Question 9.4
Can you think of other ways of enhancing the nation’s health?
1.2 Subsidising the poor
Even where healthcare is provided commercially, the State will often maintain a
role to ensure that the poorest in the land have access to primary medical
assistance (doctors and medicines) and hospitalisation where necessary.
Priorities in health services are often extended also to children and the aged.
Even the relatively laissez-faire countries such as America feel it necessary to provide a
very basic minimum benefit for those members of the community who would normally
find self-funding an onerous burden. This is perfectly understandable, as nobody wants
to live in a country where there is a real possibility of unhealthy poverty with no respite.
The provision of healthcare in this way is seen as part of the State’s welfare
package and thus an integral segment in its attempts to redistribute wealth.
This redistribution aims to allow all citizens to obtain sufficient healthcare and other
services to ensure a minimum standard of living that is (hopefully) acceptable to all
citizens. The political process is used to further this aim.

1.3 Balancing the budget
The provision of healthcare is part of State expenditure, whether the Government

provides services to all regardless of personal wealth or whether it restricts
these benefits to those who could not otherwise pay. The exchequer can
“recover” these costs through specific health charges (eg national insurance) or
via general taxation or a mixture of the two.
National insurance (NI) is a system used in the UK whereby earners are taxed an
amount on their income in addition to general income tax. In the UK, this extra tax is a
percentage of salary between two limits. The tax raised in this way is earmarked for
spending on State healthcare services and to pay for State benefits (eg State pensions).
Around 13% of the funding for the UK National Health Service is from NI
contributions.
Healthcare spending is an emotive issue (the Government can never do enough)

and, via the taxation system, will always involve some redistribution of income
from the healthy to the less so. Thus, charging more through earmarked
systems is not going to be popular.
The rich will always pay more than the poor when national insurance taxation systems
are used to raise cash for State healthcare services, because the contribution is to an
extent proportional to earnings. However, where there is an upper limit to the NI
contribution this cross subsidy is limited although, of course, it does not stop the
Government raising other taxes on income or spending.
The Government is going to be aware that, with increasing technology and

growing expectation of delivery from members of the public, the cost of
healthcare year-on-year is likely to rise faster than the cost of consumer goods.
Question 9.5
What is the implication of healthcare costs rising faster than the cost of consumer
goods?
1.4 Following social culture and/or political promises
The Government’s approach to healthcare may be determined by party political

ethics; indeed, the State role in medical provision may oscillate somewhat as the
axis of political persuasion changes after each election. But the foundations of
healthcare provision tend to be part of a developed national culture and
expectation and so the periodic swings with change of political power do not
affect the fundamentals of national medical delivery.

State healthcare programmes may be part of national culture; radical changes

may be difficult to introduce, especially in the short term.
Radical changes to the provision of State healthcare systems occur infrequently. In the
UK, for example, the development of the current National Health Service was driven by
the large social, economic and political changes that followed the Second World War.
Since then, despite many changes in political persuasion, the general ethos of providing
access to free healthcare for all at the point of need has remained.
The role of commercial insurance in the healthcare arena will depend very much
on the nature of State provision. Among the models of co-existence, one might
find:
● Insurance can be an optional alternative. Here the State promises a

comprehensive system of medical services, and insurance can provide a
higher quality of service with more individual choice and possibly the
absence of the need to wait for treatment.
This is the approach in the UK. Some treatments on the State scheme have long
waiting lists (eg hip replacement). The choice of hospital and the standard of
accommodation (ie a bed in a private room rather than in a hospital ward) can be
better in a private hospital. There is therefore a range of private insurance
available.
● Insurance can be an optional complement. Here the State provides a

limited range of medical services and leaves it to the individual to fund the
balance.
This is generally the case in America and Canada.
● Insurance can be a compulsory alternative. Here the State provides

everything for members of the population up to a certain salary/wealth
level. Healthcare insurance is obligatory for all those above this
threshold.
● Insurance can be a compulsory complement. Here the State provides

certain healthcare procedures “free” at the point of delivery. Insurance is
mandatory for all other procedures.
For example, Germany operates a system whereby virtually all people in gainful
employment must be insured against sickness under a statutory health insurance
scheme. The scheme itself is funded by national insurance contributions.
However, those with large incomes can opt for a private alternative.

The co-existence of insurance and the State can apply to direct medical services
and also to the provision of income when, due to invalidity, a person is unable to
work and thus unable to meet ongoing financial responsibilities.
In other words, State provision may include services otherwise covered by PMI and IP
cover.
Example
In the Republic of Ireland, the State and private healthcare systems complement each
other well. State healthcare is free for the very poor, but others must contribute towards
their treatment.
Private medical insurance is popular, providing for both public and private treatment
(depending on the level of cover purchased). This is due to:
● historic tax benefits
● some dissatisfaction with State-provided healthcare and a belief that the private
system is more efficient.
The main PMI provider is Government controlled.

2 Manner of State provision

This section discusses the ways that the State can provide health benefits, including the
provision of monetary benefits.
2.1 Means testing
The State’s role in meeting the cost of healthcare or offsetting the financial loss
due to ill-health will vary from nation to nation. It may be the sole provider of
healthcare from inception to recovery, or it may only “pick up the tab” in cases
of financial hardship.
In the latter case, State benefits would be “means tested”.
The means test assesses the proportion of the total benefit that the State judges the
individual should be able to provide from their own income and savings. Means-tested
benefits are provided either to people who earn less than a certain amount, or to those
who have accumulated less than a certain level of wealth, or sometimes only to those
who meet both of these criteria.
Question 9.6
List the advantages and disadvantages of means-tested State health benefits.
2.2 Provision of treatments / services
The State may provide its own medical establishments which perform the
necessary treatments; costs may, or may not, be charged subsequently to the
patient. Alternatively, the commercial healthcare system may provide the
services and the Government may reimburse the expenditure to some or full
degree.
Question 9.7
Compare the advantages of:

(a) the State providing its own medical establishments, and
(b) making use of the commercial healthcare system.

There are various ways in which the benefits for healthcare can be provided. For
example, they may:
● be lump sum or regular income
● be flat-rated or earnings-related
● depend on the lifestage of the recipient.
2.3 Lump sums and regular incomes
Other methods of illness subsidy arise with the lump sum provision of cash in
the event of health breakdown or other medical need. This would be deemed
appropriate if the onset of disability called for capital expenditure (to redesign a
house in the light of restricted mobility or to pay for a specially adapted car).
When the help provided is specific, eg buying a car adapted for a particular disability,
the benefit is often provided on an indemnity basis. Here, the State pays for the actual
costs of the help.
The State may also recognise the need to provide an income for as long as
disability continues, where the disabled person is unable to work. As with
commercial insurance, this may be subject to periodic reassessments to ensure
continuing disability.
2.4 Flat-rated and earnings-related
The amount of State benefit to be paid may be pitched with a number of views in
mind:
● a salary-related benefit, to “reward” those who have contributed more
through taxation and to reflect their likely higher financial responsibilities
● a flat benefit, to provide an incentive to return to work, to minimise the
cost on the exchequer and to encourage self-provision through insurance.
Income benefits often increase in payment in line with some form of consumer
price index.
A flat-rate benefit would ensure a minimum standard of benefits for the low paid and
unpaid, but the level of the benefit may be unrelated to living standards prior to ill
health.

However, a flat-rate benefit is simple for recipients to understand, and for the State to
administer. The cost of administration will be smaller than that for a means-tested
benefit, and the take-up is likely to be greater because the process of applying for the
benefit will be much simpler than that for a means-tested benefit.
Many countries use a combination of these approaches.
2.5 Different viewpoints for the retired, for the employed, for
children
The State may see itself as having different responsibilities as regards different
members of the population. For example, its willingness to pay a benefit may
differ as to whether the patient is unemployed, as to whether the patient is still of
a school-going age, as to whether the patient is a pensioner, a widow/widower or
a war veteran.
The aim is to try to align benefit with need and not just degree of disability.
Question 9.8
Explain how the circumstances of each of the following categories of person might be
expected to affect the welfare benefits offered by the State:
● employed
● unemployed
● student
● pensioner
● widow(er)
● war veteran.
2.6 Simple methods of funding these outgoes
Another decision the State needs to make is how to fund the benefits provided.
The State may fund its welfare expenditure in one (or a combination) of two
broad methods.

Pay as you go systems
It may use pay as you go systems.
The basic idea behind a pay-as-you-go (PAYG) system is that the current working
population effectively pays the total costs for those currently needing benefits. If there
is a shortfall in any budget year (ie if the cost of providing cover is in excess of the
contributions collected from the working population), then the State will fund the
difference from general tax revenues.
In order to work out whether this is necessary the State must:
1. Establish the degree of State subsidy.
It must work out how much the State is going to pay towards the benefits
needed, and how much individual recipients should be expected to pay. This
will determine the contribution rates paid by individuals in the working
population.
2. Estimate coming year’s outgo.
It will do this by projecting likely benefits and expense costs based on past
experience.
3. Estimate coming year’s tax revenue.
This will enable it to work out how much income the State needs in order to pay
the projected benefits.
4. Adjust this so as to incorporate healthcare outgo.
It should change the tax structure (if appropriate). The structure of general
taxation is adjusted so that the welfare budget balances, ie the general taxation
revenue equals the difference between the contributions from individuals and the
expected welfare outgo.
Question 9.9
What could be a danger with a PAYG method?

Forward funding
It may utilise a system of forward funding.
The alternative to PAYG is to take a longer-term view, so as to anticipate future welfare

costs and build up a provision for these costs before they arise. This process works as
follows:
1. Take a view on some future period, eg 5 years, 20 years.
A cynic might say that the Government would only take into account a period
related to its expected future term of office! So instead of planning to balance
the welfare budget each year, it could plan to make it balance over the chosen
period.
2. Analyse the level of State provision at this point.
This would be an estimate of State subsidy provided at this future point in time.
3. Produce a model of State outgo at this and intervening years.
This would give an expected flow of cash outgo in the future.
4. Estimate population and workforce trends.
5. Forecast taxation revenues accordingly.
These last two points will give an expected flow of cash income.
6. Calculate a specific healthcare fund such that earmarked taxation will,

over the period, meet the intended State healthcare provision.
In other words, work out what extra is needed (if any), and create a fund that
will build up the difference in the meantime.
Intermediate methods which are part modelled, part paid yearly, are often found,
especially when forecasts indicate a likely reduction in workforce in future
relative to the number of beneficiaries.
This is the case in the UK, and in most developed countries.
Question 9.10
What are the advantages and disadvantages of forward funding?

2.7 Incentives for self-provision
Whether to promote the interests of the insurance system or merely to limit the
potential outgo on the exchequer, the Government is often keen that some level
of self-provision of healthcare funding is in place. These “incentives” can take
numerous forms. By way of example:
● The State can offer tax relief on premiums for appropriate insurances.
This is the case in the Republic of Ireland, where tax relief to varying extents is
given for PMI, dental insurance and LTCI.
● The State can exclude some or all of the population from certain aspects
of the national welfare scheme.
For example, in the UK, most, but not all, people have to pay for eye tests and
glasses.
● The State can offer a reduction in general taxation where appropriate

insurances are effected.
● The State can reduce the cost of private purchase of healthcare services
by direct subsidy to the providers.
Most countries use at least one of the above methods in their State healthcare provision,
although the last two methods are rarely used in practice.

3 Who provides? Who pays?

As outlined above, any national system is a complex web of historically evolved
cultures and expectations, of budget constraints and of differing perceived
priorities to differing population segments. The role of insurance in any market
will necessitate careful study of all of these elements before a strategy can be
developed; often insurance feeds from the crumbs dropped from the social
welfare table, at other times, insurance is a strongly-promoted plank in the State
healthcare package.
The role of specific State health welfare programmes will be examined in detail at
the Specialist Application level.
Example − Australia
The healthcare system of Australia gives an indication of how complex the State
provision of healthcare can be. In summary (!):
● The Commonwealth collects the taxes but the individual states deliver the
healthcare services, albeit with subsidies provided by the Commonwealth.
● There is also a large private medical sector – participation is voluntary, but
encouraged by the Government (and about half the eligible population have it).
● A national system of care provides health benefits to everybody, regardless of
wealth. This is financed through a combination of general taxation and a
compulsory health tax levy on income − although the contribution is dependent
on income levels.
● Benefits are limited to those on a schedule – some are unlimited and some are
capped. If private treatment is taken, there can be some financial help from the
Government.
● Although benefits are available, waiting lists can be lengthy.
● Medical practitioners can either bill the Government or the patient, and the fee
schedules are not fixed. The patient may have to contribute to the costs.
● Payments to healthcare providers are complex:
− some are paid retrospectively
− some are paid prospectively
− some are regulated, some are not
− some are paid on a daily basis.

Chapter 9 Summary
The overall objectives of State provision are a balance of:
● protecting the nation’s health
● subsidising the poor
● balancing the budget
● following social culture and/or political promises.
The State provisions may be:

● lump sum or regular income
● flat-rated or earnings-related
● different for different lifestages.
Simple methods of funding State healthcare outgoes are:

● pay as you go systems
● forward funding
● a combination of the two.
The State may offer incentives for self-provision of healthcare benefits, such as:
● tax relief on healthcare insurance premiums
● exclusions from State benefits
● reduced general taxes where insurance is effected
● subsidies to private purchase of healthcare services.


Chapter 9 Solutions
Solution 9.1
Laissez-faire means “let it be” and a market-centric system is one that is based around
market forces. A State with this ethos has the view that it should have minimal
involvement in the provision of healthcare benefits and should just let economic forces
take their course, with private providers and insurance competing where they desire.
The USA is one example of a country that is reasonably close to this ethos. The State
provides little in terms of nation-wide benefits (although there is a minimum level of
provision for everybody, particularly the poorer members of the community, and
generally State involvement is increasing) − but most people who want further
healthcare either have to pay for it themselves or buy healthcare insurance. Canada has
a similar ethos.
Other countries that have this ethos are very undeveloped countries. These countries do
not have the infrastructure or medical knowledge to set up State healthcare provisions at
this stage, so probably do not have an alternative viable approach. As the country
develops, the State can provide services, although at first these will be under-developed
mainly due to funding restrictions.
Solution 9.2
Advantages
● It is cheaper for the State, in terms of saved care costs and simpler
administration.
● It encourages competition, in both healthcare insurance and healthcare provision.
● It encourages the population to take better care of itself (as people know they
will have to pay if they become ill).
● There are no cross-subsidies between rich and poor, healthy and unhealthy. This
will make it popular with people who see themselves as healthy.
● There can be lower taxes – or saved costs can be spent elsewhere.
Disadvantages
● Not popular with unhealthy and/or poor people.

● Lower security of benefits and greater uncertainty for the public.
● Against the public spirit.

Solution 9.3
Ways to educate the public may include:

● making lessons on health part of the national school curriculum
● government advertising campaigns on health issues, eg on television, radio,
magazines, cinema.
Education on health issues could be compulsory in certain areas of work, such as

catering.
These messages could include advice in areas such as:

● disease prevention
● identifying diseases (eg sexually transmitted diseases) early
● the dangers of unhealthy habits, such as smoking
● hygiene
● accident prevention.
Solution 9.4
Possibilities include:
● provision of screening facilities
● well-man and well-woman clinics and regular check-ups
● ensuring that health insurance is available, affordable and appropriate
● making overseas operations a viable option
● greater investment in sports and exercise initiatives
● providing advice, eg on diet
● accident prevention, eg accidents at work, drink-drive campaigns
● campaigns warning of the dangers of smoking, alcohol, etc.
Solution 9.5
Any means of raising money for State healthcare costs will need to rise at a rate faster
than that of consumer goods, otherwise the healthcare budget will become increasingly
in deficit. For example, raising the money by relying on a tax on consumer goods and
services sold (known as Value Added Tax in some countries) will be insufficient.

Solution 9.6
Advantages of means-testing benefits
● may be a cost-effective way for the State to target benefits to those most in need.
The State may provide little or no benefit to individuals with sufficient private
means, and instead direct resources to the less well-off to ensure that everyone
achieves a certain minimum standard of living when in ill-health
● may be redistributive if taxes are raised from those with more wealth/income,
and means-tested benefits are then paid to those with little wealth/income
● those who fail the means-test may be encouraged to return to work
Disadvantages of means-testing benefits
● people may be discouraged from providing for themselves

● may create a poverty trap whereby increases in a person’s income (or assets)
merely reduces the value of the State benefits
● may encourage people to squander (or hide) existing wealth so that they have
more chance of satisfying the means-test
● those who receive benefits may be discouraged from returning to work
● it may be perceived as unfair to those who do provide for themselves
● means-tested benefits are not taken up by all who are entitled to/or need them
● receipt of benefit has a “stigma” that identifies an individual as “poor”, and
hence may discourage him or her from claiming the benefit
● it is perceived by some as “degrading”, ie State benefits should be a universal
right rather than a payment to the poor

Solution 9.7
(a) Advantages of State providing own establishments
● can keep a closer eye on cost and claim control

● will not need to pay for profits of commercial enterprise
(b) Advantages of State relying on commercial establishments
● can benefit from their expertise, experience and economies of scale

● can transfer much of the administration
● commercial establishments may be more responsive to customer needs,
eg introduction of new treatments
● different providers will compete for the business
Solution 9.8
Employed
The employed will be paying through taxation and perhaps national insurance, so
should receive full benefits. As poverty should not be a problem for most, some sort of
sharing arrangement could be put in place (eg paying for drug prescriptions). These
could be waived for certain conditions (eg the poorly paid).
Unemployed
The aim of the State would be to pay for medical costs but, if possible, encourage a
“return-to-work” ethos, since the unemployed will not be paying for the benefits
through salary taxation. One argument is therefore to limit the benefits, in either
amount or term. However, if the view is that the unemployment is due to the general
state of the economy and not an individual’s problem, or that the unemployment is
actually doing some “good” (eg carers, or voluntary aid workers) then the benefits may
be generous.
Student
The aim of the State would be to pay for all reasonable costs. The student will
eventually be working and should not be penalised for the current temporary hardship.
It may, however, be fair to limit welfare benefits if the student is already receiving loans
or other financial support from the Government. The extent of financial support from
parents may also affect a student’s rights to benefits.

Pensioner
There is no option of work, and generally society should take good care of the elderly.
Benefits should not be restricted, but there may be a preference for regular income as
opposed to lump sum, to reflect the lower expectation of life. Benefits will, of course,
not be related to salary but could instead be related to pension.
Pensioners generally feel that they have been paying all their working life for the
“cover”, and so normally expect generous benefits. This is the case even if the State
operates a pay-as-you-go system, where the healthy working members are really paying
for the benefits of the sick elderly.
Some benefits will be given in kind (eg bus passes) or as indemnity benefits.
Widow(er)
As for pensioners, but generally an even lower expectation of life and perhaps a greater
need for more generous benefits to reflect the lack of home care available (ie from his or
her partner).
War veteran
Characterised by unemployed, long-term disability, so medical needs can be high.

Given that the disability was suffered whilst serving for the country, benefits should be
generous. Other comments as for pensioners also apply here.
Solution 9.9
If, as in most developed countries, the population is changing such that the number of
pensioners is increasing relative to the working population, then the contributions and
tax income from earners will become more and more insufficient to pay for welfare
costs.

Solution 9.10
Advantages
● The fund is not as sensitive to demographic changes compared to PAYG.

● The system fosters forward planning, so that the Government should be able to
take the necessary action (eg changing contribution rates) in enough time to
ensure the cost of paying the benefits remains well covered.
● The public will have more confidence that the State will be able to provide
healthcare benefits to them when their need arises. This makes the public more
willing to contribute to the scheme and increases the popularity of the
Government.
Disadvantages
● The money could instead be used, with immediate effect, elsewhere.

● It is more complex to administer.
● Assets need to be held and managed. An investment policy will be required,
investment decisions will need to be made and assets will need to be bought and
sold.

ST1-10: Assumptions (1) Page 1
Chapter 10
Assumptions (1)
Syllabus objectives
(f) Understand and apply the techniques used in pricing health and care
insurance products in terms of:
– Data availability
– Equation of value
– Formula approach
– Cashflow techniques
– Group risk assessments
– Options
– Guarantees.
(k) Understand the assumptions which are crucial to pricing and valuation:
– morbidity
– mortality
– lapses
– claim amount
– expenses
– investment return
– taxes
– solvency margins
– profit requirements.
(The items in bold are covered in this chapter.)

Page 2 ST1-10: Assumptions (1)
0 Introduction
In this chapter we cover the derivation of the demographic assumptions that are to be
used for pricing health and care insurance. Other types of assumptions, and other
applications for which assumptions are required (eg reserving) are covered in the later
chapters.
These next three chapters, together with Chapter 20, deal with the construction of a
basis. By basis, we mean the set of assumptions (sickness rates, expenses, interest rates,
etc) that would be used for a particular modelling application, such as pricing, or
projecting the future solvency position of the company. We cover pricing and other
aspects of modelling in Chapters 13-19.
In some cases (eg fully guaranteed IP policies ceasing at retirement) this process may
require the actuary to make long-term judgements about each parameter in the
assumption set. In other cases (eg reviewable CI contracts and particularly PMI) the
assessment is over a much shorter period, typically between one and five years.
By the end of the “Assumptions (3)” chapter you should expect to understand how the
actuary goes about deciding on a suitable assumption for each parameter. The key part
of the process is the determination of what future experience is expected. A second
aspect is what other factors may need consideration: for instance, the extent to which
margins against adverse future experience are required. What these other factors are
will depend greatly on the purpose of the basis.
The Core Reading specifically covers three different purposes – pricing, reserving and
ongoing profitability measurement. However, other modelling purposes demand
generally similar approaches to assumption setting, and you should aim to be able to
describe the principles involved for any of these.
Bear in mind also that, in Chapters 10-15, we are generally concerned with the pricing
and modelling issues of insurance contracts sold to individual lives. Group insurances
are covered specifically in Chapter 16.

1 General considerations when setting assumptions

As in all actuarial work, when setting assumptions it is important to:
● consider the use to which the assumptions will be put
● take particular care over the choice of those assumptions which will have
the most financial significance
● allow for any consistency which should exist between the various
assumptions
● ensure that the parameters derived from data are produced as accurately
as the body of data will permit
● ensure that the data used to derive these assumptions are relevant to the
risks which the policies encompass
By “risks” here we mean the insured lives involved.
● ensure that bases used for periodic valuations and reserves are flexible to
reflect changing risk circumstances.
The assumptions made should be responsive to any changes in the circumstances
of the in-force policyholders that might affect the financial experience –
including claims – of the company.
Failure to adhere to these principles increases the potential for downside risk to
the insurer. The need for a credible database which is relevant to the risks to be
insured and from which assumptions can be drawn, is fundamental to the
process, both for pricing and valuation.
We will see how these considerations affect our choice of assumptions as we go on,
both in this chapter and in the next two.
Deriving assumptions for future experience follows a common framework.
1. Investigate the historical experience and make best estimates of the parameters
from that experience. These estimates will be appropriate in the context of the
historical conditions and circumstances that applied at the time of that
experience, including the condition of the commercial and economic
environment.
2. Consider what the conditions (including the commercial and economic

environment) will be like in the future period for which you are making your
assumptions.

3. Determine what the best estimates of your assumptions will be, given the
expected future conditions.
The historical parameter estimates will be used as a starting point, (when

possible or appropriate), but the effect of the different circumstances of the
future, compared with those of the past, must be allowed for. In other words,
how will the parameter values change given the changed conditions?
The extent to which you would rely on the experience data, and the extent to
which you allow for other factors, including judgement, depends on the
credibility and relevance of the data, and how predictable the parameter is.
4. The best estimates may need to be adjusted in order to include a margin for
prudence. The size of any margin incorporated into an assumption will depend
on the purpose for which the model is required, and the degree of risk associated
with the parameter.
1.1 Assumptions used
The assumptions used will be discussed under various headings. Sources will
be suggested but no attempt will be made to suggest sample figures which, for
healthcare products, will vary substantially around the world.
For example, you won’t be required to recommend a suitable claim inception rate basis
for CI policies in Germany.
In most of the subsequent Core Reading of this chapter, the emphasis will be on the
initial derivation of premiums for a company new to this line of business; rates
thereafter will be revised and fine-tuned as its own experience emerges and as
market information indicates trends which are relevant.
We will mention separately any differences that may apply where an existing line of
business is involved.

2 Overview: demographic assumptions used in pricing

As stated in Section 0, in this chapter we will be focusing throughout this chapter on
how the demographic assumptions used for pricing are determined. The pricing process
itself is described in Chapters 14 and 15. But, as we shall see, much of what we discuss
here is also relevant for other purposes.
For the time being we will be referring only to how we would obtain best estimates for
our assumptions. The subject of what margins to consider is covered in Chapter 12.
2.1 Main demographic assumptions
This heading covers the following parameters that may enter into the model used
to price an insurance contract:
● mortality rates
● critical illness incidence rates
● long-term sickness transfer probabilities
● long-term care transfer probabilities
● other claim inception rates including PMI incidence rates
as the same principles apply in each case.
Note that the Core Reading also lists “lapse” under the heading of “demographic
assumptions”.
Here we are assuming the “ideal case” of actuaries being able to decide for themselves
on the most appropriate assumption. However, it can be the case that the regulatory
authorities will constrain, perhaps severely, this choice in a pricing context.
2.2 The general process
The values assigned to the parameters should reflect the expected future
experience of the lives who will take out the contract being priced.
Note the use of the word “reflect” rather than “equal”. As we shall see frequently in this
section, the expected future experience is the starting point in putting a value on a
parameter. We would then consider what margins might be appropriate.

The expected future experience of the policyholders will depend crucially on:
● the target market for the contract – this will be dependent on the distribution
channel involved, and the territory (geographical region) chosen
• the underwriting controls applied (or not applied) at the start of the policy
• the claim controls applied (or not applied) at the claim stage
• the policy wording, for example under a CI contract where the diseases covered
are defined
● the expected change in the experience since the time of the last historical
investigation to the point in time at which the assumption will on average apply
(eg as a result of medical advances).
In most cases, these values will be based on an adjustment to rates, or transfer

probabilities, from a standard table.
This very much depends on a suitable standard table being available. For example in
the UK, standard tables exist for CI and IP, but not for LTCI (because of insufficient
data) or for PMI (because the insurance companies are reluctant to disclose their data in
sufficient detail).
Adjustments to standard tables would typically be simple in form, for example we

might define our future critical illness (stand-alone) claim inception rates for heart
disease, as ixHD , to be:
ixHD = a.ixHD ( S ) + b
where ixHD ( S ) is the claim inception rate by heart disease at age x in a suitable standard
table, and a and b are chosen constants.
Question 10.1
Give at least two possible reasons why an insurance company might prefer to use
standard table rates in the above formula, rather than using independently graduated
rates from its own claim experience data.
Using standard table rates in this way is an example of using market data – in particular
insured lives data – as a basis for our assumption. We discuss this further in
Section 3.4.

If the company has adequate data, the adjustment (to the standard table) would be
derived by analysing the company’s own experience for the type of contract
concerned. Alternatively, the experience of a similar class of business could be
used as a substitute.
This alternative may provide appropriate data, depending on the similarity between the
contracts concerned. For example, suppose you want to price a new IP policy with a
3-month deferred period; your company has issued IP policies with a 6-month deferred
period for many years. So it might be possible to use the historical data from the 6-month
policies to provide a basis for the 3-month inception rates.
Question 10.2
What particular statistical information will you need to have from the 6-month policy
data in order to be able to estimate 3-month policy claim inception rates? Explain your
answer.
Question 10.3
Explain whether the data in the above example would enable you to estimate claim
termination rates for the new contract.
Using the experience of “similar” contracts as a basis for assumptions also depends on the
similarity of the target markets involved. So, in the above case, the past experience of the
6-month policy data might not be fully relevant to the 3-month policy design, if different
kinds of people (eg in different occupational groups) were to be attracted to the 3-month
version.
The more different the type of policy, the less similar will be the class of lives involved
and the more different will be their experience rates. For example, using CI claim
inception rates as a basis for IP inception rates could be extremely problematic.
The data would relate to an appropriate period of years, such that the volume of
data is adequate, but excessive heterogeneity due to changes over time is not
introduced.

There is a conflict here between the desire to have a large pool of data, and a
requirement not to look at significantly different generations of lives. A “generation” in
this context could be just five or ten years. If the data include lives who enjoy different
morbidity because of different generations then the morbidity implied by the data may
be misleading. This will be so if differently aged lives have seen different morbidity
improvements from one generation to the next. So morbidity investigations are
normally based on three or four years of data.
The analysis would divide the data into relevant homogeneous groups, subject
to adequate levels of data being retained within each cell.
A similar argument, of credibility versus heterogeneity, applies here. If you analysed

the morbidity experience of men and women grouped together, then the morbidity rates
observed will reflect the proportions of males to females in each group. The grouped
rates will not represent future grouped rates if this proportion were to vary over time, as
males and females have different morbidity rates.
We will look at the most important subdivisions in Section 0.
If the company has insufficient data to produce reliable results, or has no

appropriate data at all, industry sources, such as the Continuous Mortality
Investigation Reports produced in the UK, consultancies or reinsurance
companies, might be used instead, if appropriate for the product in question.
Such data might also be particularly useful for showing trends, since trends in your own
data might be down to statistical variation. Population morbidity experience provides
another important source of data for setting assumptions. All these sources of data are
discussed in Section 3.
If the adjusted rates are to apply to a class of lives which is expected to have a
different experience from that to which the analysed data relates, then further
adjustments may need to be made. This situation could arise due to a change in
target market, distribution channel, or the basis of underwriting and accepting
lives. It is worth noting however that, for many classes of healthcare risk, no
pre-standardised data may exist and the insurer must gather less relevant
information from other sources.
You should bear in mind that the class of lives concerned is almost always going to
have a different experience from that underlying the data, just due to the influence of
time.

2.3 Social and economic influences
The propensity of an individual to claim for a healthcare insurance product or

indeed to continue claiming income benefits will additionally be dependent on
several social and economic factors:
● Pessimism in the economy and the levels of unemployment. This may

encourage some employees to take advantage of group PMI cover whilst
they are still employed, hence increasing the PMI claims incidence rates.
Similar economic circumstances may provide a disincentive for some IP

claimants to “recover” and return to work; this may be especially true of
self-employed workers who may find that their clientele has disappeared.
● High inflation. This will hit the renewal price of PMI and is likely to make
policy withdrawal rates higher.
This will affect claims experience because it will increase the risk of selective
lapsing.
This point would be true of other healthcare product types, if they have
index-linked premiums, as well as for PMI. However, the effect will be most
severely felt in the case of PMI.
Question 10.4
Why will withdrawal rates under PMI policies be more affected by increases in inflation
compared with the other main healthcare product types?
● Government promises in welfare provision. The more lavish the state

promises in relation to long-term disability support and acute medical
care provision, the more difficult will be business capture in the first
place, the lower will be the retention of business in force and the worse
will be the claims experience on those left (as the lapses will hit the book
selectively).
Question 10.5
So, list all the factors that might cause the future morbidity of new policyholders to
differ from that of your own historical experience data, for a particular health insurance
product.

3 Data availability
The most important component of the premium to be charged to the insured
person is generally that which covers the pure risk ie the anticipated cost of
future claims for the future period for which the policy is to be in force. It is vital,
if this estimation of outgo is to be as accurate as possible, that the actuary uses
the most appropriate statistics available. These should be relevant, credible,
available and reliable for the purpose intended. Cost and suitability of format
may be other criteria to consider.
Relevance implies a similar class of lives and policy conditions to those expected for the
product in question.
Credibility implies a sufficiently large volume of data to enable precise estimates to be

calculated (ie with relatively little sampling error).
The actuary will use his/her judgement to compile statistics from one or more
sources that together meet these criteria. Equally then the actuary will employ
skill and judgement in projecting the historical picture afforded by these data, in
order to predict the likely future claims experience and thus the premium which
should be charged to the policyholder.
Question 10.6
Suggest suitable formats for the policy data you would ideally like to have in order to
estimate the required parameters for each of the following products. (Details of the
various categories that might be used for risk classification purposes, such as sex and
smoker status, are not required.) State how the data would be used to calculate the
parameter estimates needed.
(i) Income protection.
(ii) Critical illness (stand-alone policy).
(iii) Long-term care.
(iv) Private medical insurance.

3.1 Own data
Most of the above criteria are met by statistics drawn from in-house experience.
Relevance is a key consideration. There are many influences affecting the
amount to be paid out in benefits which are peculiar to the insurer in question:
● approach to underwriting and acceptance
● policy conditions
● claims management
● distribution method and channels
which may not be reflected in numbers taken from external sources. A

company’s own experience will generally form the best base for prediction.
Cost, reliability and format should not present problems.
In many lines of healthcare business, however, the volume of business for many
insurers over the recent past, is not sufficient to be deemed credible. This is
especially true when the projection requires detail down to particular risk cells.
Where insufficient in-house data exist, the actuary must look elsewhere and
must make appropriate adjustments to allow for the characteristics of the
imported statistics which will be less than perfectly relevant as estimators of
future claims outgo.
The case of a brand new insurer or an insurer launching a new line of healthcare
product is an extreme case. It could take many years before the insurer’s data
can be deemed credible for all but very high-level analysis. The actuary here will
be totally reliant on other sources such as those listed below.
The key point here is that own data (especially if they relate to the actual product you
need the assumption for) has the great advantage of relevance. On the other hand,
credibility of own data is a major issue for most lines of healthcare insurance and for
most individual companies. Much greater reliance on the other sources of data is
therefore usually necessary for determining assumptions for healthcare products than,
for example, for most life insurance products.
3.2 Population data
In many countries in the world, the national government produces a periodic

analysis of healthcare experience for the population. The degree of
sophistication varies enormously. It is only appropriate to deal here with some
of the issues arising. Population data is a very important source of information
to the actuary in healthcare premium assessment; indeed for some lines and
some risk cells, it is the only base from which a first estimate of future costs can
be established.

Population data are readily available (in many territories) and are often free. The
numbers involved make them credible.
However they have drawbacks:
● The national experience is not particularly relevant to the subset of lives

who will be accepted for insurance. This position may be improved if the
population analysis is split into socio-economic groups, regions and age
blocks.
Question 10.7
Explain why splitting the data by socio-economic group and region will improve the
relevance of population data.
● The circumstances of the onset and continuation of a disability are

unlikely to coincide exactly with the definitions of a “claim” under the
insurance policy.
Question 10.8
There is a particular difficulty with population data that causes both of the above
problems. What is this difficulty?
● The accuracy and reliability of the national statistics may be questionable,

especially in healthcare where definitions may be subjective and the
scope for double counting is enormous.
For example, critical illness policies cover heart attack and coronary artery
bypass surgery as separate causes of claim. Policyholders who suffer a heart
attack as well as undergoing bypass surgery would only incur one insurance
claim, but would be represented twice in the population records. The overlap
would have to be allowed for when trying to infer CI claim rates from
population data.
● Data may not always be available electronically or in the appropriate

format.
● The population experience may be somewhat out-of-date before it

becomes published.

3.3 Reinsurance data
A reinsurer often provides statistics relevant to the risk to be insured (to assist
in pricing and reserving) as part of the range of services on offer. Here the
reinsurer is keen that the statistics proposed are as accurate as possible, since
the profits under the treaty will reflect the premiums calculated.
This last point will depend on the type of reinsurance used for the business, once it has
been set up. (It is almost invariably the case that a reinsurance treaty will be set up for
the business in question, since this is the usual means by which the insurer will pay the
reinsurer for the services received.)
The various types of reinsurance that might be involved are discussed in Chapter 26.
Reinsurers will draw information from their involvement with other companies in
the market and are thus in an excellent position to assist a company with a first
time incursion into a new product line. Reinsurers were largely behind the
development of Critical Illness (or Dread Disease Insurance) in many territories
from the 1980s, where no insured experience existed. Here they used statistics
from other markets, weighted by local population information.
Even when products become relatively commonplace, reinsurers can still be used very
much as data “experts”. As the whole industry develops then so too does the experience
data of the reinsurers, who can then rely more heavily on their own experience (through
the reinsurance of their clients’ portfolios) for determining their advice. Their breadth
of exposure throughout the market should enable them to pinpoint the most relevant
data for the type of policy and target market proposed.
The actuary must assess the divergence of reinsurance data from his/her
company’s own likely future claims experience and make appropriate
adjustments. This is true even if a large share of the risk has been ceded initially
to the reinsurer.
So, despite the reinsurer’s expertise, there will never be a perfect match.
Question 10.9
“Some reinsurance treaties for critical illness products involve 90% or more of the
original risk being passed on to the reinsurer, on an original terms basis. Surely, in this
case, the burden of responsibility for getting the price right could be 100% passed on to
the reinsurance company, because the 10% of risk still covered by the insurer (even if
incorrectly priced) would be negligible?”
Comment on this statement.

There may be an explicit charge by the reinsurer for providing this advice, but it
is normally provided on the basis of accepting a share of the business written.
3.4 Market data
Market data have a national relevance to the company concerned. Care must
however be exercised where policy conditions differ, or where it is felt that
underwriting approaches and claims management procedures are likely to be
markedly different from the market average.
Two sources of market data are discussed here:

● insured lives data
● published returns.
Insured lives data
In a well-established insurance market, there may be an agreement between

companies to pool claims and policy statistics so that overall industry-wide
information might be gleaned which would be more credible than that which
individual companies could access. An example of this is the Continuous
Mortality Investigation Bureau in the UK which collects data from nearly all
players in the income protection and critical illness markets. The compiled
aggregate information is published for the benefit of all. Individual companies
may get an analysis of their own experience.
It is from this industry source that standard morbidity tables are usually produced, and
which can be very useful as a base reference for experience monitoring purposes and for
setting assumptions, as we described in Section 2. Standard tables will not be published
very often, because they involve a great deal of preparation. The pooled experience
would normally be expressed in relation to the most recent standard available, and a
new standard would be considered when it was felt that expected future experience
could no longer be easily represented as simple adjustments to the existing table.
The advantages of information in this form is that:

● it represents insured experience
● it is generally of sufficient volume to be statistically credible
● it reflects local companies (reflecting market practices) and has been
compiled by experts (individual company glitches resolved).
Its drawbacks surround the fact that it remains only a market average and hence
not strictly relevant to any one company. Additionally, it may take some years
before the final published tables are released, thus reducing its applicability.

The key points are that industry data:

● have much more credibility than own company data but are less relevant
● have less credibility than population data, but do relate to policy claim
experience which makes them considerably more relevant.
Question 10.10
List the reasons why industry data are unlikely to be as relevant as own data, for setting
assumptions for one of the long-term health insurance products.
While market claim data are available for long-term classes of business
(eg critical illness and income protection), such data for general insurance
classes are often very limited, except at total level.
Returns to an insurance supervisor
Statistics in this form may also be drawn from the published returns to the local
regulator.
In most territories, insurance companies have to submit returns to their national

governmental supervisors at regular intervals. These returns show much that is
common to normal company accounts, including information on annual revenue and
balance sheet items. In addition, they will typically include much more detailed
information about the policies in force: primarily this is to do with the calculation of the
supervisory reserves, but also includes information on the numbers of policies, amounts
of benefits and premiums, all broken down by policy class. A breakdown of the
numbers of policies going on and off the books during the year, broken down by cause
as well as policy class, is also often given.
While their accuracy is not questioned, the degree of detail which the actuary
can extract in the estimation of risk in future individual cells must be
questionable. The returns are produced to assess solvency and certainly not to
assist competitors in the compilation of their own tariffs.
Nonetheless, the information afforded can provide a high-level check on

premiums produced from other sources. Perhaps more vitally, the process
affords an analysis of likely market positioning when the company’s rates are
first published.

Question 10.11
Explain how you could use supervisory returns to produce broad estimates of claim
experience rates for PMI policies.
State what you think is the most likely shortcoming of this approach for pricing
purposes.
3.5 Other sources
Trade magazines
Trade magazines, national and global, will often be a source of statistics to

assist in the risk projection process. These again will, of necessity, lack detailed
breakdown; but they may provide market information and a reasonability check.
These will give information about the types and levels of benefits offered and the
premium rates that companies charge. They will not, however, normally include any
claim statistics.
Actuarial consultants
Consultants, like reinsurers, may have access to data both from national and
international sources. Many of the points mentioned above in Section 3.3 (on
reinsurance) are valid here also, although the likelihood is that the consultant
would not share directly in the risk and will require reward directly for the
assistance in helping to compile premiums (or simply to provide data or
software).
In other words, consultants would normally charge a fee for their services.
Overseas data
Some information may be available from overseas territories which is credible (in
terms of volume) and readily available. Even where this is insured data, the
actuary must be careful with differing cultures, differing state healthcare
provision (which will affect insurance experience), differing market practices,
differing legislation and differing policy conditions.
Overseas data are always likely to be less relevant than the equivalent population and
insured-lives data of the home territory.

Rate table software
In some territories, for individual business, there may be companies who issue
software comparing market premium rates for similar products of a given class.
This may be useful either in gathering initial data, or in checking the
reasonableness and competitiveness of office premiums once calculated.
This information is very similar to what might be found in trade magazines, but usually
in more detail.
3.6 Making adjustments for credibility and relevance
In this section we discuss the adjustments that need to be considered when using the
various sources of data for setting assumptions. The general ideas involved have
already been discussed in Section 2.
The chosen body of data may well require adjustment to meet the purposes of
the premium production exercise. This cannot be a precise methodology and
broad-based ratios will be necessary initially. More accurate allowances can be
made when an insurer’s own experience is more voluminous. Some of the
adjustments which might be considered are proposed here.
Where the Core Reading is saying “initially”, it is referring to the case of a relatively
new product, and a market where relevant experience data are likely to be scarce.
While this may be typical of many markets in healthcare insurance products, it will not
always (or even currently) be the case. For example in the US, PMI business (known
simply as Health Insurance in its home territory) is extremely well established and
many companies will have very adequate own data to work from.
Data drawn from own experience
The actuary should look to trends arising from market data to discern their
relevance to his/her own company. Any cell-subdivision which leads to data
lacking credibility would be similarly weighted by market data where such detail
is published.
The idea here is that, because our own data lack credibility, we need to look to more
credible sources (like market data) to support our estimates.
Stating an assumption as a simple adjustment to a standard table, as we described in

Section 2, is one example of this. Simple statistical fitting procedures can be used to
obtain values of the adjustment parameters (eg of constants a and b in the example
given in Section 2) that are consistent with the company’s data. (We will still need
further adjustments, though, to allow for future changes: see Section 5 below.)

Where no standard table exists, other methods need to be used. This in effect will boil
down to trying to develop a table of rates to use from a combination of one or more of
the different data sources. The individual methodology used will depend greatly on the
format of the data available and how much credence you want to give to each source.
Details of how this should be done for individual cases are beyond the scope of this
course, but statistical techniques (studied in earlier subjects) will be very much
involved.
Data drawn from local population
There are two conflicting aspects in comparing population data and the
experience of insured lives. The latter should be healthier and less prone to
claim because they have been underwritten and the less healthy declined or
loaded. However, the population proposing for insurance are arguably doing so
because they expect to gain from the contract, where the policy is deemed
non-essential; those not expected to claim will keep their money in their pockets.
For these reasons, the improvement in experience from population to insured

lives might not be so marked. This has been evident in the development of
critical illness in many territories, where anti-selection and moral hazard have
been diagnosed. Actuaries may choose to offer a small discount on population
statistics but the validity of this will depend on their company’s approach to
sales, marketing, underwriting and claims.
Basically there is no universal rule to apply here. The adjustment to be made to

population data to make it appropriate to a given insurance purpose will depend on the
specific details of the case involved. The conflicting tendencies discussed in the above
two Core Reading paragraphs essentially reflect the drawbacks listed in Section 3.2, and
particularly as described in the solution to Question 10.8.
Data drawn from reinsurers
The actuary would look to the source of these data and discuss their relevance
with the reinsurer. In many cases, the reinsurer will already have made
allowance for such externalities and the company actuary will need to assess
whether further loading is required. In particular, the actuary will adjust for the
specifics of underwriting and claims management, which may not be known to
the reinsurer.
Data drawn from market sources
Here the actuary will need to consider the extent to which his/her company’s
own experience will differ from the average of contributors to national data.

The strictness of underwriting and claims management might be reflected in

similar ratios used for life insurance standard tables. But caution should be
exercised if this is a launch into a new healthcare product; strict underwriting in
mortality may not translate directly into similar margins for critical illness or
income protection business.
The idea here is that, if the company issues life insurance products as well as healthcare
insurance, then the levels of adjustment the company currently applies to standard
mortality tables may be similar to that needed to apply to standard morbidity tables.
The rationale for this would be that the company’s underwriting and claim handling
philosophies for the two types of risk should be similar.
Differences in policy conditions from the average may produce more

straightforward ratios if the cost of risk has been well analysed, ie any
adjustment to be made for data drawn from policies with a measurably higher
propensity to claim (based on benefit conditions more favourable to the
policyholder), can be derived simply from a ratio of the increased risk in these
policies to that underlying the market norm.
Of course, we will need the appropriate data in order for us to be able to calculate such
adjustments, eg we will need to be able to subdivide the data according to the
differences in policy conditions, and this may not always be possible.
Data drawn from overseas sources
The actuary here may choose to use broad based population ratios to assess the
higher or lower likely claims experience locally than that inherent in the database
available. The many potential differences underlying overseas and local
healthcare data demand a cautious approach to premium derivation by this
method.
For example, we may have some overseas insured lives data for a particular product we
would like to launch, but no home (local) industry data. However, we do have broadly
relevant population data from both areas. So we can estimate our home insured lives
experience from:
{home population morbidity rates}

{overseas industry morbidity rates} ¥
{overseas population morbidity rates}
This, of course, can only be a broad starting point to estimating future claim experience,
and further adjustments to these estimates will almost certainly be required.

Question 10.12
Suggest reasons why further adjustments might be required.

4 Developing the demographic assumptions
4.1 Claim incidence rates
Claim incidence rates, in general, include:

● rates of transition from healthy to claiming for IP policies
● rates of transition from able to claiming, and from a lower benefit level to a
higher level, for LTCI contracts
● rates of claim occurrence for CI policies, for each disease/procedure type
separately
● rates of claim occurrence for PMI policies, for each benefit category separately.
Incidence rates need to be calculated for all product lines. We begin by

choosing the most suitable database. In some instances (reinsurance data or
market data), this may come in the form of incidence rates. Otherwise these
have to be calculated using exposed to risk techniques. Adjustments will have
to be made, as discussed above, in order to produce rates which are relevant to
the company, its products and the time frame for which they are to be sold.
We have covered all these points already.
The rates will need to be broken down into discrete risk cells. After due analysis
these may afterwards be combined.
Question 10.13
(i) Explain what you think a “risk cell” is, and why we need to break down the
(experience) rates in this way.
(ii) What analysis will lead to cells being combined and why would this be done?

Typically the split for long-term healthcare products would be:

● age
● sex
● smoker status
● occupation
● size of benefit selected
● class of product (eg whether stand-alone, rider to savings vehicle)
● individual or group
● distribution source
● region (for group risks).
Other factors include:

● duration since policy entry
● duration since start of current benefit, where appropriate (eg for LTCI transition
rates to higher benefit levels)
● underwriting status (ie whether the life was accepted at standard rates or was
subject to special terms).
For PMI, market practice in some countries has ruled sex out as a rating factor,
though internal company analysis may continue to monitor the experience with
regard to this attribute and arguably the claims differential between the genders
can be very significant. Smoking status is not yet widespread as a premium
determinant in PMI and the size of benefit is not relevant. Premium rates are
generally split by age groups.
Question 10.14
(i) List the main factors used for subdividing short-term health insurance incidence
rate data.
(ii) List the main factors that are typically used as premium determinants of
short-term health insurance products.
Where the probability of claim is deemed to be a compound of many different

events which have different propensities, the incidence rate is derived from the
combination of these probabilities. This is certainly true of critical illness and
PMI. Long-term care and income protection incidences tend to be derived as
single rates.
The individual (non-combined) incidence rates are those derived in the solution of
Question 10.6, ie for disease type (CI) or benefit category (PMI).

In particular, for CI, rates are derived separately for each of the main classes of
claim eg cancer, heart attack, stroke, coronary artery bypass surgery, total
permanent disability. The others are derived individually or proportionately.
Each is projected separately, before being combined to produce the global
incidence rate.
Additionally, sophisticated IP and PMI models may allow for higher incidence
rates among lives which have claimed historically and recovered – in effect,
previous claims experience is being used as a risk factor.
Allowance will be made in all incidence rates for trends, both improving and
worsening, so that the premiums charged reflect the likely claims outgo in the
appropriate period of risk. Trends will be most relevant if they are derived from
the insurance market under consideration. Of particular note in a healthcare
context is the future plans for state welfare provision (eg where PMI is an
alternative or complementary to state provision), the economic well-being of the
country (eg rising unemployment can affect IP incidences) and inflation
generally.
The factors contributing to these trends are those listed in the solution to Question 10.5.
We’ll now show the process described in the above Core Reading paragraphs using
formulae, for CI contracts.
Let iˆxj (0) be the rate of claim inception at age x by disease or procedure j, judged to be
appropriate for the present time (specified as applying to a particular “base” calendar
year 0), derived from all the combined sources of information available. These
individual rates will be projected in order that they will be best estimates of the future
experience by each cause, in each future calendar year. The expected cause j incidence
rate at age x in calendar year t (ie t years after the base year) might be written:
iˆxj (t ) = a j (t ) ¥ iˆxj (0)
where a j (t ) is the t-year projection factor for disease j. We then combine the rates for
each disease into a single claim inception rate for a given age and calendar year:
n
iˆx (t ) = Â iˆxj (t )
j =1
where there are n causes covered in the contract.

Question 10.15
Why do we need separate adjustment factors a j (t ) , for each disease?
The constants a j (t ) could also be age specific, as changes in morbidity over time may
not be the same at every age.
Note that the use of this (or any other) adjustment formula is only an example of how
“past” experience rates might be adjusted to make them applicable to the future. More
sophisticated adjustment techniques may not involve explicit formulae at all, but reflect
individual judgements about each case (ie for each disease and for each age). However,
care must be taken not to get into the realms of spurious accuracy in doing this, as the
considerable uncertainty involved in any projection (and particularly of morbidity claim
rates) would normally only justify broader brush approaches.
For PMI and other short-term contracts, the future premium rates tend to be applicable
for one year at a time, at the end of which policies are up for renewal and different rates
can be charged. Projections of incidence rates for each benefit category are then much
less problematic than for the long-term health insurance contracts. However, expected
claim amounts for each benefit class for the period in question are also required, and
these will need projecting as well.
Question 10.16
State the main factor that has to be taken into account when projecting claim amounts
for PMI policies.
4.2 Claim recovery rates
Claim recovery rates are important to any contract where the benefit is paid out
in the form of an annuity:
● under LTCI, the benefit will cease if the policyholder recovers from
disability or dies; recovery is unlikely given the claim conditions and age
profile of the beneficiary, and hence is generally ignored in pricing
● under IP, the benefit will cease if the claimant recovers or dies or if the
policy expires; the rate of recovery or rate of continuation is crucial to the
costing process.
A large database will be needed to be able to calculate rates which are age, sex
and duration dependent, not to mention the influences of occupation and cause
of claim.

Question 10.17
List the main factors used for subdividing claim recovery rate data.
Question 10.18
State how you expect claim recovery rates to vary in relation to the following factors:
(i) The length of the deferred period of the policy.
(ii) The length of time since the claim payments were started.
Medical advances will play a role in both aiding speedier recovery and extending
life in disability where formerly, death might have ended the claim.
This means that the effect of medical advances on total expected claim costs – and
hence morbidity claim experience overall – is not clear cut.
Question 10.19
Explain which one of the factors listed in the solution to Question 10.17 will be most
influential in determining whether medical advances will improve or worsen IP claim
experience.
The keenness to return to return to work is a key factor in controlling claim

continuation rates. The economic environment (availability of work) may be
outside the insurer’s control; but policy conditions (the ratio of all post disability
income, including IP benefit, to pre-disability salary) can be managed to ensure
that experience is in line with expectations. Claims for large benefit amounts
tend to continue for significantly longer than those for small amounts.
Question 10.20
Explain the bit in the above Core Reading regarding policy conditions.
The other key aspect of IP claims management is in helping claimants to return to work
as soon as possible – often referred to as claim rehabilitation. Allowance for the effects
of this should be taken into account when setting recovery rate assumptions, both when
interpreting historical data and when considering any future adjustments that might be
necessary.

4.3 Mortality
The actuary will need separate rates of mortality, among healthy (non-claiming)
lives for IP, LTCI and CI, and among lives in claim for IP and LTCI. Special
consideration needs to be given to the survivorship requirement for stand-alone
CI. Where policy conditions do not have a significant death benefit, it is
important that neither mortality rate be overestimated, as the whole contract
would be under-costed.
The CI “survivorship requirement” is the policy condition that requires a policyholder

to survive for a specified period of time (eg 28 days) following the date of disease
diagnosis, in order for a claim to be valid. So, in the case of CI policies, “neither
mortality rate” refers to the mortality of CI policyholders while healthy, and to the
mortality of potential claimants following the date of disease diagnosis. Because death
reduces the probability of sickness claims occurring in both cases, it is clearly important
not to overstate the mortality rate assumptions, unless there is a significant death
benefit.
It is usual for the effect of mortality during the survivorship period to be allowed for by
an adjustment to the claim incidence rate. The adjustments will be specific to the
different disease categories (as the post-diagnosis survivorship can differ quite
dramatically for the different diseases).
Mortality rates should be taken from the recent experience of a credible body of
policyholders for the same contract. As a rate of decrement, however, this is
deemed less significant than others which give rise to benefit.
So, using the stand-alone CI contract as an example, reducing mortality rates by 10%
will increase the population exposed to risk of critical illness by far less than 10%. (For
example, if mortality rates are normally expected to be 0.005 each year, then even if
they reduce by 100% (to zero) the number exposed to risk of critical illness inception
would only be about half a percent bigger than it would have been.) This means that the
resulting increase in critical illness claims will be much lower than, say, if critical
illness claim inception rates had themselves increased by 10%.
On the other hand, claim costs will be much more sensitive to mortality improvement
after claims have started (ie for IP and LTCI policies in payment).
Question 10.21
Explain why this is the case.

So the significance of the mortality assumption does depend on whether we are

considering non-claiming or claiming policyholders. This therefore has an impact on
how much effort we would normally expend on determining the assumption.
For stand-alone CI, IP and LTCI, the non-claimants’ mortality would merit the least
research, and we would probably base the rates on a standard mortality table – quite
possibly for assured lives – but with adjustments to allow for full future mortality
improvements. The same formulaic approach as used for claim incidence rates,
described in Section 4.1, would probably be used.
For IP and LTCI claims in payment, the mortality assumption would merit much more
effort in order to estimate the future rates with more confidence. This is because the
assumption has a bigger financial impact, and because the mortality of sick lives is a lot
less predictable than for the population as a whole. The subdivisions of data used
would probably be the same as for claim recovery rates (see Question 10.17).
Claim termination rates for given ages can be obtained by combining the appropriate
recovery and mortality rates, if required.
4.4 Lapse
A lapse describes the situation where a policyholder decides to stop paying contractual
premiums under one of the long-term products, or fails to renew his or her contract
under a short-term product. In both cases the implication is that no reimbursement is
paid to the policyholder, and the policy simply terminates at that point, with no benefits
payable.
On the other hand, some long-term health care products pay a cash lump sum to the
policyholder on policy withdrawal, and this would then be usually referred to as a
surrender, with the payment of a surrender value.
Determining a lapse rate assumption follows very much the same pattern as for the
other demographic assumptions described above. That is:
● analyse own data, subdividing into relevant risk cells, regrouping as necessary to
compromise between homogeneity and credibility
● take into account industry and reinsurers’ experience, especially with regard to
trends
● project historical lapse rates in order to obtain best estimates of future
experience, taking into account all factors that are expected to make the future
rates differ from the past.

The big difference compared with other demographic assumptions is the big influence
of human behaviour on the future experience. In turn we have to think about the factors
that influence this. These factors can be:
● economic (can the person continue to afford the premium?)
● political (what state benefits are offered as an alternative?)
● commercial (is there a better or cheaper competitor’s product?)
● awareness (is there a belief that the policy is necessary?).
Lapses affect the contract in a number of ways.
● Firstly, an early lapse may cause financial loss, where insufficient

premiums have been received to recover the initial strain (commission
and expense) involved in writing the policy.
Earlier in the course, we defined initial capital strain to be:
{initial supervisory reserve} + {initial expenses} - {first premium}

= {initial supervisory reserve} - {initial asset share}
where “initial” means the amounts on day 1 of a policy.
This represents the amount of capital required to finance a policy. However, the
above Core Reading is referring to a different definition of initial strain, ignoring
the supervisory reserve and the initial premium, ie referring only to the cashflow
items of outgo on day 1.
The Core Reading is essentially saying that, if the accumulated value of the
cashflows to the date of lapse is negative (ie the asset share is negative), then the
company makes an overall loss from that policy equal to (the negative value of)
the asset share.
● Secondly, where no surrender value is payable and a reserve has been

accumulated, a lapse will work to the benefit of the insurer.
By “reserve” here, the Core Reading is referring to the accumulated asset share,
not the supervisory reserve. So the only difference between this and the
previous case is that, if a lapse occurs when the asset share is positive, then the
company makes a total (accumulated) profit from the policy equal to its asset
share at the date of lapse.

Question 10.22
How do we work out the overall profit (or loss) made by a policy that pays a surrender
value on withdrawal?
Question 10.23
What is the importance of the supervisory reserve value at the date of surrender or
lapse?
● Thirdly, at any time, the effect of lapses may be selective, such that the
healthier lives will be more likely to withdraw, leaving a worsening
propensity to claim among those continuing.
For policies that pay indemnity benefits, the above will mean that the continuing
policies will generally be those that incur larger, as well as more frequent,
claims.
For example, PMI lapse rates are also heavily correlated with claims
experience – generally the lowest claiming members have lapse rates
which are approximately twice the rate of the highest claiming members.
Question 10.24
So, overall, why can we say that the lapse rate is an important assumption for pricing?
Modelling should be employed to estimate the susceptibility of the product

design and the company’s capital to each form of lapse.
The idea is to get an indication of the sensitivity of such things as profit, price and
capital requirements to changes in the lapse rate assumption, so we can understand how
important the assumption is and therefore how much care and effort we should apply in
order to determine the assumption. (This is called sensitivity testing).
A company’s own set of lapse rates will be highly dependent on distribution

methods and after-sales service. Hence the use of statistics from another
provider is at very best a short-term measure. The level of economic confidence
and the ongoing competitiveness of the product sold are two other key
determinants. Own-product lapse experience should be calculated as early as
possible, divided by distribution type if necessary.

After-sales service is a factor that mostly affects short-term products, such as PMI,
where there is regular contact between insurer and insured at each annual renewal.
Market or industry data sources are altogether much less useful for estimating lapse rate
experience than is the case for other demographic assumptions.
Question 10.25
List the reasons for this.
Question 10.26
State the subdivisions of data that you might use in order to analyse the lapse rate
experience of own company data, for CI policies.
Further details of analysing withdrawal experience are covered in Chapter 28.
Where competitive pressures drive down premiums, lapse and re-entry may be a
particular problem for offices, especially if policies have large benefits.
For example, premiums on critical illness products in the UK fell during the 1990s as a
result of competitive pressures.
Question 10.27
Explain the problem of lapse and re-entry, and why this is a particular problem in the
conditions described in this Core Reading.
The withdrawal assumptions should reflect the expected future experience in

respect of the contracts that will be taken out.
Each of the healthcare product types may exhibit different lapse experience.
Certainly the PMI renewal experience will reflect the rate of premium increase,
the perceived service delivery within any state-provided alternative (length of
waiting lists etc) and the current confidence in the economy (where PMI
competes with state provision).
The common theme here is that all of these factors affect the ongoing desirability of
having the insurance – either compared to what is available without insurance, or
compared to the competition.

Question 10.28
List the factors that might make future lapse rate experience different from the past, for
IP policies.
Lapse rates will be based on an analysis of the company’s recent experience.

Ideally, this should relate to the contract being priced, but if no such experience
exists or the available data are inadequate, then the experience under any similar
contracts would be analysed.
If the company does not itself have adequate data, there may be industry-wide
experience that it could use …
… though you should recall the limitations of this, as stated above. Reinsurers may also
be a source of lapse rate data.
There will be no population data that can be relevant to lapse experience.
Question 10.29
Why not?
The results of such analyses should be assessed to see if they have been
affected by special factors such as an adverse economic situation in the country.
Question 10.30
How would you expect a deterioration of the economic situation to affect lapse rates for
the following non-linked regular premium contracts:
(i) Stand-alone critical illness.
(ii) Pre-funded long-term care insurance.
(iii) Private medical insurance.
Adjustments are likely to be required to ensure that the assumptions derived

from these analyses reflect the expected experience of the lives being rated.
We should adjust to allow for differences in characteristics that might affect lapse
experience between the data used in the analysis and that expected on future new
policies. Such characteristics were listed in the solution to Question 10.28.

Question 10.31
How might a change of distribution channel affect withdrawal rates?

5 Projection to midpoint of insurance usage

We have already made the point about projecting our experience assumptions so that
they will be relevant for the appropriate time period. Here we consider what that time
period should be.
The database for premium estimation is essentially historic. The actuary will
need to gather all information available from the local market on trends and
developments in order to project this experience forward for the product’s
lifetime. The actuary must incorporate not just the policy term but also the
length of time for which the current terms are to be offered.
So, given we are going to use our assumptions for pricing, the assumptions will have to
be relevant for policies issued this year, next year, and each subsequent year until the
pricing basis is next altered. As each cohort of policies issued in any of the above years
will continue (paying premiums based on the same prices) until they terminate or until a
premium review date, then the assumptions must stay valid for an average of:
[expected shelf-life of proposed premium rates]

+ [expected duration of policy to termination or to next review date]
Incidence rates will vary by age and by calendar year.
Example
Suppose we have estimated claim incidence rates that apply, on average, on 1 January
2004 (so 2004 is our “base” year), for lives aged x. These rates are defined as ix (0) .
(Remember that these are probabilities of claim inception, over one year, for lives aged
x at the start of the year.)
We are planning to launch a product on 1 January 2005, for which we hope the
premium rates will not need to be changed for three years. This means we would need
to set the rates assuming lives started their policies, on average, on 1 July 2006. So for
a life aged x at entry, we would calculate their premium rate assuming claim incidence
rates of:
1
2 [ix (2) + ix (3)] in the first policy year
1
2 [ix +1 (3) + ix +1 (4)] in the second policy year
… and so on.
Claim termination rates will also vary by duration from commencement of claim.

The average claim size (for private medical insurance) will be a function of
inflation, current protocols and hospital charging structures; but here we need
only look at a year at a time, because premium rates are reviewed at least
annually, and policies are renewed once a year.
If, for example, premium rates are reviewed every six months, and policies are renewed
annually, the very last claim will occur within 18 months from the date the premium
rates were last reviewed, so the timescales are much shorter than for long-term
insurance.
It is imperative that, where there is considerable uncertainty as to future

experience, the contract allows for some form of future review. Otherwise, the
cost of the reserves required could make the premium to be charged unsaleable
in terms of perceived value for money.
Question 10.32
State the aspect of assumption setting to which the above paragraph of Core Reading is
specifically referring, and explain the logic behind the final sentence.

Chapter 10 Summary
Determining demographic assumptions
This involves:
● making best estimates of future experience, using all sources of available
historical data
● historical parameter estimates need to be adjusted to allow for changes (known
and expected) up to the time for which the assumptions are to apply
● data need to be adjusted in order to reflect the specific circumstances of
company and product
● best estimates may need to be adjusted to include margins for prudence.
Data availability
Important themes are credibility and relevance. The main different sources are:
● Own data – least credible but most relevant.
● Reinsurers’ data – provided in return for share of business. Fairly relevant and
credible: “expert” data source.
● Population data – credible, but problems of relevance due to non-insured lives
and different definitions of sickness from insurance claims.
● Insured lives’ data – more relevant than population data, but very heterogeneous.
May include standard tables.
Less important sources are supervisory returns, trade magazines, overseas data, and rate
table software.
Obtaining parameter rate estimates from data
External data sources may give rates in appropriate form. Otherwise use exposed to risk
techniques.
Rates need to be analysed by specific risk cells, combining into broader homogeneous
groups where possible to aid analysis.
It is important to know the risk factors (subdivisions) for each assumption and for each
product type.

Projecting the rates
Analyse and project total claim incidence rates for IP and LTCI.
CI incidence rates are analysed and projected separately by each cause of claim, then
combined.
PMI incidence rates and average claim costs are analysed and projected for each benefit
or treatment category separately.
Project to mid-point of insurance usage.
Importance of assumptions
Claim incidence rates very important for all product types.
Claim recovery rates are important for IP policies.
Mortality rates are important for claims in payment under IP and LTCI.
Recovery and mortality rates should not be overstated.
Mortality assumption less important pre-claim, unless significant death benefit is

provided.
Allow for medical advances carefully, as they can produce opposing effects on overall
claim costs, depending on cause of claim and product type.
For lapses and withdrawals take the most recent investigation for that contract or related
contracts, or industry statistics, as a starting point. Some adjustment might be
necessary. The commercial and economic environment is important.
Need for regular reviews and/or short policy terms
Essential to prevent excessive contingency margins and/or excessive cost of capital,

making the policy too expensive to sell.

Chapter 10 Solutions
Solution 10.1
You should hopefully have got at least two of the following:

● The data are likely to be scarce, so that the graduation could be very unreliable
and inaccurate over large parts of the age range. Using a standard table, which is
based on a much larger body of data, gives the company more confidence that its
assumption will be realistic.
● The company has a greater chance of making a significant error if it is setting its
own assumptions without reference to a standard table.
● It is much simpler!
● When monitoring the experience, it is often convenient to compare your own
experience with a standard table, especially if this is a commonly used standard
throughout the industry. This would enable the company to see how its
experience compares with the industry as a whole, as well as indicating when
(and how) its pricing basis may need changing.
Solution 10.2
You will need to know about all persons who were continuously sick for 3 months or
more, including those who recovered between 3 and 6 months duration of sickness. If
the only claim data collected related to those people who had actually claimed under
their 6-months deferred period policy, then you would be understating the claims that
would have occurred under a 3-month deferred period policy, possibly quite
significantly.
Solution 10.3
It might be suitable for estimating termination rates occurring after 6 months of

continuous sickness, but would provide no information about rates relating to durations
of 3 to 6 months of continuous sickness. Termination rates can vary quite markedly
with duration in the first year of sickness, so we could not simply use the same rates
regardless of the sickness duration.

Solution 10.4
PMI will be most affected because the policies are all short term in nature, generally
renewable annually. Policyholders have to make the decision consciously to renew
their policies at the renewal date, so that a large hike in premiums could put off large
swathes of policyholders from renewing.
The other main healthcare products are long term in nature, with guaranteed annual
renewal until the expiry of the initially chosen policy term. Policyholders have to make
a conscious decision to stop paying premiums under their existing policies (ie to lapse
their policies).
There may also be an incentive to keep a long-term policy going (at least to its next
review date in the case of reviewable premiums), if the company has increased its
charging rates for new business since the existing policy was taken out.
Solution 10.5
We have already made reference to most of these factors. They are:
● changes in the target market (this will happen unintentionally, and probably only
slightly, every time the product is altered, since different products will appeal to
different people; the target market might also change substantially for economic,
fiscal or cultural reasons)
● changes in the distribution channel
● changes in territory targeted
● changes in the impact of medical science, such as rate of diagnosis of critical
illness, health care provision, treatments/cures, health education, nutrition
● changes in state provision of healthcare benefits, or to its funding, particularly
affecting PMI experience
● changes in selective withdrawals – if your group of policyholders experiences a
different level of withdrawals by policyholders of below-average health from
that experienced by the group of lives underlying your investigation
● changes in underwriting practice
● changes in claim control practice
● changes in policy wording
● changes to the economy – eg worse IP and PMI claim experience tends to occur
during economic downturns.

Solution 10.6
(i) Income protection insurance
Data required:
● Dates of birth, entry, exit, diagnosis, first stopping work through sickness,
notification of sickness, start of sickness claim, end of sickness claim.
● Reasons for exit and/or end of sickness payments.
Method is to construct central exposures to risk, grouped by age, separately for healthy
and for claiming policyholders ( ExH , ExC ).
Count the numbers of transitions arising from the exposure, also grouped by age. Note
that, for a deferred period of d weeks, this means we will have to include all new claim
inceptions (ie dates of starting to pay claims) that occur up to d weeks following the end
of the investigation period. Similarly we must exclude all claim inceptions beginning in
the first d weeks of the investigation period.
Calculate transition rate estimates as:
Ix Rx
sˆ x +½ = rˆ x +½ =
E xH E xC
Dx Mx
mˆ x +½ = nˆx +½ =
E xH ExC
where I x , Rx , Dx and M x are the numbers of sickness inceptions, recoveries, deaths

from healthy and deaths from claiming, and sˆ , rˆ , mˆ and nˆ are the estimates of the
corresponding transition intensities.

(ii) Critical illness insurance
Data required:
● Dates of birth, entry, exit, diagnosis or treatment, notification of sickness, claim
payment.
● Reason for exit, type of disease or procedure involved.
Method is to construct central exposures to risk, grouped by age, for healthy

policyholders ( ExH ).
Count the number of claims due to each particular disease or procedure arising from the
exposure, also grouped by age, I xj (relating to the j’th disease/procedure type) . This
means that all policies showing dates of diagnosis occurring in the investigation period,
and which ultimately lead to a claim payment, should be included. This should be the
case even if the date of claim payment occurs after the investigation period.
The I xj figure should include an allowance for any incurred but not yet settled (IBNS)
claims. IBNS includes those claims occurring during the investigation period that, at the
time of performing our investigation, have been reported to the company but have not
yet been paid out (these are sometimes called reported but not yet settled – RBNS). It
also includes future claims arising from diseases commencing during the investigation
period but which have not yet been reported (called incurred but not reported – IBNR).
The I xj figure should exclude all claim payments made during the investigation period
that relate to diseases diagnosed (or procedures carried out) prior to the start of the
period.
The claim inception transition rate for disease/procedure j is then estimated from:
I xj
mˆ xj+½ =
ExH
Initial (q-type) rates of transition could then be calculated, if required, using (for
example):
iˆxj = 1 - exp È - mˆ xj+½ ˘

Î ˚

(iii) Long-term care insurance
Essentially we need the same kind of data as for IP policies, except we will need
exposures to risk separately for each of the different claim states. This will additionally
require dates of transition from one benefit level to another, but no return transitions
will normally occur. The transitions are summarised in the following diagram:
Benefit level
Able 1 2 n
Dead
For example, we will estimate the transition intensity from benefit level 1 to benefit
level 2 using:
D1:2
mˆ 1:2
x +½ =
x
E1x
where D1:2 1
x is the number of transitions between benefit levels 1 and 2, and E x is the
central exposed to risk (observed waiting time) for benefit level 1.

(iv) Private medical insurance
A logical approach would be the following.
Assuming all policies are annually renewable, we need to:

● count all policies that are taken out or renewed during each year of the
investigation, subdivided by age ( N x )
● count the number of claim inceptions arising from each year’s cohort of policies,
subdivided by age and class of benefit or procedure involved ( I xk , where k is the
benefit class)
● record the total amount of all claims paid from each cohort ( C xk ).
The estimate of the claim inception rate for benefits of category k is:
Ik
iˆxk = x
Nx
and the estimate of the average cost of each claim under benefit category k is:
C xk
cˆxk =
I xk
Both claim inception and claim amount data are necessary for PMI products, as claim
amounts are also uncertain – they are only determined at the date of claim.
Alternatively (and this is most often what is done in practice), we could:

● calculate the number of policy years of exposure during a chosen investigation
period (this would normally be split into individual calendar years – called
accident years); this will be our N x
● count the number of claim inceptions arising from this exposure, subdivided by
age and class of benefit, as before, producing I xk
● record the total amount of claims paid for this accident year ( C xk ).
The estimates would then be calculated as before. It is important that all IBNS
(including IBNR) claims that relate to the same accident year of exposure are included
in I xk and C xk ; it is also important that claims paid which relate to previous accident
years are excluded – as described for CI in part (ii).

Comment
In this question you needed to apply general principles (learnt in earlier actuarial
subjects) in the context of the specific healthcare products, in order to come up with a
specific solution for each case. If you were off the mark with your first attempt at this
question, look closely at the solution. While you probably won’t need this kind of detail
in the ST1 exam, if you are able to answer this type of question then it indicates that you
have a good grasp of the way the main healthcare products work – and this is important.
In particular you should note the way that CI data are separately analysed by claim type,
and PMI data by benefit category. The resulting rates, once adjusted for time and other
factors, will ultimately be combined for the purpose for which the assumptions are
required (eg pricing).
Solution 10.7
Morbidity amongst healthcare insurance policyholders varies significantly according to

occupation. A person’s socio-economic group is usually defined by his or her
occupation. So, by knowing the kinds of occupation that are followed by the majority
of a company’s policyholders, the company can investigate the experience of
approximately the right type of people (by focusing on the population experience of the
socio-economic group(s) involved).
Morbidity also varies significantly by geographical region, so that provided the regional
distribution of the company’s target market is known, we can use the data to help us
obtain more relevant estimates of morbidity rates.
Solution 10.8
The underlying difficulty is that we are not dealing with insured lives. There are
therefore two aspects to the problem:
● a different class of lives will be involved (even once you have chosen the most
suitable socio-economic groups to use, etc)
● the degree of sickness that triggers a claim under an insurance policy will be
different from the definition of sickness used in the population statistics.

Solution 10.9
In favour:
● Involves less work for the direct writer, so there will be some cost savings.
Against:
● The reinsurer could go insolvent, so the insurer will be left with 100% of the
risk.
● Even 10% of the risk could be onerous if large volumes of business are written.
● The reinsurer could reap too much profit from the treaty if the price is too high.
● The insurer is concerned about its own standing in the market place. Misplaced
pricing of this product (which may result if the reinsurer takes sole pricing
responsibility) could damage the insurer’s reputation. New business volumes,
both of this product and other products provided by the company, could then
suffer drastically.
Solution 10.10
“Long-term” health insurance products are IP, CI and LTCI.
As the Core Reading says, the industry experience is a “market average”: more
precisely, it is the average claim experience amongst all the policyholders covered by
those companies that contribute to the pooled data. One of the key problems, which is
especially acute for morbidity data as opposed to mortality, is the much greater
heterogeneity that exists between the experiences of different companies, even where
they may be described as relating to the same product type. Reasons for this
heterogeneity are essentially those listed in the Core Reading at the start of Section 3.1:
● approach to underwriting and acceptance
● policy conditions (eg different diseases allowed as a CI claim by different
companies)
● claims management (eg different degree of effort made to rehabilitate IP
claimants to get them back to work)
● distribution method and channels (leading to different types of lives insured).
To this list we might add:

● territory and other aspects of target market (different type of lives insured)
● data are likely to be more out of date (than own data).

It is the second and third bullet points of the list (policy conditions and claims
management) that make heterogeneity so much more of a problem for morbidity data
than for mortality data.
Solution 10.11
For PMI, we should at least be able to work out the average number of policies in force
during the year, and the total claim amounts paid out. Taking the ratio of these will give
a crude estimate of the expected cost of claims per policy in force during the year.
The main drawback is likely to be absence of any detailed information regarding the
breakdown of policyholders by age, sex, smoker status, and so on. Some returns do
sometimes provide this (at least in some years), in which case the data would be more
useful.
In addition, the claim experience of a different company will be intrinsically different

from your own, due to different target markets, underwriting, claim definitions, etc.
This will make even reliable data of limited use to your company’s future experience.
Solution 10.12
Possible reasons are:

● different subsets of lives (relative to the population) take out insurance policies
in the two countries …
● … which may be a consequence of different selling methods
● different policy conditions will make claim rates different, even if the class of
lives is equivalent
● underwriting standards (at inception or at claim stage) may be different
● the data may not relate to the same time periods
● the overseas population morbidity data may be compiled differently from home
population statistics, using different disease criteria or groupings, making
comparison inappropriate
● the overseas industry data are likely to be very heterogeneous, so it is unlikely
that any single company’s experience will reflect the industry average.

Solution 10.13
(i) Risk cells
A risk cell represents a collection of risks (lives) who all share the same attributes with
regard to the particular factors that are deemed to influence morbidity. So males aged
45, who smoke, work in professional occupations and who live in the Strathclyde area
of Scotland could be a single risk cell.
Analysing the data by the different factors that affect risk, enables the company to offer
different terms (eg different premium rates) to people with different risk classifications.
Major reasons for doing this are to reduce the risk of anti-selection from high-risk
groups, and to increase the attractiveness of the product to the lower-risk groups. The
subdivisions are necessary so that the individual effects of each factor can be accurately
assessed, and appropriate prices determined.
(ii) Combining risk cells
The big problem with analysing the experience of individual risk cells separately is that
the volume of data in each is so small that no credibility can be given to the results, and
so no useful information (about the effects of each factor) can be obtained.
Not all risk factors are equal in their relative effects on morbidity, so by combining risk
groups whose morbidity is relatively similar, we can obtain significantly larger but still
relatively homogeneous risk groups. Trial and error combinations of risk cells followed
by comparison of the experience rates between them can help determine the most
appropriate combinations to use ultimately for pricing purposes. We would then expect
to end up with different sets of premium rates or charges for different risk groups,
eg according to age, sex, smoker status, and so on.
Solution 10.14
(i) Age, sex, smoker status, occupation, class of product (eg PMI, dental plan),
benefit level (eg level of excess), individual or group, distribution source, region.
(ii) Age, occupation (sometimes), class of product, benefit level, individual or

group, distribution source, region (sometimes).

Solution 10.15
It is very likely that claims incidence (or the pattern of disease diagnosis) could change
differently over time for different causes of claim. For example, new screening
techniques could accelerate times of diagnosis for certain diseases, increasing claim
incidence rates for those causes but not for others.
There are many other factors – developments in medical science, specific changes to
underwriting practice, changes in policy wordings, etc – which can be specific to
different disease types so producing different effects on incidence rates for each disease.
This is one of the main reasons why the rates are analysed and projected separately for
each claim type (at least the main ones), rather than projecting the overall combined
critical illness claim inception rate in one go.
Solution 10.16
Inflation of hospital treatment costs.
Solution 10.17
Age, sex, smoker status, occupation, size of benefit, class of policy (particularly the
length of the deferred period), whether individual or group, length of time since start of
claim (or since start of sickness), distribution source, territory, and cause of claim.

Solution 10.18
(i) Deferred period
The majority of sickness durations (ie the times between onset of sickness and ultimate
recovery or death) are very short, usually under 6 months in length. Of the remaining
cases (ie those that are greater than 6 months in length), the great majority will
experience durations well in excess of 6 months.
So, for short deferred periods (ie of less than 6 months) the recovery rates tend to be
very high in the period immediately after the start of claim. For longer deferred periods,
these initial recovery rates tend to be very much lower.
Additionally, the length of the deferred period can affect the type of individual taking
out a policy, affecting recovery rates further.
Note that the underlying variable affecting recovery rates is the time since the onset of
sickness. So, provided all other factors (like the type of lives insured) were the same,
the deferred period would not affect the rate of recovery as at a particular duration
since the start of the disease.
(ii) Duration since start of claim
Recovery rates will decrease with increasing duration since the start of claim, reflecting
the reducing proportion of the less serious cases remaining. This effect will be more
pronounced the shorter the deferred period is (as explained above).
Solution 10.19
Cause of claim – ie the type of sickness or disability involved.
With some diseases (eg terminal cancers), medical advances may prolong life but not
necessarily make the person well enough to return to work – so this will worsen the
claim experience. (In effect the recovery rates will not alter whilst the mortality rates
will reduce.)
For some other causes – such as serious physical disability due to injury – medical
advances could both reduce the time taken for the patient to go back to some sort of
work, and make any return to work the more likely. In this case mortality rates are
unchanged, while recovery rates have improved, so improving claim experience.

Solution 10.20
It is necessary to keep a financial incentive for the claimant to return to work. These
conditions take effect at the date of claim and would be set to limit the benefit to some
proportion (less than 1) of total income prior to the claim starting. The need is to ensure
that total income while claiming is below that which would be earned if the
policyholder stopped claiming.
Solution 10.21
There are two main influences at work:

● the difference between the total claim cost between those that do or do not die
after starting benefits may be very significant, whereas someone who dies in the
non-claiming state may never have claimed anyway
● the mortality rates of claiming (ie sick) policyholders are much higher than for
non-claiming (ie healthy) policyholders, so the absolute impact of, say, a 10%
reduction in mortality will be much greater.
Solution 10.22
The total value of the profit from the policy as at the date of surrender would be equal to
the asset share minus the surrender value.
If the surrender value exceeds the asset share, then the policy makes a loss equal to the
surrender value minus the asset share.
Solution 10.23
The difference between the supervisory reserve and the surrender value is the amount of
supervisory profit (or loss) that is made on surrender.
Supervisory profit or loss is to do with capital flow: a profit means that the company’s
supervisory capital – the excess of its assets over its supervisory reserves – has
increased, and a loss means that it has decreased. A supervisory profit is (in theory)
distributable to shareholders; a supervisory loss means that shareholders need to
provide capital.

Solution 10.24
An assumption is important if, by changing it, a big difference is made to the final
outcome (which in this case, means the price or the premium payable for the contract).
Because lapses cause profit or loss, a different lapse rate assumption leads to different
profits. This may be:
● directly, where each lapse causes a profit or loss depending on the asset share at
the time of lapse
● indirectly, in that a high level of lapsing increases the propensity of “selective
lapsing” which will affect overall claims experience.
If we then set our price so that a certain level of profit is produced (as we normally do
with cashflow pricing – see Chapter 14), then a different lapse rate assumption will lead
to a different price (or premium) being produced. (This is the same as saying that the
price would be sensitive to the lapse rate assumption.) So the lapse rate is an important
assumption.
In general, any parameter that affects the profit of the product in a big way will be an
important parameter in pricing, because of its effect on the resulting price.
You may recall from earlier subjects, that cashflow pricing methodology involves
projecting supervisory profit. So it is the effect of lapses on the supervisory profit each
year that will be instrumental in determining sensitivity.
Solution 10.25
The reasons why market data are less useful in predicting lapse rate experience include:
● lapse rates are generally much more unpredictable than other demographic
experience rates, because they are dependent on human choice
● there is much more heterogeneity in lapse rate experience between companies,
reflecting differences in distribution channel, target market, product design,
benefits provided, etc, so the data will be less relevant
● past data and future experience are both influenced by changes to the economic
environment, the level of market competition and the standards of customer
service. These are all very difficult to allow for and to predict.

Solution 10.26
Possible subdivisions include:

● policy type (eg stand alone, claim acceleration)
● different series (eg issued in different past years with different policy wordings)
● sales channel
● sales agent
● policy duration
● premium size
● benefit size
● premium payment frequency (annual/monthly)
● premium payment method (cheque/direct debit)
● age
● sex
● smoker status.
Solution 10.27
Lapse and re-entry is where policyholders find they would be better off lapsing their
current policies and taking out new ones. (This is only really an issue for long-term
policies such as IP, CI and LTCI, because the “lapse and re-entry” of a short-term
policy would essentially be the same as an ordinary policy renewal, but with more
underwriting involved – so no-one would bother.)
This is going to be a problem when premium rates are falling, so that even though a
lapsing policyholder is older than when his or her premiums were originally calculated,
the premium rate for a new policy at the current age is still cheaper.
The problem with this is that only healthy lives can benefit from lapse and re-entry, as
unhealthy lives will not be able to take out new policies, or at least not at the standard
rates of premium. So the company will have the same total set of lives in force as it
would have had without lapse and re-entry, but for a healthy sub-group a lower
premium is being paid than before. In addition, the company is having to incur another
round of set-up expenses and commissions, including underwriting costs, for these
lives. This will make the overall profitability from the portfolio lower than if lapse and
re-entry had not occurred, and could quite easily now be loss making.

Solution 10.28
The factors that might make future IP lapse rates change in future include changes in:
● economic conditions, especially those affecting employment
● availability of, or the level of, long-term state sickness benefits
● distribution channel
● sales methods
● target market
● territory
● product design
● policy wording
● benefits provided
● underwriting practice
● claims-handling practice
● price
● competitiveness
● standards of customer service.
Solution 10.29
There is no population equivalent of lapsing a policy (whereas members of a population

can die or become sick). So no data exist.

Solution 10.30
The two things to consider in a scenario of economic deterioration are:

● whether people can still afford to keep the policy going, and
● whether they would get any cash from surrendering the policy.
(i) Critical illness
The premiums are fairly low so there should be very few policyholders who now find
themselves unable to continue paying premiums.
There is almost certainly no surrender value available, so there is no incentive to

surrender.
So you would not expect the economic downturn to affect lapse rates materially for this
contract.
(ii) Long-term care insurance
The premiums are probably a non-trivial portion of policyholders’ incomes. Some

policyholders will now be unable to pay these premiums.
Some LTCI policies offer some compensation on discontinuance after the first few
years, though usually as paid-up policy benefits.
So you would expect an increase in discontinuance rates.
(iii) Private medical insurance
PMI contracts technically terminate at the end of each policy year, so no surrender value
is payable – indeed the notion of a “surrender” for a PMI contract has no meaning.
Policyholders simply have to decide whether or not to renew their policies each year.
PMI premiums can be quite expensive, so some policyholders will no longer be able to
afford them.
So it is very likely that lapse rates – ie non-renewal rates – will increase.

Solution 10.31
Each of the following can be associated with a change in distribution channel:

● A change in who initiates the sale can affect withdrawal rates (withdrawal rates
are likely to be lower if the client initiates the sale).
● The sales practice may be different: for example, where clients have been put
under more sales pressure to buy a policy, or to take a larger policy, then
withdrawal rates are likely to be higher than where sales have been more strictly
based on need. This might particularly be the case where the intermediary’s
rewards are largely based on initial commissions, rather than renewal or level
commissions (see Chapter 8).
● Sales of policies made without proper information being gathered about the
client’s needs, can lead to inappropriate policies being sold through ignorance
(though this is again a reflection of poor sales practice).
● Different levels of financial sophistication of the client base can lead to different
perceptions of the value of a contract, and could lead to different lapse rates.
Different target markets may encompass different levels of affluence and economic
prosperity. There may then be differences in withdrawals that arise through economic
hardship.
Solution 10.32
It is referring to the extent of the margins required, in the basis, in order to protect the
company should its claim experience turn out to be worse than expected according to its
best estimates.
This is essentially a function of what is colloquially known as the expanding funnel of

doubt – the further into the future we project our rates, the more uncertain we are about
their reliability, so the more margins we need to cover ourselves against future losses.
A policy that has a shorter term, or has more frequent review dates, will require smaller
margins in the assumptions simply because we do not need to project them for so long
into the future. In the long run this enables premiums (or charges) to be cheaper, and
products to be more competitive on price. It also enables reserves to be smaller.
With so much uncertainty inherent in trying to project morbidity rates over the long
term, the margins required to cover fully the risks under long-term guaranteed products
would make them prohibitively expensive.

We might argue that we could still issue long-term guaranteed healthcare products
provided the company’s shareholders (or other providers of capital) were prepared to
take on the risk. The problem here is that the company would still need to set up very
large supervisory reserves for these policies, as soon as they had been sold, based on
totally prudent assumptions of future experience (ie including full margins for adverse
experience).
The Core Reading is making the point that the cost of this capital would feed through to
higher product prices, which would still make them prohibitively expensive. And if the
cost of capital were not allowed for in the price, then the return on capital would be
inadequate and the product not worth selling from the shareholders’ point of view.
Don’t worry if you didn’t come up with this level of detail the first time you answered
this question. The ideas involved are covered more fully in later chapters. This will be
a good question to revisit when you come to revising the course.




using the course.

Chapter 11
Assumptions (2)
Syllabus objectives
– morbidity
– mortality
– lapses
– claim amount
– expenses
– taxes
0 Introduction
In this chapter we cover all the financial assumptions that may be required for any
particular application, namely:
● benefit amount
● benefit inflation
● expenses
● expense inflation
● commission
● clawback (of commission)
● investment income
● taxes.

This chapter also covers volumes and mix of business assumptions.
As in the previous chapter, the material describes assumption setting primarily in the
context of pricing. Whilst we cover setting assumptions for other purposes (reserving,
calculating embedded values, etc) in Chapter 12, you should remember that much of
what is said in the pricing context is equally valid in other contexts.
If you have not read Chapter 10 recently, we suggest you read again the introduction to
that chapter before reading on, just to remind you of what this subject is all about.
Remember, as you consider each of the separate assumptions, one of the guiding
principle in constructing any basis is consistency between the assumptions. We revisit
this point in Chapter 12.

1 Benefit amount
1.1 Long-term contracts (IP, CI, LTCI)
With these kinds of product, the benefit level is fixed in the policy terms and so no
assumption has to be made about its amount. Even so, an assumption has to be made
about the average size of the benefit that will apply when performing the relevant
modelling (be it pricing or some other purpose) – we look at this in Section 10.1 below.
Only with the very large policy sizes would the insurer seek to alter the
assumptions (possibly more expense in establishing the contract but more
evidence in ascertaining the health of the proposer). However, the underlying
experience does vary significantly depending on benefit size. The larger policies
tend to have better claim experience because:
(a) the policy holder will tend to be from higher socio-economic groups, and
(b) there is a stricter level of underwriting imposed for larger sums insured.
The Core Reading is discussing here whether to determine a different price per unit of
benefit for policies of different sizes. If the answer is yes, then for particularly large
policies different expense and claim experience assumptions would be made in the
pricing model (say) and a different price structure per unit of benefit would result.
Size of benefit is here acting as a risk factor, and we are deciding whether and by how
much premium rates should reflect the impact of this factor.
1.2 Short-term contracts (PMI)
For PMI, the policy promises largely to indemnify certain medical expenses of
the claimant. Hence, the actuary has to forecast not only the number of claims,
but also the amount of each claim in order to assess the premium payable.
We have already discussed this in the previous chapter. Here we are trying to determine
an expected value for the size of benefit resulting from claims occurring during the next
policy year. The best starting point will be an analysis of the company’s recent
experience, where this exists.
The trend in PMI benefit amounts is a function, not just of medical inflation, but
of any likely change in medical treatment protocols, of the future charging
structure of hospitals and consultants and the future age-profile of the portfolio.

A medical treatment protocol is basically the set of procedures adopted for particular
medical treatments. A change may involve the use of new treatments, or require more
or less specialist medical staff to be used (consultants, anaesthetists, radiologists, etc),
any of which may change the costs of treating a given acute condition.
A change in a hospital’s charging structure could involve, say, charging for use of an
operating theatre according to the time taken to perform the operation, whereas hitherto
it might have been a single lump sum charge for the type of operation, regardless of
how long the particular operation took.
Premium rates will normally vary by age, so it may be necessary to accommodate age-
specific claim amount assumptions in our pricing model.
The actuary might take the average claim size from an equivalent existing player
and adjust this for differences in policy conditions, differences in negotiated
hospital contracts and for future trends in provider capacity and charges.
An “existing player” just means another insurer who has past experience in this line of
business: so we could be looking at other insurers – or market data in general – to help
us assess the likely level of future claim costs.
PMI insurers often make “deals” with individual hospitals, or hospital groups, to
perform specific treatments for standard agreed costs, in return for requiring the
insurers’ PMI policyholders to use only those hospitals for their treatment.
Question 11.1
So in what way(s) do we need to allow for any hospital deals in setting the claim
amount assumption, and why?
Question 11.2
What does a change in “provider capacity” mean, and how will this affect future claim
costs?

2 Benefit inflation
For most long-term healthcare products, the size of the benefit chosen at outset
has some rationale in terms of medical need or practical income where salary is
no longer available. Under all these guises, the sum insured needs to be inflated
periodically, if the policy is to be kept in line with its original purposes.
Increasing the benefit and premium annually in line with some index or fixed
percentage is not wholly appropriate since the risk increases with age and thus
some form of initial funding must be performed. This again involves modelling.
The point being made here is that long-term insurance contracts that have inflating
premiums and benefits require the same kind of modelling treatment as do level
premium contracts.
The reason becomes clear when you consider the per-unit premium rate that is being
charged for the benefit each year: this rate stays constant throughout the term of the
policy (premium reviews excepting), as both premium and benefits will be inflating in
the same proportion. The additional annual increases in the expected cost of claims
each year, reflecting the increasing age of the policyholder, has to be allowed for by
charging too much premium in early policy years to make up the shortfall from higher
claim costs during later years – as with all conventional long-term contracts.
This is what the Core Reading is meaning by “initial funding”. The modelling required
is simply the usual cashflow projection model used for pricing all long-term insurance
contracts – more on this in Chapter 14.
The process is further complicated by the absence of a simple index to describe

medical costs. A consumer price index is often used as an alternative. Many
companies avoid the problem of unknown future indexed benefit increases by
escalating premiums and payouts at a fixed annual percentage (often reduced to
the rate of increase of consumer inflation, if this be less). The cost of these
increases will be fully modelled as indicated above.
Inflation of medical costs is not the only, or even necessarily the most relevant,
consideration in determining how benefit levels should increase.

Question 11.3
Giving brief reasons, suggest the most likely sort of index for determining benefit
increases under each of the following contracts:
(i) Income protection policies.
(ii) Critical illness policies.
(iii) Long-term care insurance policies.
Question 11.4
Suggest two possible problems that might result from using fixed annual percentage
increases to benefits and premiums.
Even though benefits and premiums may be increased at the same rate or in line with
the same index, an assumption will need to be made for this increase, as this will affect
the final result. So, whichever method is chosen for determining benefit increases,
these should be explicitly included in the model being used. Fixed percentage rates of
increase require no assumption, but those linked to an external index need an
appropriate inflation rate assumption to be made. A similar approach to that used for
inflating expenses – see Section 4 below – would be followed.

3 Expenses
When thinking about expenses we can make a distinction between direct expenses and
indirect expenses (or overheads). The direct expenses are those that relate specifically
to a class (or classes) of business, whereas overheads cannot be allocated directly to a
class (or classes) of business.
Furthermore, direct expenses can be either fixed or variable. Variable expenses are
those that depend in some way on the level of business – for example, they might vary
by the number of policies sold or by the amount of claims paid.
The parameter values for expenses should reflect the expenses expected to be
incurred in processing and subsequently administering the business to be
written under the product being priced.
The expense assumptions should reflect the incidence of the direct expenses from each
of the following activities (or functions):
● initial acquisition (eg initial commission and other marketing and sales costs)
● initial medical underwriting
● initial administration
● renewal administration
● renewal reward to sales channel (ie renewal commission, or similar)
● investment
● withdrawal expenses
● claim administration
● termination.
Question 11.5
Which one of the main healthcare insurance products (CI, IP, LTCI and PMI) will have
larger renewal costs than all the others, and why?
Question 11.6
State with reasons which one(s) of the above types of expenses would not be important
for PMI contracts.

In addition, the expense assumptions should produce premiums (or charges) that will
make an appropriate contribution to the company’s overheads.
Note that the distinction between direct expense and overhead is subjective – for
instance, the property costs of the “new business administration” department could be
considered as part of the direct initial administration expenses for CI business, or as part
of the insurer’s overall expenses.
The values (for the expense assumptions) will be determined after analysing the
company’s recent experience for the type of product concerned. The result of
this analysis will be a division of the expenses by function, as appropriate, and
possibly by whether the level of expense is expected to be proportional to the
level of premium or benefit, or can be expressed as an amount per contract.
The latter division will be for variable expenses. In addition, it will also be useful to
also identify the level of fixed expenses associated with the product, and a suitable
contribution to overheads.
More detail on the different types of expense is given in Chapter 28, where the
mechanics of an expense analysis is covered.
Question 11.7
Describe how you think the above nine types of expense and the contribution to
overheads should be allowed for in a pricing model of any of the long-term health care
insurance products. (For example, commission would be allowed for as the appropriate
percentage of the premium paid.)
Question 11.8
For PMI, the policies in force in any one year are a mixture of policies renewed from
the previous year, and policies issued to individuals for the first time. However, the
same premium is usually charged in either case.
Suggest and explain how you would allow for the relevant expenses when pricing the
product.
If the company has insufficient recent experience to provide meaningful results,

or suitable recent experience is not available, the parameter values may be
based on a similar line, or on any industry data or data from a reinsurance
company.

3.1 Dealing with per-policy expenses
Per-policy expenses are expenses that do not vary by policy size, for example the
administration expenses in the solution to Question 11.7 above.
For nearly all long-term healthcare products, premiums are expressed as a rate
per unit of sum insured.
For example, the premium rate for an IP policy may be expressed as £3 per £100 pa
benefit. To allow properly for the per-policy expenses, we therefore calculate a
premium for a policy of average benefit size, and then use the same rate of premium
(per unit of benefit) for policies of any size. Provided the assumption for the average
policy size is borne out in practice, then the company should receive the per-policy
expense loadings that it assumed in its pricing basis. (Note that the average benefit size
is part of the pricing basis for a particular product: see Section 10.1 below.)
This means that, whilst we might have thought of the expense loading as being per
policy, it will vary in practice in proportion to the size of the policy actually taken out.
Question 11.9
Explain why this might be a problem, even if the average policy size assumption turns
out to be realistic.
Question 11.10
Why isn’t this a problem for PMI?
We now discuss possible ways of correcting for this problem, where it occurs.
An area of risk with expenses relates to how to incorporate into the charging
structure the expenses which do not vary by size of contract. The following are
examples of ways to handle this problem:
Individual calculation of premium rates or charges
With this method, the actuary simply calculates the premium or charges for the contract
using the actual benefit level, age, term, etc for the policy in question, loading explicitly
for the per-policy expenses. This would probably only be done for the large cases: very
small policies priced on this basis would end up paying a very large percentage of their
premium as expense loading – the premium rate would then seem unreasonably large.

Policy fee addition to the premium – or deduction from income

benefits
This approach may need to be modified if the resultant policy fee or charges
would make premiums uncompetitive.
This is the same problem as we mentioned for smaller policies using the first method.
The idea is that the policy fee would represent the per-policy expense costs, and the
premium rate would only cover the other, proportionate, expenses. However, the policy
fee may need to be reduced from its theoretical level in order to make the total
premiums for small policies more competitive (and, perhaps more importantly, more
reasonable). But to avoid not covering expenses, the reduction will need to be
compensated for elsewhere.
So the actuary will reduce the policy fee to the level required on grounds of
reasonableness and/or competitiveness, given where the company wants to be in the
market. The contribution to expenses determined as a percentage of premium will then
need to be increased. A model portfolio would be used to ensure that the total expense
contribution received by the company, for the assumed volume and mix of business,
would be the same as what it would have been using the theoretically correct premium
rates and policy fee.
However, any such modification would lead to increased risk for the company.
Question 11.11
What is the risk here?
Sum insured differential
Different premium rates are charged according to the band into which the
requested benefit falls. This would complicate premium rate cards but would be
easily applicable by a computer system. It would require an estimation of the
number of policies likely to arise in each band.
By “premium rate cards” we are really referring to any manual system of premium
calculation. With increasing computerisation of the sales process these are decreasing
in importance anyway.

Provided the premium rates charged for each band are the theoretically correct ones for
the average benefit level for each band, then we really only need to know the expected
numbers of policies in each band for practical purposes. For example, fixing a band
level to be higher than any benefit size reasonably found in practice would be a waste of
time.
Of the above three ways of dealing with expenses that are invariant by size of contract,
the most common approach is the second method (policy fee addition). However, the
approaches are not mutually exclusive: when the third approach is used it is also often
combined with some form of flat policy fee.
3.2 Dealing with fixed expenses
Expense loadings need to allow for the likely volumes of business sold, and this
is a particular area of uncertainty for a competitive product line.
Fixed expenses, such as the costs of developing a new product, also need to be
recouped. The amount of loading for these purposes should be such that, given the
anticipated volume of sales of the product over its expected lifetime, the total loadings
received will at least recoup the direct expenses of the product (both fixed and variable)
and pay a fair share towards the company’s overheads. Provided the new business
assumptions do not turn out to have been too optimistic, the product should make an
additional contribution to profit. The new business assumption must itself reflect the
expected competitive position of the product in the market over the period.
Question 11.12
Suggest how there can be a circularity problem in the above.
3.3 Comparison with life insurance
Generally, more work is required to put a healthcare product on the books than
for a life-only product. The main reason for this is the extra underwriting effort
required – non-medical limits are often lower, more information may be required
and more time is taken to assess the morbidity. Product development costs
might also be higher as more effort is needed to derive incidence rates, develop
policy literature and train sales staff. Hence initial expenses are higher.
Question 11.13
What are non-medical limits?

Further, unlike life assurance where the consumer often sees a need for the
product, healthcare products normally have to be sold, which can involve
considerable time in explaining the key features of the product and why it is
beneficial for the client to buy the policy.
One of the reasons why life insurance is more “popular” is because it often needs to be
purchased as a condition of taking out a loan to buy a house.
Claims expenses are also more onerous than for a life product. More time and
medical information will be required to determine the validity of a claim,
ie whether it meets the definition under the policy.
More time and expense will also be involved in the maintenance of a claim – for all
policies where an income is payable (IP, LTCI).
Question 11.14
State the main items of expense for claims in payment.
3.4 Marginal costing
Expense loadings are often used as the optional margin to secure

competitiveness; this can only be done with careful monitoring and on a very
short-term basis. Failure to cover expenses is as important a contributor to
insolvency as a failure to cover claims.
The marginal expenses of a policy can be considered to be those expenses that are
incurred only because the policy exists. In other words, they are the variable expenses.
In the very price-sensitive distribution channel of brokers, companies have sometimes

set charges or premiums for certain products with expense loadings that are only
slightly greater than those required to cover the marginal expenses, thereby making an
apparently insufficient contribution to fixed expenses. This is then justified on the
grounds that there is still some contribution to fixed expenses, as opposed to the zero
contribution which would result from trying (and failing) to sell an uncompetitive
product with a “correct” contribution built in.

What really matters to the company is the total contribution to fixed expenses (and
profit) that results from selling the product as a whole, not per single policy. This total
contribution can be represented broadly by:
[ total contribution ] = [per-policy contribution ] ¥ [number of policies sold]

where the per-policy contribution is the profit from a single policy net of marginal costs
(but ignoring fixed costs). The company’s total profit can then be thought of as:
Ï ¸
[Total profit ] = ÔÌ Â [ total contribution ]Ô˝ - [overheads]
ÓÔall products ˛Ô
so we need to find the level of expense loading that will maximise the “total
contribution” from a given product. In a very competitive market this might be
achieved only by having very low per-policy margins thereby ensuring sales. With less
competition, higher per-policy margins will be possible without jeopardising volume.

4 Expense inflation
Any product which offers a level premium in return for an increasing risk, must
incorporate an element of expense inflation, even if the premiums are annually
reviewable.
This means that, when setting the premium rate that will apply over the period of cover,
assumptions about the inflation increases throughout the policy term will need to be
made. (This is similar to the discussion we had in Section 2 about benefit inflation.)
This comment also applies where premiums are increasing, eg at a fixed rate or in line
with an index. In the latter case, the expense inflation assumption should be consistent
with that assumed for the index.
Question 11.15
Why should an allowance be made for expense inflation when calculating premiums for
contracts where premiums are annually reviewable?
Notice the difference here between a policy being reviewed and being renewed. If a
policy is renewable annually (like PMI), then the period of cover is only one year, after
which premiums can be increased to reflect increases in expenses, etc. In practice, for
short-term policies, an implicit allowance for expense inflation would be made by
simply increasing per-policy expenses to the level that would apply at the average time
those expenses are expected to be incurred.
An inflation assumption will be necessary to apply to loadings in respect of renewal

administration, claim administration and policy termination expenses.
Rates of inflation will be partly related to prices and partly related to salary costs.
We would expect them to be mostly related to salary costs because the majority of an
insurance company’s costs are staff costs. In addition it should be noted that different
companies can be subject to different rates of expense inflation, even when operating in
the same country. This can be due, for example, to different levels of supply and
demand of the appropriate type of labour, in different local regions of the country.
The recent expense inflation experience of the company (or, if not available, of
the industry) should be analysed to ascertain the best yardstick for future
projection.

This is to determine the way in which the company’s expense inflation behaves. For
example, if past expense inflation has appeared to reflect 20% price inflation plus 80%
earnings inflation, then an appropriate future inflation assumption would be the average
of the expected future price and earnings inflation rates, weighted in the same
proportions. (This is provided there are no reasons for the weightings to be different in
future.)
Thus the following may be considered when setting the value of this parameter:
● current rates of inflation, both for prices and earnings
● expected future rates of inflation
● the differential between the return on government fixed interest securities
and on government index-linked securities, where such exist
● recent actual experience of office/industry.
The third approach is really just one way of arriving at the expected future inflation of
the second point. Also it is only approximate – it will be out by the extent of any
inflation risk premium implicit in the price of the government fixed interest bonds.
When pricing a contract, as we are here, we have to consider two distinct aspects of
expense inflation:
● the inflation of expenses during the term of a future new policy, from the issue
date to its termination date
● the inflation of all expenses between “now” (the date at which you are setting
premium rates to be used in future) and the dates at which the future new
policies are actually issued.
As an example of the second point, you might set your per-policy initial expense
assumption at £250, but for a policy issued in one year’s time it perhaps ought to be
£260, for one issued in two years’ time it should be £272, and so on.
So we need to make the overall future expense assumptions appropriate to the future
period over which we would expect the pricing basis to be used. In the case above, for
example, if we expected our basis to apply for the next four years, say, we might fix our
initial expense assumption at £275, for all policies to be issued over the four-year
period.

5 Commission
These assumptions will be determined by the amounts that the insurer intends to
pay the distribution system as commission. This may be influenced by current
levels of sales remuneration in the market place and/or by any legislatively
imposed rates of commission. The pricing actuary will need to include any
special arrangements that have been agreed between salesmen and insurance
company.
In cases where a single tariff of health insurance premiums is to be sold by

different distributors each receiving different commission structures, the pricing
actuary will need to make forecasts of the volumes of business to be sold under
each arrangement, so that the appropriate rates can be loaded into the premium
formula, on average, and thus that the overall commission loadings will support
the commission paid. These assumptions on volumes have to be monitored
against actual experience and adjustments made as appropriate.
So an important additional assumption is the mix of future new business by distribution

channel (or whatever method of subdivision identifies the different remuneration
packages properly). We look at this in Section 10.3.
Levels of remuneration may be higher than on standard life insurance. A higher

level of initial commission could be justified on a healthcare policy due to the
extra effort needed on the part of the salesman. This involves both explaining
the benefits to a prospective policyholder and collecting the extra information
required for the underwriting process.
Commission is often paid at a higher rate on the initial premium than on

subsequent premiums, to reflect the additional work involved in the process of
sale.
(As is also the case for life insurance.)
Commission can be expressed as a percentage of premium, or as a percentage

of the sum insured, or occasionally as a fixed sum.
We discussed commission structures in detail in Chapter 8.

6 Clawback
Where the salesman is paid a higher commission in year one than in subsequent
years, there is a probability that the insurer will lose out if the policyholder
lapses at an early duration and the product has a level annual commission
loading in the premium.
This will essentially be the case whenever a policyholder pays a regular premium and
the salesman gets a higher commission at the start of the policy than at any later time.
So this would also include policies of one-year terms payable by monthly premiums,
that have single commission payments made at the start of the contract.
Under these circumstances, the commission is not deemed “earned” for a

number of months into the policy term, although it is paid to the salesman. The
salesman is required to repay part of the initial commission if the policyholder
withdraws, other than through a claim, during this earning period (as described in
Chapter 8). The insurer thus takes a “credit risk” on the initial commission paid,
and the commission loading should not assume full clawback will be obtained in
all cases where it is theoretically due.
Question 11.16
Explain fully what is meant by this “credit risk”.
The actuary must make assumptions as to early lapse rates and estimate the
proportions of the unearned commission which will be reclaimed.
Question 11.17
Initial commission paid at the start of a policy has a two-year earnings period, such that
a clawback of 50% of the initial commission (without interest) is made on a lapse at the
end of year 1. Lapse can only occur at the end of each policy year.
Calculate the expected amount of clawback payable at the end of the first year,
assuming lapse rates of 10% and that 5% of clawback payments are not made. Express
your answer as a percentage of the initial commission paid per policy. Ignore mortality.
Past experience by distribution type will be the best guide to the relevant
numbers. The standard approach compares the numbers of early lapses against
the policies “exposed”, at each duration subject to clawback; the analysis would
be split by product type also – though credibility of numbers may be an issue
here. In-house parameters may be compared to any market figures available and
those proffered by reinsurers or consultants. Again this will be monitored and
amended in the light of emerging experience.

7 Investment income
The rate chosen will depend on the assets in which the reserves are invested,
which in the case of health products tends to be fixed interest assets / bonds.
This is true where contracts provide benefits that are fixed in monetary terms. Where
benefits are inflation linked, as they sometimes are, index-linked bonds would be
preferred – provided they have good security and are readily available.
Some equity-based investment is also a possibility here, in order to match real increases
in benefit (or expense) outgo.
LTCI, for example, would have a long expected investment period, and the need
to mirror increases in care costs (as far as possible) might prompt a more
equity-based approach.
In general, though, asset types other than fixed interest or index-linked bonds would
only be appropriate if benefits were neither fixed in monetary nor in real terms.
For example, some health insurance products operate in a unit-linked

environment and some assumption will be needed as to the returns available
when profit-testing these products; typically a managed-fund approach is used
and the investment income depends on the expected mix of equities and bonds
within the managed fund over the duration of the policy.
This will give the unit-fund growth rate assumption to use in the pricing model.
A separate assumption will also be needed for the investment return on the company’s
non-unit reserves for these contracts.
Any assumption for investment return should be consistent with the basis
chosen elsewhere for inflation.
Consistency is an important principle when setting assumptions. So here we mean that

the implied relationship between our investment and inflation assumptions should be
realistic. We will return to this in the next chapter.

Thus the value assigned to this parameter will be affected by:

● The significance of the assumption for the profitability of the contract,
which will depend on the level of reserves built up and the duration of the
policy.
The first step in considering what the investment assumption should be is to establish
how important the assumption is for the results of the modelling we are performing. If,
for example, there is very little sensitivity to the investment assumption, then the actual
value chosen for the parameter would not be critical.
This point is also important when it comes to considering the size of the margins
required for the investment assumption (see Chapter 12).
The two key factors which lead to sensitivity to the investment assumption are the size
of the reserves built up (relative to the cashflow, for example), and the investment
guarantees given:
● The larger the reserves, the greater the proportion of total cashflow (and profit)
that arises from investment income, and hence the greater will be the sensitivity
to changes in the investment return.
● The higher the investment guarantee the greater the care needed over setting the
level of the assumption.
Note that it is possible for the choice of investment assumption to be critical, and yet the
contract may be subject to very little investment risk (provided the correct investment
assumption has been made!). The following question includes an example of this.
Question 11.18
Comment on the importance of the investment return assumption for the

following contracts:
(1) regular premium without-profits critical illness insurance
(2) regular premium without-profits pre-funded long-term care insurance
(3) single premium without-profits pre-funded long-term care insurance (initially
healthy)
(4) regular premium unit-linked income protection insurance
(5) private medical insurance.

● The extent of any reinvestment risk and the extent to which this can be
reduced by a suitable choice of assets – the less important the
reinvestment risk the less account needs to be taken of future investment
yields.
Reinvestment risk refers to the uncertainty of the return that can be obtained from
investment in the future. The best estimate of the return available from future
investment may well differ from the best estimate of the return available from
investment now, and may also differ according to how far into the future the investment
is made. The overall best estimate investment assumption will reflect the expected
balance between the expected future and current investment yields.
If the actual cashflow is positive over a future period, then the company will need to
buy assets. The more that such future investment is expected to occur, the more the
investment assumption should reflect the expected future investment returns. Even if
the actual cashflow is predicted to be negative in the future, mismatching of assets and
liabilities by term may still mean that assets have to be sold and bought in the future, so
that the future reinvestment yields will still be important. However, the greater the
degree of matching, the less influence future investment rates should have on the
investment return assumption.
Of course, when you are pricing a new contract then all investment is to be made in the
future. Nevertheless you will have a much better idea of what investment returns are
likely to be at the point of sale of the contracts you are pricing (which will take place in
the near future) as compared to much later in the terms of those contracts. The expected
time between changes to the company’s pricing basis for a contract will therefore also
be important in establishing the best estimate investment assumption to use.
Question 11.19
Comment very briefly on the exposure to future investment conditions in the

following contracts:
(1) regular premium without-profits critical illness insurance
(2) regular premium without-profits pre-funded long-term care insurance
(3) single premium without-profits pre-funded long-term care insurance (initially
healthy)
(4) regular premium unit-linked income protection insurance
(5) private medical insurance.

● The intended investment mix for the contract, as affected by the above,
the current return on the investments within that mix and, where
appropriate, the likely future return.
This is, of course, a very important point: consider the likely mix of assets which will
back the contract in the future, investigate the returns that such assets are yielding now
(and in the past), and attempt to predict the returns that will be obtained from the future
asset mix bearing in mind the impact of future changes to the economic environment, in
particular.
The intended investment mix for the contract will not be derived from looking at the
contract in isolation, as it will be affected by the level of free assets available to the
company to support writing the business. This is because the extent of matching
necessary to control the investment risk will be less when there are more free assets,
hence affecting the mix of assets used.
● For PMI we would expect the investment return to have minimal impact.
This is because it is an annually renewable contract and so, when calculating premium
rates, we will only be considering claims for treatments that will be carried out in the
next year or so, until premiums are next reviewed. The investment period is therefore
relatively short.
● The investment return will grow in significance as the likely benefit date is
further into the future (eg funded long-term care insurance) or where
guarantees are given (eg on accelerated critical illness).
The more onerous the guarantee, the more cautious the insurance company should be in
its asset selection. This caution should then be reflected in the investment return
assumption (because the expected return will differ according to the assets selected – as
described under the previous bullet point).
As with the first Core Reading bullet point in this section, the extent of the guarantee is
also very important for determining the size of the margins that we would include in the
investment return assumption – see Chapter 12.

8 Taxes
The actuary will need to allow for the rates of tax applicable to the line of
healthcare business in the territory where the business is being written.
When considering what future tax rates to assume, the best you can really do is to use
current rates, allowing for any future changes which you know are going to happen.
The ways in which a state can levy taxes are numerous, but most will have
impact on the return which shareholders will get for supplying capital to finance
the business and hence must be considered in the premium basis.
The following three approaches are the most common.
Taxes on profits
The insurance company is taxed on the profit arising from the contracts being
written (and those already in force). In this case, none of the elements in the
basis need to be altered, but the return afforded by premiums over claims and
expenses may need to be adjusted to permit the appropriate net return.
So we just need to ensure that the expected present value of the future profits from each
policy, multiplied by [1 - tax rate] , meets the target level of profit required. (See
Chapter 14 for more details about pricing methodology.)
In many countries, the taxes on profits are liable to reflect the level of reserves
being allowed by the tax authorities.
Question 11.20

Taxes on investment income or expenses
Under this methodology, the insurer is taxed on the excess of investment

income over expenses incurred. With this regime, the actuary includes
investment income and expenses net of the relevant tax rate. The return to the
shareholders is thus the amended profit which emerges.
This is commonly known as an “I – E basis”. This will involve applying the appropriate
rates of tax to the different components of the investment return, for example to income
and to capital gains. Different rates of tax may also need to be applied to investment
income from different asset types (for example, from fixed interest securities or from
equities). If you wish (or need!) to allow for tax rates at this level of detail then clearly
the investment model used will need to identify these different components of the
investment return separately.
Where the investment model only consists of an assumed future overall interest rate,
then the approach would be to assume a tax rate on the return which is the estimated
overall effect that the various tax rates would actually have through the taxation of the
individual components separately. This will require making assumptions about the mix
of assets held, the relative contributions of income and gains to the overall return, and of
course the actual future tax rates involved. (This is also a good example of potential
model risk: the impact of taxation may, in reality, turn out to be worse than expected
because we failed to model the investment returns sufficiently realistically.)
This treatment must be consistent with that of expenses (by assuming that these are also
fully net of tax). Care must be taken to follow the effect of the tax rules carefully when
E exceeds I. Details of this are beyond the scope of this course, but are covered in
Subject SA1 (and SA2).
In some territories where this has operated, the state has noticed that heavy
initial expenses have relieved many long-term insurers of paying tax in the
foreseeable future; it has thus changed the rules to “allow” expenses to offset
the tax on investment income only on a staggered basis eg over the first three or
seven years. The incorporation of this into a pricing calculation requires
profit-testing techniques (which, remember, is the method we are basically using for
all policy types other than one-year renewables anyway).
The main thing is to make sure that the taxation structure is accurately included in our
modelling.

Taxes on premiums
In some territories, insurance premiums are taxed by the state. Financially, the
insurer remains neutral to this levy, although the insurer may collect it on behalf
of the state. However, any additional charge on the premium makes the total
cost of this line of healthcare insurance more expensive and hence reduces its
consumer attraction. The actuary will often then look to other product designs
which can produce contract formats which are not liable to premium taxation.
So no direct allowance for taxation is needed in the pricing model when this method
applies. You just need to make sure that the premium that the customer is quoted and
charged includes the premium tax.
However, some assumptions in the pricing basis may be influenced by the level of tax
on premiums applying. For example, an increase in premium tax may reduce sales
volumes and increase lapse/non-renewal rates. (This is another example of
consistency.)

9 Volumes
A further element in the actuary’s assumptions is the likely future volume of new
business to be written of each policy type. This will assist in the allocation of
expenses to the premium basis for each typical policy. It will also be important
in assessing the amount of company reserves which will be needed to support
the product launch.
The effect on the expense assumption has already been discussed (in Section 3.2).
The point about reserves is that the company needs to be sure that it has enough capital
available to meet the new business strain (to a great extent caused by the supervisory
reserving requirement). The total amount of capital required will be a function of the
volume of new business sold. (We return to this again when we discuss the modelling
aspects of pricing in Chapter 14.)

10 Mix of business
10.1 Average policy size
An estimation of policy size will be a factor in the allocation of expenses.
We have already discussed the implications of this for expected claims experience (in
Section 1.1) and expenses (in Section 3.1). We therefore need to make an assumption
for the expected average size of policy in the pricing model. This would be based on
the company’s past experience for the product (if any) and market data relating to
similar products, allowing for any trends that might be expected to continue.
Considerations of inflation and general levels of consumer demand for the product are
also relevant in trying to estimate this parameter.
10.2 Split by product
The actuary will need an estimate of the company’s future business production
for each product line so that indirect expenses may be charged accurately to
each contract for pricing purposes. Similarly, future product numbers and sizes
will enable the actuary to allocate the investment income from free reserves to
each business line and thus price more accurately.
10.3 Split by distribution channel
Where healthcare products are priced uniformly but sold through a number of
different distribution channels, the actuary will need projections of the volumes
(and related expenses) to be sold through each channel. These assumptions will
need to be monitored, especially if actual rates of commission paid differ from
the averages inserted in the pricing basis.
We have also discussed this in Section 5.

10.4 Split by territory
As already seen, the healthcare risk can vary substantially between territories
and even significantly between different regions within one country. For
example, the income protection risk can vary dramatically between a heavy
industrial urban centre and an agricultural rural community. The actuary may
use region of domicile as a rating factor for premiums. If region is not used as a
rating factor, the actuary will have to allow for differences in healthcare risk
through averages in the product costing. For any cross-subsidies of this nature,
forecasts of business volumes by territory will be needed.
10.5 Split by sex
In some territories and for some lines, the market practice (or legislation)
dictates that an insurer does not discriminate between the sexes in pricing
healthcare. The healthcare risk will almost certainly vary by sex and thus the
actuary will need estimates of relative numbers and sizes so that accurate
“unisex” prices might be charged.
10.6 Split by occupation
As we have already discussed, the occupation of the policyholder has a big

bearing on his propensity to make a healthcare claim. Where occupation is not a
risk factor or where there are broad groupings of trades, the actuary will allow
for likely volumes at each risk level, so that over the whole portfolio, an adequate
premium can be charged.
10.7 Mix of business risk
It is worth stressing that with any of the above averaging and cross subsidies,
the insurer may be laying itself open to anti-selection if it attracts a higher
proportion of the higher risk lives than expected in the pricing basis. This may
well happen if a competitor prices with more detailed subdivision and hence
wins more of the lighter risks. The actuary must monitor the experience in terms
of the categories of risk cells becoming new business, in order to reappraise his
pricing assumptions on a regular basis.

So the problem is that the company has had to charge average premiums to a
heterogeneous group of lives, so that the company will only receive the necessary
amount of premium in total if the assumed mix of business (for the group concerned)
materialises in practice. Because consumers are always seeking best value for money,
the tendency is always for a greater than expected proportion of the higher-risk lives to
take out insurance, so causing the anti-selection described above. The mix of business
can be a very important assumption, and (as with any assumption) leads to the risk of
the assumption being “too optimistic”. (There is more on this subject in Chapter 23,
where we talk about the nature of risk.)

Chapter 11 Summary
In constructing a basis the actuary will consider the future experience expected for the
contract concerned, and modify it as appropriate given the purpose of the basis. The
guiding principle in constructing any basis is consistency.
Benefit amount
Average claim amounts have to be assessed for PMI. These should be based on own
recent experience and on market data. Medical inflation and other changes that can
affect medical costs should be allowed for.
Long-term contracts have pre-determined benefits. Underlying claims experience varies

by benefit size. Some rating adjustment may be made for large cases.
Expenses
Expenses will be loaded for in accordance with the results of the most recent expense
investigation. Assumptions will be split by type of expense: initial, renewal, claim or
termination, and between per policy, per unit of premium or per unit of benefit.
For long-term contracts, charging the same premium rates for all sizes of policy causes
cross-subsidy. This can be reduced or removed using individual calculations, policy
fees, or a benefit differential.
Per-policy contribution to fixed costs are made by reference to expected volumes. Care
must be taken if using marginal costing to secure competitiveness.
Expenses are higher for healthcare products than for life insurance because of the
greater effort involved in selling and more work needed in underwriting and claims
management.
Benefit and expense inflation rates
Investigate recent inflation rates of the company and of relevant price or earnings
indexes. Allow for impact of changes in economic conditions. We could look at the
difference between yields on government fixed interest and index-linked bonds.
Standard indexes can be weighted to reflect actual experience better.

Commission and clawback
Commission rates should be based on what will be paid. We may need a weighted
average if we pay different rates for the same product to different sales channels.
Allow for clawback on early policy lapse, if appropriate. Reduce the allowance to
extent of credit risk of intermediary.
Investment return
This will be set bearing in mind the significance of reserves for the contract, the policy
term, the extent of investment guarantees, the importance of reinvestment and the
intended asset mix for the contract. Fixed-interest or index-linked securities are most
common. Little relevance for PMI; big factor for LTCI. Note what you need for unit-
linked.
Taxation
Use known current rates plus any known future changes. Apply to profit calculation as
appropriate ( I - E or profits basis). Any premium tax affects marketability.
Volumes
Assess in order to choose per-policy contribution to cover fixed expenses, and to judge
adequacy of capital to support new sales.
Mix of business
Assumptions may be needed for the mix of business by product type, distribution
channel, territory and sex, and also for average policy size. Will be necessary if the
company charges the same premium rates to heterogeneous groups within each
category.

Solution 11.1
Hospital deals should make the insurer’s claim costs more predictable and should also
help to keep them under control. Presence or absence of such deals, either in the past
experience or expected in the future, will affect both the expected value of the average
claim cost and its volatility – which in turn will affect the margins that the company will
need to include in the basis.
Solution 11.2
Provider capacity is the capacity of hospitals to provide treatments when required by

policyholders. If capacity reduces, treatments will tend to become more expensive, and
vice versa.
So this is really a factor influencing future benefit inflation, as described in the next
section.
Solution 11.3
(i) Income protection
This replaces lost income from earnings, so an index of national earnings (or one
relating to the earnings of the particular occupation) would be best.
(ii) Critical illness
Thinking about the needs being met, critical illness benefits can be viewed as serving a
range of possible purposes: to provide care, to repay debts, to replace lost income, to
meet ongoing costs, etc.
These each suggest different things to link the benefits to, for example:
● care – inflation of medical treatment costs
● repay debts – no inflation (provided the debt is of fixed amount)
● income replacement – earnings inflation
● ongoing costs – price inflation.

In practice the link would probably be to one the last three, possibly also depending on
the purpose of the policy (eg whether specifically required for repaying the mortgage on
critical illness).
(iii) Long-term care insurance
Benefits under this policy are required to meet the costs of long-term care, which mostly
relate to nursing and residential home costs. Linking the benefits to an index of such
costs would seem to be the most appropriate link for policyholders.
In many cases, and especially for LTCI, companies put a ceiling on the rate of benefit
inflation they will pay, in order to contain their costs to be within affordable bounds.
Solution 11.4
If the inflation of the relevant costs is higher than the fixed rate, policyholders may
become under-insured. This is particularly a problem for any policy designed to meet
specific costs, such as IP or LTCI. Policyholders may be very disappointed if their
policies fail to cover the costs they were originally designed for. This may lead to bad
public relations and significant marketing risk, eg producing reduced future sales and/or
higher lapse rates.
If the inflation of relevant costs is lower than the fixed rate, policyholders may become
over-insured. This may also make premiums too expensive, increasing lapse rates.
Over-insurance is a particular problem if it happens to IP policies, where benefits may
be capped at the time of claiming to keep benefits within the maximum permissible
replacement ratio. Policyholders caught in this way could be seriously disgruntled,
producing knock-on adverse marketing effects.
Overall the problems arise through the policy not meeting customer needs properly.
Solution 11.5
PMI will have the highest renewal administration costs.
This is because, at renewal, the company has to send notices to each of its policyholders
asking them to agree to continuing their insurance cover. This may or may not involve
a change in policy conditions at the time, and the circumstances of the policyholder may
also have changed. It will invariably involve a change in premium, which incurs the
company in further costs (assessment of risk and calculation).

While the expenses of renewing a PMI policy will not be as high as that involved in
insuring a PMI policyholder for the first time, the costs will still be higher than for a
long-term contract on renewal. In this latter case all the company usually has to do is to
inflate the premium and benefits as required for its records, and receive and bank the
premium.
Solution 11.6
Expense types that are not important for PMI are:
Investment
The short-term nature of the business means that reserves are small, so there are little
monies to invest. The investment expense assumption – along with the investment
assumption itself – will make little difference to the price of the contract, and would
normally be ignored.
Withdrawal and termination
These are the same, as far as PMI is concerned, and are generally referred to as lapses.
They are simply policies that fail to renew at the renewal date, and the expense of
administering them tends to be swamped by the costs of renewal overall. Most of the
cost of non-renewal is felt by having to spread all of the year’s renewal costs over the
smaller number of remaining policies that do renew.
There may also be some policies that cancel mid way through the policy term (eg due to
death or a change in circumstances). These will incur costs, the level of which will be
relatively minor.
Solution 11.7
Initial acquisition
Load for commission exactly as it occurs – almost certainly a percentage of the first
year’s premium.
Related sales costs (ie costs of sales process attributable to the sale of that one policy)
would probably be as a percentage of premium for consistency with commission. Any
sales staff are likely to devote their time and attention in proportion to the size of the
premium.

Initial medical underwriting
Probably as a percentage of the level of benefit, incurred at the start of the first policy
year, as underwriting costs are likely to increase with larger benefit levels.
Initial administration
A flat average cost per policy in year 1.
Renewal administration
A flat (plus inflation) average cost per policy in years 2 onwards (or from month 2
onwards).
Renewal reward to sales channel
Load for this exactly as it occurs – almost certainly a percentage of premiums from the
second year onwards.
Investment
This is most realistically represented as a percentage of reserves. It would be simple to

deduct it from the assumed rate of return in the pricing model.
Withdrawals
The cost of administering lapses or surrenders should be included in the model. A flat
(plus inflation) average cost per withdrawal should be allowed for. Products that pay
discontinuance benefits (such as some LTCI products) will involve higher costs, as
calculations (and sometimes payments) are involved, but the principles would be the
same.
Claim administration
Include as a fixed (plus inflation) per-policy cost occurring at the time of each benefit
payment. An alternative would be to assume a flat proportion of each benefit. This
might be particularly appropriate for benefits that inflate (as inflation will still be
included) and might reflect the extra costs involved in managing the bigger claims
(eg more effort expended in getting policyholders with large IP claims back to work).

Termination
This will be very small, as health products tend not to offer benefits on maturity, so will
probably be ignored. Alternatively, include as a fixed (plus inflation) per-policy cost
occurring at the end of the policy.
Contribution to overheads
Each policy will need to contribute its fair share to covering the company’s overheads.
A flat per-policy amount each year (plus inflation) will be included in the model, based
on the company’s expected overhead level relative to the total volume of business it has
on its books.
Solution 11.8
Initial and renewal expenses
Initial expenses are likely to be significantly greater than those associated with renewals
(eg initial medical underwriting). An assumption is usually made about the number of
years new policies are expected to be renewed, and the excess of the initial costs over
the renewal costs are spread over this number of years. Adding this annual (amortised)
initial expense to the expected renewal cost for the year gives the total per-policy
administration expense assumption.
Commission would be dealt with in a similar way, as initial commission rates are set at
a higher level than renewal commission (in order to attract new business), but would
normally be expressed as a percentage of premium.
Claim administration expenses
These would typically be allowed for by a percentage increase to the average claim cost
assumed for the year.
Solution 11.9
Large policies are subsidising small policies. The degree of overpayment by large
policies could be so great as to make them very poor value for money, going against
principles of equity and quite possibly making them uncompetitive.

Solution 11.10
It is not a problem for PMI because premiums are not expressed as a rate per sum
insured or benefit amount, so the question of cross-subsidy (at least between large and
small policies) does not arise. Each policy will pay whatever per-policy expense
loading was assumed in its pricing basis.
Solution 11.11
The risk here is in selling more smaller-sized policies than anticipated (either more in
absolute terms, or as a proportion of the new business portfolio). If this happens the
company might not recoup the marginal expenses. In addition the contribution to fixed
expenses would be smaller than necessary.
Solution 11.12
The future volume is a function of competition, which might itself be a function of

price. The price is a function of the expense loading, which is itself a function of future
volume. So future volume is a function of future volume!
(In order to get round this you could assume some bands of price, say, across which
future volume is insensitive, so as to home in on a final answer.)
Solution 11.13
The non-medical limit is the maximum benefit for which one can apply for cover
without automatically requiring specified underwriting evidence (usually a medical
examination or a private medical attendant’s report). Hence, every policy application
for benefits above this limit will require this further evidence. However, applications
for lower benefit amounts may still require further evidence if the underwriters feel that
this is necessary (eg the information supplied on the application form suggests that the
applicant is a high risk). See Chapter 29, Glossary.

Solution 11.14
The main expense items are:

● costs of administering payments
● costs of monitoring claim validity, and enforcing changes to benefit entitlement
(eg reducing benefits under IP during recovery when some partial employment
becomes possible for the claimant)
● costs of efforts expended on rehabilitation (eg helping IP claimants to return to
work)
● costs of assessing claims to higher levels of benefits (eg for LTCI).
Solution 11.15
A reviewable contract guarantees cover for more than one year (the actual period being
specified), but is subject to periodic reviews of the premiums that apply. Premiums
would only be changed (at a review date) if there is a change in the expectation, by the
insurer, of the future experience of the portfolio of business to which the policy belongs.
The change in expectation will typically be as a result of overall experience being
different from that assumed in the pricing basis.
With no change in expectation between review dates, the premiums would not be
changed. However, inflation of future expenses is expected, and allowance for this will
be included in the premium being charged at any stage. So the fact that premiums are
reviewable does not alter the need to allow for expense inflation when calculating the
premium.
Solution 11.16
This is the risk that the intermediary will become bankrupt between the time of sale and
the time of policy withdrawal, and is then unable to repay part or all of the commission
clawback what would normally be payable. The greater the likelihood of this event, the
less credit the insurer should allow in its pricing basis for clawback of commission.
Solution 11.17
The expected clawback is:
0.1 ¥ 0.5 ¥ 0.95 = 4.75%
of the initial commission.

Solution 11.18
(1) Regular premium without-profits critical illness
Not very important: reserves are small so that profits will be insensitive to changes in
investment return.
(2) Regular premium without-profits pre-funded long-term care insurance
Important: the reserves are large and so a change in the assumption should make a
significant difference to the resulting price.
(3) Single premium without-profits pre-funded long-term care insurance (initially

healthy)
Critical: the reserves are much larger (for much longer) than the regular premium case,
making investment return one of the key cashflow items of this contract. (The need for
margins may not be as great as for (1), because we might be able to invest in matching
assets – at least to the extent that the uncertainty of the claim costs allow – and therefore
secure a known investment yield when the policy is taken out.) Nevertheless, it remains
of vital importance to get the investment assumption correct, that is, equal to (or lower
than) the investment yield that the single premium will secure on the day that it is
invested!
(4) Regular premium unit-linked income protection
This is a bit harder to think about! First let’s clarify how investment returns affect
future profits. It does so in the following ways:
● in determining the rate of unit growth in the future, any charges linked to the
future size of the unit fund will be affected (eg the regular fund management
charge)
● the claim annuity values will be a function of an assumed future investment
return – this is what we will use to establish the reserve required, at the time
when sickness payments are assumed to start each year, so that we can calculate
the expected cost of claims from inceptions occurring each year
● the rate of return that the company assumes it can earn on its non-unit assets,
particularly on its supervisory non-unit reserves, contributes to future income.

Now consider the importance.

● Unit fund sizes are not likely to be very large under this kind of policy
(assuming it is a stand-alone IP product, it is essentially providing protection
benefits). The effect of different fund growth rates on future charges and hence
on profit is therefore likely to be small. So this assumption is not very
important.
● The discounting of future claim amounts, possibly over many future years of
claims, could make a big difference to the discounted value of the claim costs –
so this is an important assumption.
● Whether the non-unit interest rate is important depends on the size of any
non-unit reserves required, which in turn depends on the charging structure of
the product. For example, the levels of (positive) non-unit reserves required will
be less for policies with relatively high levels of regular (rather than initial)
charges, and/or for policies with fewer guarantees (eg with frequent reviews).
Modern product designs would generally aim to minimise guarantees, and it is
possible for these reserves to be small, and hence the assumption to be fairly
unimportant.
Be careful, though, not to overstate this case. The problem with all healthcare
products is the extent of uncertainty involved with the future claim experience,
so that reserves tend to be large – compared, say, with those for an equivalent
life insurance product – even when there are quite frequent reviews.
(5) Private medical insurance
Policies are generally of one-year duration, and claims are settled either during the year
or (usually) quite soon afterwards, so the investment return will not be important.
Solution 11.19
(1) Regular premium without-profits critical illness
Limited exposure, as investment income is of limited importance anyway.
(2) Regular premium without-profits long-term care insurance
High, as cannot match with most of the liabilities until late in the term.
(3) Single premium without-profits long-term care insurance (initially healthy)
Much lower than (2), but still some exposure to reinvestment risk due to uncertainty of
when the claims will start, and to the need to reinvest future investment income.

(4) Regular premium unit-linked income protection
This will probably only be significant for the interest rate used to discount the claim
costs (see Solution 11.18 for an explanation). This interest rate will be the yield
obtainable from the (matching) fixed-interest or index-linked bonds (as appropriate) in
the year of claim inception. After claim inception there should be relatively little
reinvestment risk – the uncertainty comes from having to invest the necessary reserves
at the time of claim inception, so the yield obtained will be totally susceptible to the
future investment conditions at those times.
(5) Private medical insurance
Of almost no importance.
Solution 11.20
If the tax authorities permitted a strong reserving basis for calculating the profit used for
tax purposes, this would reduce the level of profit, and hence the amount of tax. (The
tax is, in fact, only delayed, but this will still reduce its value, possibly significantly.)
Tax rates would need to be set at a high level to ensure the required amount of tax
overall is recouped. The reverse would apply if a weak reserving basis was used.
In practice, the preference is to ensure that the reserves used are not too cautious, so as
to avoid charging apparently penal tax rates.

Chapter 12
Assumptions (3)
Syllabus objectives
– morbidity
– mortality
– lapses
– claim amount
– expenses
– taxes
0 Introduction
In this chapter we cover:
● the pricing assumptions related to the cost of capital and the profit requirements
● the margins that may be required in any basis
● how assumption setting for other purposes (reserving, calculating embedded
values, etc) may differ from the pricing context
● dealing with unit charges when pricing unit-linked contracts
● the important principle of consistency that should be followed when deciding
upon a basis.
If you have not read Chapters 10 and 11 recently, we suggest you read again the
introduction to Chapter 10 before reading on, just to remind you of what this topic is all
about.

1 Reserving and solvency margin requirements

Within many territories, the writing of a policy creates an additional need for
regulators’ reserves, such as the statutory minimum solvency margin (or
solvency capital requirement). These reserves are often expressed as a percentage
of premium or sum at risk or initial policy reserves. It is thus appropriate to
charge each new policy for the cost of this capital.
Remember that all of the supervisory reserve for a policy, as well as the additional
reserve required for the minimum solvency margin, ties up capital in the business.
The charge is the interest cost in holding these reserves as statutory capital
rather than investing it directly in business acquisition. Thus, if a particular
policy has an internal rate of return of 10% and statutory capital is invested in
assets which yield 4%, the charge to the policy will be effectively a negative
cashflow of 6% of the amount of these solvency (capital) requirements for as
long as they are required.
The key point here is that the supervisory reserves, including all additional solvency
capital requirements, should be fully incorporated into the pricing model. For the cost
of capital to be accurately modelled, this means that:
● the reserves included in the pricing model should be calculated using the
assumptions that the company would be realistically expected to make, under the
assumed future conditions implied by the pricing model
● the rate of interest at which the net profits are discounted (the risk discount rate)
fully allows for the returns required by shareholders on the capital they have
invested.
Question 12.1
So will the assumptions used for calculating the reserves in the pricing model be on a
best estimate or a prudent basis?
We look at how we determine the discount rate in the next section, and we look at the
methodology of how we include the reserves in the model in Chapter 14.
Some companies, which are adequately capitalised, decide not to charge some
policies with the cost of their solvency (capital) requirement. This is done to
make the pricing of this line of business as competitive as possible. The actuary
will be aware however that, somewhere else within the company, that charge is
being levied, ie that funds which might earn 10% are being invested to earn 4%.

A company that ignores the cost of capital in this way has to be careful that it isn’t
fooling itself into thinking that a particular product is more profitable than it is. This is
particularly important if the company is trying to compare the merits of alternative
product designs, if the reserving (and/or solvency margin) requirements of these
products differ substantially.
Solvency margin requirements are often minimised by use of suitable

reinsurance arrangements. Pure reinsurers often have lower solvency margin
requirements than direct writers do, and as such the higher the proportion
reinsured, the lower the total solvency margin required.
So as well as reducing the direct writer’s capital requirement, the total capital required
by the industry to support a particular policy is reduced. It would be hoped that some of
the cost savings from this could be fed back to the consumer by charging lower
premiums. It would therefore seem appropriate to allow for any (financing) reinsurance
in the company’s pricing models (see the Reinsurance chapter, later in the course, for
more details).

2 Profit requirements
2.1 Risk discount rate
We now turn to the derivation of a suitable risk discount rate to use in our pricing
models. As we discussed in the previous section, a key aspect of the risk discount rate
will be the return required by the shareholders on the capital they invest in the insurance
company.
It is reasonable to suppose that the owners of an insurance company decide

where to invest by comparing the returns offered by different companies, relative
to the risks which are run, and are able to move their capital from one company
to another if they wish.
An investor will demand a higher expected rate of return from a risky investment
than from a safe investment to compensate the investor for the risks of default,
commercial failure and so on. This is often expressed by saying that the
investor requires a “risk premium” over and above the expected returns on safer
investments.
It is useful to borrow from economic theory the concept of the “risk-free” asset,
namely an asset which offers a certain return, absolutely free from all risk of
default.
Investing in an insurance company is certainly not the same as investing in the

economist’s idealised risk-free asset. Investors will demand an expected rate of
return equal to the risk-free rate plus a risk premium. Such a rate of return is
called a “risk discount rate”. The question is, what risk premium is appropriate
to compensate for the risks of investing in an insurer?
The capital asset pricing model
The Capital Asset Pricing Model, CAPM, has been widely used by stock market
investors to answer exactly this sort of question. The idea behind CAPM is that
a well-diversified portfolio of shares cancels out the risks of investing in
individual shares and leaves only the unavoidable risks of investing in the stock
exchange.
A suitable proxy can be chosen to represent risk-free assets, such as short-term

deposits issued by a stable government, and estimate the average risk premium
which the diversified portfolio of shares has yielded over the risk-free rate, over
a period of time.
The short-term deposits here are just one example of an asset which is almost risk-free.
Alternatives are very short government bonds, or long dated inflation-proof government
bonds. It will be impossible to find any assets that are perfectly risk-free.

The above paragraph of Core Reading is explaining how you would quantify the risk of
investing in equities. That risk is measured as the difference in return comparing
“equities” in a general sense with some risk-free asset. Take a well diversified portfolio
of shares (eg a suitable index) to represent general equities, and short-term government
stock to represent the risk-free asset. Compare the returns from these two over a period
of time to iron out any random fluctuations.
The question can then be asked as to how risky a particular company’s shares
are compared with the diversified portfolio. The result of the CAPM is that the
proper risk premium for any particular share is in proportion to its Beta.
According to the CAPM, the expected return on any asset is given by:
Ei = r + ( Em - r ) bi
where: Ei = E [ri ] is the expected return on asset i (eg our company’s shares)
r is the return on a risk-free asset

Em = E [ rm ] is the expected market return (eg the stock market)
b i is the “beta factor” of asset i (defined as the covariance of ri and rm

divided by the variance of rm).
So this equation specifies the relationship between the risk premium for an asset (the
risk premium is {Ei – r}) as proportional to the market risk premium {Em – r}. The
factor of proportionality is b i .
The beta factor b i can be thought of as a measure of the riskiness of the asset relative to
that of the market. A value greater than 1 implies that, when the market is rising, the
asset’s value will increase more than the market average; and conversely, when the
market is falling, it will decrease in value more than the market average.
This process identifies the systematic risk (or market risk) of the asset, ie the risk that
cannot be eliminated by diversification or making the same investment many times
over. It takes no account of the specific risk of investing in a specific company (which
can be eliminated by sufficient diversification). The rationale for this is that the life
company’s shares are assumed to be just a small fraction of the investor’s portfolio – the
CAPM does not reward specific risk.
Note that the shareholders’ required return on capital is also a function of the
availability of capital. The harder it is for the company to raise capital, the greater will
be the returns the company will have to offer in order to raise the amount required, and
the greater the returns will have to be to keep the shareholders happy.

The CAPM is just one example of how the market might assess the shares of a
company. The point to note is that it is not up to the actuary alone to decide
what an appropriate rate of return is for shareholders. The actuary will need to
make some assumptions, but the market is the final judge.
Allowing for the product-specific risk
So what does an actuary actually do in order to determine the risk discount rate to use in
a particular pricing model for a particular product? So far we have the CAPM, which
can give us the value of Ei : the rate of return that shareholders expect from investing in
our company to compensate for the risk involved. However we cannot simply use this
overall rate as the risk discount rate in our pricing models. Why not?
The reason is that not all projects are equally risky. The insurer should view itself
as an investor like any other when it considers the riskiness of a new product, as
in the long run the profits emerging from the whole company are the profits
emerging from the products which it sells. A change in the mix of business, for
example away from old and safe contracts towards new and innovative
contracts, would change the market’s evaluation of the company’s riskiness. In
practice, competition makes it very difficult to allow properly for the very
high-risk business.
So if we propose to launch a new product with innovative design features, this will
change the overall risk premium demanded by the company’s shareholders, and the only
way to satisfy this demand is for this product to generate a higher return on capital. In
other words, the risk discount rate used needs to be higher, and basically the higher the
risk, the higher the risk discount rate we should use.
The following are among the features that can make a product design riskier,
viewed as an investment:
● lack of historical data
● high guarantees
● policyholder options
● overhead costs.
Question 12.2
What features in a product might lead to a lower risk discount rate?
It is not easy to assess these risks, and it is even harder to say what effect they
should have on the risk discount rate.

We can devise a theoretical approach to this as follows. First think of the rate of return
on a product as a random variable R. We then need to assess the variance of the return,
var[ R ] (various ways of doing this are described below). Then suppose the
shareholders require their rate of return to exceed, say, the risk-free rate r with a 95%
probability. Assuming that, for example, R follows a normal distribution, this will be
achieved if we use a risk discount rate equal to r + 1.645 ¥ var[ R] . (1.645 is the
95th percentile of the standard normal distribution.)
Part of the variance of R is due to the variance of the cashflow components of the future
profit. This is referred to as the statistical risk.
The level of statistical risk could be assessed:
● In some situations analytically, by considering the variances of the

individual parameter values used.
● By using sensitivity analysis, as described in Chapter 19, with

deterministically assessed variations in the parameter values.
Sensitivity analysis tells you to what changes in your assumptions (eg increase or
decrease) your profits are most susceptible. If this was, say, an increase, the idea is then
to find the increased parameter value that you assess as corresponding to a 5%
probability level. (Note that this is a subjective assessment.) By using this increased
parameter value in the profit test, you can calculate a revised return on capital from the
product (keeping all other items, including the premium, unaltered). The change in the
return obtained will (crudely) show how the variance of an individual parameter
translates into the variance of return on capital.
● By using stochastic models for some, or all, of the parameter values and
simulation.
Here we would vary the important parameter values stochastically according to their
assumed probability distribution, re-computing the rate of return for each new scenario.
Doing this, say, 1,000 times will then give a good idea of the variance of the rate of
return.
In theory, a separate risk discount rate should be applied to each separate

component of the cashflows, as the statistical risk associated with each
component will be different.
However, in practice applying a separate discount rate to each component of the

cashflow would usually not be done. One reason is simplicity. Also, it would be tricky,
both in terms of time and data requirements, to analyse accurately the variability of the
different cashflow components.

Consolidating the various approaches
Finally we need to consider how we can bring together the two approaches – that of
using the shareholders required return (eg using CAPM) and the statistical approach
described above.
If we consider that the overall required return Ei is a true reflection of the riskiness of
investing in the company as a whole, then projects that are less risky than average will
require a lower risk discount rate than Ei , while projects that are more risky than
average will require a higher risk discount rate than Ei . We can assess this relative
riskiness using the statistical approaches described above.
Of course, as the projects develop and lead to actual profits (or losses) then the nature of
the riskiness of the company as a whole could change, thereby changing Ei . This is not
inconsistent with our methodology, as the change in Ei will also reflect the changing
mix of risk discount rates that we have used for pricing the individual projects
themselves.
Also, if Ei has not changed much since last time a product was priced (or repriced), and
the product concerned has not changed its risk profile fundamentally, then it would be
logical to use the same risk discount rate as was used before for pricing (or repricing)
the product. So, it should be possible to take the most recently used risk discount rate
for a product, and then adjust it as necessary to reflect changes to the statistical riskiness
of the product, to the overall required market return Ei , or to both.
In reality, the assessment of the risk, and the conversion of that into a risk discount rate,
is a very inexact science. The most important points to remember are that:
● The risk discount rate must be higher than the risk-free rate, hence changes in
market rates of interest should cause risk discount rates to change.
● The margin between the risk-free rate and the risk discount rate should attempt
to reflect all sources of risk in the product.
● The risk discount rates used for pricing different products should reflect the
relative risk of those products.
● The overall return earned on the whole capital of the company, generated from
its entire business activities, needs to meet the required rate of return (cost of
capital).
● The risk discount rate is simply a number that is used as a criterion in profit
testing. It is set to ensure that the rate of return from the product is satisfactory,
given the inherent variability of the return and the required return on capital.

2.2 Profit criteria
You should recall from Subject CT5 how it is possible to determine premiums (or
charges on unit-linked policies) using profit-testing methods. The approach is to decide
on some profit criterion (or criteria) that a product needs to satisfy, and then to calculate
the price that just meets this criterion (or criteria).
Profit criteria are most often framed in terms of the net present value. This is defined as
the expected value of the future profits generated by a policy, discounted at the risk
discount rate. So an example profit criterion would be to require a net present value of
zero.
Question 12.3
If a company prices its contracts on the basis of producing a zero net present value on
all its products, what will this achieve for the shareholders? (All of the company’s
products incur new business strain.)
We will discuss this and other commonly used profit criteria, when we describe the
pricing models, in Chapter 14. For now be aware that no pricing basis can be complete
without specifying the particular profit criteria that must be met.

3 Margins needed, and the ultimate price for the contract

The assumptions derived in previous sections and in Chapters 10 and 11 are
estimates of the expected values for the parameters.
Where a cashflow model is being used to price an insurance contract, the risk to
the company from adverse future experience would be allowed for, as described
in Chapter 14:
● either through the risk element of the risk discount rate
● or through assessing what margins to apply to the expected values.
If a formula model, as described in earlier subjects (eg Subject CT5 –

Contingencies), were being used for pricing, the first approach above is not
available and the risk of adverse future experience would be allowed for by
taking margins. However, this model does not help the actuary to quantify what
these margins might be and hence he or she must use judgement based on past
experience.
(We also describe the formula approach in Chapter 14.)
The important point from the above is that, by including a margin or margins
somewhere in the basis, the risk from adverse future experience is reduced. The basis
actually chosen for pricing, inclusive of margins, will fix the level of risk the company
will be subject to once the product is issued at that price.
Let’s consider each “method” of the Core Reading in turn (but in reverse order!).
Apply margins to the expected values
At one extreme, all margins could be incorporated in the assumptions for each
individual parameter; and the risk discount rate would then (in theory) be the risk free
rate. Hence, for example, our assumption for the future investment return might be
written as:
i ′ = i ′′ − m
where i ′′ is the best estimate of the future annual investment return, m is the margin
and i ′ is the interest rate assumption in the pricing basis, inclusive of margin. Once the
product is in issue, then the company risks making less profit than it anticipated if i (the
actual rate of return achieved) is lower than i ′ . Hence the larger the value of the
margin m, the lower the probability that i < i ′ and the lower the risk of making a
particular loss.

Assume a higher discount rate
Alternatively, we might have priced assuming best estimates for the individual
parameters, and included margins for risk by assuming a higher risk discount rate. The
company will now make less profit than it requires if i is sufficiently low that the return
on capital is less than the required rate of return.
These alternatives can lead to the same result (in effect, the same premium), but they are
just different ways of expressing the margin and the resulting risk. In each case the risk
of loss occurs once the margin is “used up”, whether that be the margin in the individual
parameter assumption, or the risk premium in the risk discount rate.
Modelling will play a big part (in assessing the margins) as the actuary will employ
stochastic processes to view the likely outcomes of variables with differing
distributions.
There are also useful deterministic modelling exercises that the actuary can do in this
direction, as we described in Section 2.1. We discuss the details of the modelling
aspects, later, in Chapter 19.
Where uncertainty is prevalent in future outcomes, the prudent actuary creates

margins to ensure, as far as possible, that the insurer’s promises are met. This
is especially the case in healthcare. The volume of relevant statistics is not
nearly as credible as in life insurance; claim outcomes are often more subjective
(less clear-cut) and more influenced by factors outside the control of the insurer
eg social and economic circumstances. It is fair to say that the funnel of doubt
is wider for healthcare insurance than it is for pure life cover.
Although the primary worry is that of adverse experience compared with assumptions, it
is not the only consideration: marketability and competitiveness are also important. For
instance, when determining the inception rate for pricing a critical illness insurance
contract:
● if the inception rate is under-estimated the company is at risk of a substantial
loss;
● if the inception rate is over-estimated the company is at risk of not selling the
product.

However, here it is worse to under-estimate morbidity than to over-estimate it. It is

better to end up selling low volumes of very profitable business than it is to sell high
volumes of loss-making business. If you are selling badly rated business you may
accumulate a lot of it before realising it is badly rated and hence loss making, whereas if
your rates were too high you will soon realise this (from observation of competitors’
rates) and you could quickly adjust them. Here the actuary will need margins to guard
against the risk that the inception rate is under-estimated (eg assume inception rates that
are higher than best estimates).
The price ultimately charged, and the margins incorporated, will depend on a
number of factors such as:
● the competitive nature of the market
ie how competitive the market is
● the company’s USP (unique selling proposition)
A company may be said to have a high USP if it is the only company in a market
selling a particular product. The lower the company’s USP, the more similar its
products are to others sold in the market
● the company’s attitude to risk
● the credibility, accuracy, relevance and “up-to-date-ness” of the data
● the size of the company’s free reserves or parental guarantee.
Question 12.4
If the level of each of the above factors is increased, how will you expect to adjust the
margins in your pricing basis?
In the last bullet point above, the Core Reading is referring to the additional financial
security available to the company in the form either of free assets, or due to the
existence of a parent company with additional capital. Similarly to our discussion in
Section 1 with respect to the solvency margin, the company must be aware that it is
putting its capital (and hence its solvency) at greater risk by reducing its pricing
margins.

The extent of the margins depends heavily on the purpose of the basis concerned. Here
we are concerned with pricing, so the margins will also be influenced by the need to
have competitive premiums. Nevertheless, the margins must reflect the risks involved,
and hence the size of the margins must crucially depend on:
● the degree of risk associated with each parameter used
● the financial significance of the risk from each parameter.
All sources of risk and the extent of these sources of risk should therefore be brought to
a consideration of the margins required for pricing (or, in general, for other purposes for
which a basis is required). Chapters 23 to 25 will cover Risk. Remember that the same
principles will apply whether we are allowing for the margins through the risk premium
in the risk discount rate (which would be the normal approach when pricing), or through
adjustment to the individual parameter assumptions (which would be the approach when
reserving).

4 Unit charges
A further assumption that may be required is the level of unit charges that the
unit-linked policy will bear. These are often the residual items to be estimated
when the other profit contributions are fixed and the total return on capital needs
to be achieved. Assumptions may thus be required for management charges, for
bid-offer spreads and for any unit surrender penalty.
This begs the question as to what is, and what is not, an assumption. The charges,
mentioned in the previous paragraph, are fixed by the company at the levels which it
expects will achieve the required profitability. As such, the set of charges for a
unit-linked contract defines the overall price for the product. So the charges are not
“assumptions” in the normal sense.
However, the Core Reading is pointing out how we might deal with the situation in
practice. Unlike conventional business, where the price of a contract is defined by the
fixing of a single number – the premium – the price of a unit-linked contract is defined
by a whole multitude of numbers: all the different types of charges and their values,
referred to above.
In practice, some of these charges may be set outside of the normal pricing process. A
particular example of this would be the bid-offer spread, especially where more than
one class of unit-linked product is investing in the same unit-fund link, and it would not
be possible to apply a different rate of charge from that made on other products. (In this
case, though, setting the bid-offer spread to be this value in our pricing model is not
strictly an assumption, as we know what the value is going to be!)
Even for those charges that are product specific, the company may wish some to be
fixed in advance (eg for marketing or competitive reasons). Also, it may simply be
more straightforward to home in on the value of one (probably key) policy charge,
while assuming pre-determined values for all the other charges. It is these assumed
values for the “other” charging rates that the Core Reading is referring to as
“assumptions”, in this context.
Much of the mechanics of pricing unit-linked products (using cashflow techniques) is

assumed knowledge from Subject CT5. However, the material in Section 2 of
Chapter 14 of this course, on cashflow techniques, will remind you of what you need to
know about this for Subject ST1.

5 Consistency
One of the guiding principles in creating a valid basis, mentioned at the start of
Chapter 10, is the principle of consistency. The assumptions need to be considered in
their totality, not in isolation. Consistency means ensuring that we make realistic
allowance for the way that variables behave together, where correlations exist between
them: sometimes the relationship between two parameters will be more important than
the absolute values of those parameters. (This is similar to the idea of including
dynamic links between variables in our models: we explore this in a later chapter.)
Particular concerns will be:
Investment return and inflation
The long-term relationship between the rate of expense inflation, benefit inflation and
the rates of return on different types of asset must be valid. (However sometimes you
do not need to make assumptions about future investment conditions – eg when there is
no reinvestment risk.)
Tax
If the company is taxed on “I–E” type taxation then the investment income assumptions
and the expense assumptions should both reflect the same tax treatment.
In profit testing the product, the profits should be measured net of tax.
New business volume, lapse and non-renewal rates, and expenses
We have already discussed how the loading for fixed expenses will reflect the expected
volumes of new business (see Chapter 11). The lapses and non-renewal rates will also
affect volume. So for any modelling purpose it is important that these three
assumptions are mutually consistent.
Lapse and non-renewal rates and investment return
Lapse and non-renewal rates can be affected by the general economic climate, which
will be one of the major factors behind the investment return assumption. Note that
lapses may also be affected by discontinuance terms and renewal commission levels.

Morbidity experience and investment return
Claim incidence rates (and termination rates, where applicable) will be affected by the
general economic climate, which in turn will be related to the investment return
assumption, as above.
Morbidity experience and claim expenses
With claim expenses such an important issue for healthcare insurance, it is key that our
assumptions for these are consistent with the assumptions that determine claim volume.
Morbidity experience and non-renewal or lapse rates
The higher the level of lapses, the greater the opportunity for selective lapsing, where
better risks leave, causing the morbidity experience for the business as a whole to
deteriorate.
Other products
The basis should normally be consistent with that of related products. In fact, the basis
of some closely related product might form the start point for any new product’s basis.
For example, the basis for a new stand-alone critical illness insurance might take as a
start point the company’s current accelerated critical illness insurance product.
Question 12.5
Explain what might happen if the company doesn’t use a consistent basis for the above
product.

Chapter 12 Summary
Cost of capital assumptions
Profit testing methods of pricing explicitly include the cost of holding the supervisory
reserves and required solvency margins (solvency capital requirements) in the profit
calculations. The cost of the capital to the shareholders is then taken into account by
discounting profit at the risk discount rate.
Risk discount rate
Those who provide capital to the life company expect a return on their capital of:
● that which they could obtain from a risk-free asset
● plus a “risk premium” to compensate for the volatility of return.
This return on capital demanded by the investors is the risk discount rate. The actuary
will need to price products to meet that rate if the company as a whole is to earn that
rate.
The risk discount rate can be determined by quantifying the risk premium appropriate
for the company. One way of doing this is by using the capital asset pricing model.
The market’s view of the risk discount rate is not necessarily the most apt for any given
product or project, as each may have different levels of riskiness. Factors that affect
riskiness include:
● lack of historical data
● high guarantees
● policyholders options
● overhead costs.
Statistical risk may be assessed analytically, using sensitivity analysis, or using

stochastic modelling.
Profit criteria
Profitability can be compared (and premiums or charges set) by reference to specific

target measures, such as net present value (discussed later).

Margins
Margins will be necessary to guard against adverse future experience. However

competitive pressure forbids too much prudence in a pricing basis. Margins are
included either through adjustments to the risk discount rate or to the individual
parameter assumptions.
Unit charges
When pricing a unit-linked product, some of the charges that need to be calculated in
the pricing model may need to take assumed values (or values that may be known in
advance). This may be because:
● the charging rates are fixed externally to the product (eg bid-offer spread)
● the charging rates need to meet other criteria (eg marketing purposes)
● it is a convenient way of homing in on the value of single key charges.
Consistency
It is important that the relationships between the assumptions in a basis are realistic,
reflecting the correlations that exist between variables.

Solution 12.1
Prudent. (Because that is the type of basis that the company will realistically expect to
use for setting up its reserves in the future.)
Solution 12.2
Basically, the opposite reasons to those mentioned as risky:

● benefits based on contingencies about which there is a lot of reliable data
● no (or not very onerous) guarantees
● no policyholder options
● low overhead costs (since this reduces the risk posed by low business levels)
● the ability to vary charges (in the case of unit-linked contracts).
Solution 12.3
A zero net present value implies a return on capital exactly equal to the risk discount
rate. This by definition means that the product should produce the returns required by
the shareholders, allowing for the inherent risks – see Section 2.1.
Solution 12.4
If the market became more competitive, margins in the pricing basis would need to be
reduced.
If the company’s USP was increased, margins in the pricing basis could be increased.
If the company became more risk averse, margins in the pricing basis would be
increased.
If the credibility, accuracy, relevance and “up-to-date-ness” of the data improved, the
margins could be reduced.
If the size of the company’s free reserves or parental guarantee increased, margins in the
pricing basis could be reduced.

Solution 12.5
The company will end up selling two fairly similar products, at the same time, of which
one must be expensive relative to the other. If the market is competitive (it probably is
for critical illness insurance), this might affect consumers’ buying and discontinuance
behaviour:
● more of the cheaper product might be sold relative to the other
● holders of the more expensive product may lapse their existing policies and take
out new cheaper ones, to the disadvantage of the company (this is the lapse and
re-entry option we described in the previous chapter)
● policyholders could feel aggrieved at the perceived inequity, with resulting bad
publicity for the company, and ensuing marketing risk
● the company’s profits will become more sensitive to the type of business sold
(ie its profits will be at an increased risk from changes in the mix of new
business).

ST1-13: Models (1) Page 1
Chapter 13
Models (1)
Syllabus objectives
insurance:
– actuarial models – stochastic models and Monte Carlo simulation
∑ objectives and requirements
∑ basic features
∑ uses (pricing, return and capital, profitability assessment)
∑ volatility and sensitivity
– multi-state modelling in pricing, reserving and reporting
– comparison of formula and cashflow approach
– cashflow approach to price setting
– model office methodology in assessing capital requirements
– when to use deterministic models (systematic risk assessment)
– when to use stochastic models (random risk measure).
(The items in bold are covered – or partly covered – in this chapter.)
0 Introduction
We now consider the subject of modelling. In this chapter we look at the basic
requirements and general features of a model, before looking in detail at the application
of modelling to:
● pricing (Chapters 14 and 15)
● other aspects (Chapter 19).
Constructing a model and setting assumptions (that will be used for the model) are
interrelated processes and generally should be considered together. The chapters on
setting assumptions (Chapters 10-12 and 20) are therefore very relevant to this topic.

Page 2 ST1-13: Models (1)
0.1 Need for models
The actuary advising a healthcare insurance company will require models to assist with:
● product pricing
● assessing return on capital
● assessing capital requirements
● assessing the profitability of existing business (including the present value of
future profits on the existing portfolio)
• any other work involving financial projections.

1 Objectives and requirements
1.1 The prime objective
The prime objective in building a model is to enable the actuary advising a life
insurance company to give that company appropriate advice so that it can be run
in a sound financial way. To this end, models will be used to assist in the day-to-
day work of the company and to provide checks and controls on its business.
Any modelling investigation is essentially a variation on a common theme, namely a

projection of the company’s balance sheets and income statement (or profit and loss
account).
The investigations that the actuary might perform include:

● ongoing financial projections (ie revenue account, balance sheet, solvency)
● financial projections to assist in decision making (eg for pricing, product design,
determining capital requirements, shareholders’ dividends, resource allocation to
subsidiaries and distribution channels, reinsurance needs and how best to satisfy
them, investment strategy)
● expense budgeting (measuring the total expected expense charges of all the
business and use as an upper ceiling for setting an expense budget)
● profitability measurement (eg embedded values, described later in the course).
Models will need to satisfy the following requirements:

● The model must be valid, rigorous and adequately documented.
● The model points must represent the business accurately.
● The model must include all the necessary parameters.
● Those parameters must be set appropriately.
● Results should be verifiable and communicable to intended recipients.
● The model should not be overly complex.
We shall now consider each of these aspects in turn.

1.2 The requirements of a model
The model being used must be valid, rigorous and adequately documented.
A rigorous model is one that produces realistic (and hence useful) results under a wide
range of circumstances and conditions. Such a model will generally give realistic
results even if the particular assumptions that make it valid are not exactly borne out in
practice. In other words we are able to use the model in a variety of circumstances and
remain confident that the results will be reliable.
For reasons of practicality the model is likely to contain some deliberate

approximations. For instance very minor product classes might not be modelled
accurately, but approximated by other related products, or left out entirely. The actuary
must be sure that such treatment does not materially affect the quality of his or her
eventual advice.
Proper documentation is essential so that any user of the model can understand what the
model does and how to use it, and crucially what assumptions have to be met in order
for the results from the model to be valid. For practical reasons it is always important to
have well-documented models so that other users can change or improve them in the
future.
1.3 What is a model point?
A “model point” is a data record that is fed into the computer as input for the modelling
program. It will represent either a policy or a group of policies, containing data on the
most important characteristics of the policy (or group of policies). Question 13.1 in the
next section gives an example.
The underlying business being modelled will typically comprise a very wide
range of different policies, and these will need to be brought together into a
manageable number of relatively homogeneous groups. The groupings need to
be made in a way that each policy in a group is expected to produce similar
results when the model is run.
It is then sufficient for a representative single policy in each group to be run

through the model, the result to be found, and for this result to be scaled up in
order to give the result of the total set of policies in the group. The
representative single policy in a group is termed a “model point” and a number
of such “model points” can then be used to represent the whole of the
underlying business.

1.4 Choosing model points
The model points chosen must be such as to reflect adequately the distribution
of the business being modelled.
Question 13.1
If modelling a portfolio of new and existing income protection policies, what would you
expect to see in a typical model point? (Assume that anything not specific to a policy is
fed into the model at a higher level.)
In-force business
The big stumbling block in pre-super-PC days was the limited number of model points
that could be handled. The problem still exists but is now much less severe. Some
companies may have millions of policies to model. In terms of both amount of data and
computing time, moving beyond around 100,000 model points may be difficult. It is
therefore normal to group the data to fit in with computing and time constraints.
This would be done with a data handling package, grouping policies of the same
product type which share acceptably similar age, term, and duration (for instance by
grouping age into 5-year bands). The model point for such a group will then contain
average values for premium, benefit guaranteed, etc.
The validity of this grouping would need to be checked. One way of doing this would
be to compare model outputs from ungrouped and grouped data in respect of one block
of policies, checking that they were acceptably close.
New business
If the model includes new business (and it nearly always does), the actuary must decide
what business mix by product should be assumed. Factors to look at would be the most
recent new business production, trends therein, any intended marketing changes, any
planned new product launches and any imminent and pertinent legislative or fiscal
changes.

1.5 Selection of parameters
The parameters used must allow for all those features of the business being
modelled that could significantly affect the advice being given.
As we have said before, the purpose of using any model will be to assist the actuary in
advising the company about the decisions it ought to make. A parameter must be
included in the model if different values of that parameter would alter the decision
reached. Conversely, if the decision reached would be the same whatever the value
assigned to some parameter, then that parameter is irrelevant and can be ignored from
the model altogether. For instance, if the business is affected by changes in interest
rates then there will need to be an interest rate parameter in the model; otherwise
interest could be ignored.
Question 13.2
Quickly list at least ten features that could be included as parameters in a model
healthcare insurance company that will be likely to affect the future financial results of
the company (eg investment return).
The inputs to the parameter values should be appropriate to the business being
modelled and take into account the special features of the company and the
economic and business environment in which it is operating.
In general the model, whether stochastic or deterministic, would be run on some central
basis, and then a range of different alternative bases would be tried in order to assess the
sensitivity of the results to variations in the assumptions. As mentioned already, the
central basis may be realistic (ie best estimate), or it may include margins for prudence,
depending on the purpose of the model.

1.6 Verification of results
The outputs from the model should be capable of independent verification for
reasonableness and should be communicable to those to whom advice will be
given.
The outputs from the model would be items such as:

● all future revenue account and income statement (profit & loss account) entries,
such as premiums written, expenses, investment income and claims,
● all balance sheet entries, from “now” onwards, such as supervisory reserves and
total assets, and related information such as required solvency margin
● miscellaneous information on the policy portfolio, such as numbers of policies in
force, amounts of new business written in each year, number of withdrawals.
The above outputs will normally kick off from the start point of the model. So a start
point of 31 December 2006 should give balance sheet items as at 31 December 2006
and revenue account results starting with the year 2007. Some models might be able to
project backwards, which can be useful for the checking described below.
It is important to check the output from the model against data that are independent of
the model. Typical ways of doing this are:
● to reconcile results with those of the last supervisory valuation
● to reconcile with results from the last time that the model was run
● to perform simple ratio checks on future years’ results – eg the increase in
reserves as a proportion of premium and investment income
● to construct a very simple “back of the envelope” model of the company, using
perhaps just a few model points to represent the whole policy portfolio. Check
the full model’s output against this for order-of-magnitude errors.
An important check if you are updating rather than creating a model is to compare the
last set of model projections with actual experience.
The results must be communicated in an understandable way bearing in mind the

audience concerned. Some mention of the underlying methodology would normally be
appropriate, and any critical assumptions should be highlighted. It is often useful to
include suitable sensitivity test results (or, for a stochastic model, to indicate the central
range of results).

1.7 Complexity versus time and cost
The model, however, must not be overly complex so that either the results
become difficult to interpret and communicate or the model becomes too long or
expensive to run.
Considerable actuarial judgement may be required in the choice of the model to

be used and in deciding on the number and type of the underlying model points.
Question 13.3
What factors would influence the number of model points chosen?

2 Basic features of a model

All healthcare insurance models include some element of cashflow and profit
projection. Given this very basic commonality we can describe a number of reasonably
distinct variations. These are distinguished both by their purpose and structure: as you
might expect, the design of any model should be closely linked to its function. The four
“types” are:
1. Single policy profit test model. This projects the expected cash and profit flows
from a single policy from the date of issue. It is a key model for pricing and
product design.
2. New business model. This projects all the expected cash and profit flows arising
from future sales of new business. It is useful for assessing future capital
requirements for the new business, and the overall return on capital achieved
from future sales. The expected present value of the future profits is the
“goodwill” item in an appraisal value of the company.
3. Existing business model. This is a cash and profit flow projection from all the
existing business a company has in force at a particular time. This is important
both as a means of assessing the intrinsic value of the existing business (the
embedded value), and also for testing the solvency of the company’s existing
business.
4. Full model office. This is essentially the sum of (2) and (3). This model is of
fundamental importance in assessing the impact of future management
decisions, of all kinds, on the future financial development of the company.
These four models differ almost entirely on the basis of which policies are included in
the model. The models will also tend to differ in terms of the focus of their output,
which of course is related to the functions of the model. For example, for the profit test
the focus is on the annual emergence of profit, whereas users of the full model office
will be primarily (but not solely) interested in projections of the company’s supervisory
balance sheet and the projected distributions of profit.
Apart from this, the basic construction of the models is essentially the same. Each
model will require (among other things) a policy liability model, an expense model, and
an asset model. The liability model will be a product modelling program which projects
cashflows and other related values (eg supervisory reserves required) for policies over
their future term to expiry. With the probable exception of the profit test, this will often
be an off-the-shelf package sold by one of the larger consultancy firms.

Policy liability model
This package will need to be tailored to the company’s product range. Each product to
be modelled will need to be fully specified in the package’s language. This involves
defining aspects such as product type, charging structure, surrender values, and any
special features such as options.
As input, the policy liability model will take model points, which represent the existing
portfolio and expected new business, and parameter values for variables such as claim
incidence rates and withdrawal rates.
One of the key functions of the policy liability model is to project forward, to the end of
each future year of the projection period, the in-force portfolio of policies. This is a
function of the existing in-force portfolio (if any) at the start of the projection period,
the new business projected in each future year (if any), the future transitions between
the non-claiming and the (different) claiming states, the future mortality, lapse and non-
renewal rates, and the expiry of policies as they come to the ends of their terms. The in-
force projection is directly needed in order to calculate the supervisory reserves and
required solvency margins at the end of each projection year.
The other key function of the policy liability model is to project the total policy
cashflows that arise each year, which will (in conjunction with the asset model) enable
the projected assets of the company to be calculated for each year end. It will also, of
course, enable the annual projected profit to be calculated.
The new business model points might be the product of a separate sales projection
model, perhaps building up the business levels expected from each distribution channel.
Expense model
The expense model for the full model office would need to calculate the total expected
expenses of the company, building them up from staff numbers, resultant salary costs,
system costs, property overheads, etc. This expense model might itself require some of
the outputs from the model as constructed so far; for instance administration staff
numbers might (broadly) depend on the total number of policies in force, commission
costs will be a direct function of the premiums and types of policies sold and in
force etc. It is important to note that, at least for the full model office, the fixed
overhead expenses should be modelled globally, and hence more realistically than just
assuming the fixed expenses are the per-policy expenses summed over all policies in
force.
The expense components for the other model types would be restricted to the expenses
related to those parts of the business being modelled. The modelling of fixed expenses
is more difficult in these cases, especially for profit test and new business models.

Asset model
The asset model will almost certainly vary in its complexity according to the overall
type of model and the purpose for which the model is being used:
● At one extreme the asset model for the profit test will commonly consist of a
future total annual expected investment return only. The assumed rate may vary
by type of asset fund (eg different rates assumed for unit fund assets as opposed
to non-unit assets).
● At the other extreme, if using a full model office to assess the company’s future
investment strategy, we would need a stochastic asset model capable of
producing an appropriate distribution of returns for each asset class, that
projected income and gains separately, and of course that reflected the mix of
assets held by the company from time to time.
This might be part of the same software package as the product modelling part,
or it may be modelled separately.
In any case, care will be needed to ensure that the two parts interact properly
(noting that the projected assets are partly a function of the projected cashflows
generated by the liability model).
Question 13.4
Give an example of where cashflows from the liability model will be at least partly
determined by the asset model, rather than the other way round.
The way in which the projected assets of the company are calculated can be summarised
by the following (over-simplistic) recursive formula:
At +1 = At (1 + it ) + CFt (1 + it )½
where At is the value of the assets at the start of year t, CFt is the total of the policy
cashflows arising during year t, and it is the overall average return on the assets during
year t. It would be necessary in practice to ensure that the separate components of the
investment return, that is capital appreciation and income, are properly allowed for in
this projection.

Consolidation
The various outputs would then be consolidated (ie added up) at a higher level, allowing
at this stage for any factors not incorporated in the detailed model, such as adjustments
for unmodelled business, tax computation, or incorporation of separately determined
contingency reserves.
A diagrammatic representation would look something like this:
Data modelling Sales

package projection
In-force portfolio New business

model points model points
Parameters
Product modelling Asset

package (policy model
liability model)
Expense
model
Consolidation Manual
adjustments
Draft results
Compare with
supervisory
valuation
Verification
process
Compare with
previous model
results
Compare with
highly simplified
Presentable
model
results

2.1 Projecting cashflows and profit
A model for projecting insurance business needs to allow for all the cashflows
that may arise. These will depend on the nature of the contract, in terms of its
premium and benefit structure and any discretionary benefits such as options to
convert, extend or increase cover without evidence of health.
In this case, by discretionary benefit we are talking about benefits that are dependent
upon policyholder choice, which basically means options (and associated guarantees)
included in the policy conditions. We discuss how these benefits can be valued in
Chapter 17.
Allowance for supervisory reserves
A model also needs to allow, where appropriate, for the cashflows arising from
any supervisory requirement to hold reserves and to maintain an adequate
margin of solvency.
Here we can distinguish between what the company might refer to as physically real
cashflow, and notional cashflow.
The real cashflow includes: premiums and investment income as positives; payments to
policyholders, commission to agents, expenses and tax as negatives.
If there is a supervisory requirement to hold reserves (this can be safely paraphrased as

“always”) then the insurance company will need to fund the establishment of these
reserves. This is done by contributing money to reserves from the cashflow or, initially,
from the company’s free assets or other source of capital. This item is the “increase in
reserves” and is a negative from the company’s perspective.
At maturity or earlier claim the reserves will be released to help pay the appropriate
policyholder benefit. This will be a “decrease in reserves” (or “release of reserves”) and
will be positive.
These flows are examples of notional cashflow, ie where the flow does not involve a
physical exchange of money. The real and notional cashflows together combine to form
the profit flow. The investment income from the supervisory reserve will also be
included as a positive contribution to the profit flow.
The total profit arising over the year, for any of the model types, can be calculated as:
( At +1 − Vt +1 ) − ( At − Vt ) = ( At +1 − At ) − (Vt +1 − Vt )
where Vt is the total supervisory reserve at the beginning of year t.

Notice that the investment return on the reserves is effectively included in ( At +1 − At ) ,

(which includes the investment return on all the assets). You should also see that the
right hand side of the formula is showing the calculation in terms of the total cashflow
(including investment returns) less the increase in reserves.
(The Core Reading is simply saying that the model will need to include an allowance
for the supervisory reserving requirements in its projection.)
Allowance for supervisory solvency margin (or capital requirement)
In addition there might be a minimum supervisory solvency margin (or capital

requirement) to cover. This works in the same way as the reserves above: just as the
policy cashflow must fund the establishment of certain reserves which are then released
at the end of the policy’s life, so the policy cashflow might also need to fund the
establishment of a solvency margin (or capital requirement). The required solvency
margin (or capital requirement) would then be included in the value of Vt in the above
formula.
Thus any initial solvency margin requirement will be allowed for via a negative in the
profit flow in respect of “increase in solvency margin”. It is possible that further
increases to the required solvency margin will be necessary over the contract’s term,
depending on the type of contract and the particular regulations in force. The release of
this solvency margin may occur over the policy’s life, at maturity or on earlier claim.
Any “decrease in solvency margin” will be a positive in the profit flow.
The company might be targeting a level of free assets greater than that implied by the
supervisory minimum requirement; for instance, that for every policy the company
should have free assets equal to twice the supervisory minimum solvency requirement.
If so, this should also be allowed for. The assets covering the solvency margin
requirement may be quite different from those supporting the reserves and this would
need to be allowed for in the investment return assumption.
2.2 Modelling different states
The model will need to project separately the cashflows arising from different
states and reflect the transitions between these states, eg under income
protection those healthy lives paying premiums and those disabled lives
receiving benefit.

This is a key element of the policy liability model. Cashflows will differ markedly
depending on the current state: eg healthy, sick but not yet claiming, and claiming.
Further subdivisions within the “claiming” state may be necessary, eg for the different
benefit levels under a LTCI policy. The projected volume and mix of policies in each
state in the future will be a direct consequence of the assumed new business, transition,
mortality and lapse rates input into the model. If the projected future business from our
model does not faithfully reflect the application of these input assumptions, then the
model is failing.
2.3 Allowance for interactions
The cashflows need to allow for any interactions, particularly where the assets
and the liabilities are being modelled together.
This is closely related to what we talked about at the end of Chapter 12, where we
discussed how it was vital for assumptions to be consistent with each other. We are
now saying that this idea of consistency must be extended to include how we model the
behaviour of all the future variables.
It is absolutely vital that the asset and liability models are completely consistent. To
achieve this the model should be dynamic, meaning that the asset and liability parts are
programmed to interact as they do in reality.
One of the most important examples of such interaction is the way in which the
supervisory reserves will need to be consistent with the projected investment conditions.
In particular, the valuation rates of interest assumed by the model for this purpose will
be a variable, projected by the model itself, and should be the interest rate(s) that the
company would realistically be expected to assume, at that future time, if the investment
conditions projected by the model were actually to occur.
A further dynamic link, related to this, concerns the response of the company’s
investment strategy to changing conditions. In particular, were the model to project
worsening solvency margins (ie smaller free assets in excess of supervisory
requirements), the model should then realistically incorporate the management’s
response to this scenario: this may, for example, involve switching to more closely
matching assets.
Incorporating dynamic links is important for all modelling, but it is particularly vital
when modelling stochastically (see below). A deterministic model can have its
assumptions tweaked to reflect realistically the dynamic responses required for a given
deterministic (single) scenario, but this would be impossible stochastically where
variables are changing yearly and ongoing responses need to occur automatically as
each simulation is run.

2.4 Stochastic and deterministic approaches
The key features of the deterministic process are as follows:

• Each of the parameters in a deterministic model has fixed values.
• The model produces results in the form of a point estimate.
• It is possible to sensitivity test the results of a deterministic model by
running the model with different parameter values.
A deterministic model is therefore essentially a “one-question-one-answer” model,

although it can be used with sensitivity testing to give a better feel for the variation
around that one answer.
The key features of the stochastic process are as follows:

• Some of the parameters in a stochastic model (eg number of claims or
claim amounts) are allowed to vary and have their own distribution
function.
• A stochastic model must be run many times using random samples from
the distribution functions.
• The model produces results in the form of a probability distribution.
A stochastic model is therefore essentially a “distribution-in-distribution-out” model.
Subject CT6 describes stochastic modelling and the Monte Carlo method of
simulation.
You may also have met the basic principles of these types of methods in Subject CA1
and possibly in other ST subjects.
Stochastic modelling may be more important for healthcare insurance than for pure life
insurance for a number of reasons.
With health and care products, the future incidence experience is far less easy to
predict than pure life insurance. The added difficulty lies in the potential benefit
amount, which may vary by policy-specified inflation (LTCI, IP), by medical
inflation (PMI), by changes in accepted medical protocols (PMI) or other factors.
With such uncertainty and hence volatility of cashflows, it is important to be able

project the distribution of possible future outcomes.
The ability to use stochastic models and simulation needs to be allowed for,
where appropriate, in order to assess the impact of financial guarantees.

The kinds of guarantees that are important in healthcare insurance are those referred to
in the last-but-one paragraph of Core Reading. For example, future benefit payments
may be of guaranteed amount, either in monetary or index-linked terms. The expected
cost of this guarantee can only be realistically assessed using a stochastic investment
(and inflation) model. In doing this modelling, it would be vital to incorporate dynamic
links between the financial and demographic variables.
Question 13.5
Why?
Stochastic modelling does have some disadvantages:

● time and computing constraints – so stochastic modelling work might be done
with a very simplified version of the model
● the sensitivity of the results to the (deterministically chosen!) assumed values of
the parameter(s) involved.
This second point can therefore lead to spurious accuracy: the great complexity of the
model may give the appearance of highly precise answers, but if we have little
confidence in the parameter values then we can have little confidence in the answers
being correct. It’s the old saying: rubbish in equals rubbish out!
Question 13.6
State with reasons whether you would use a deterministic or a stochastic model for the
following purposes:
(a) Assessing the estimated loss to your portfolio of PMI policies if there was an
epidemic of influenza as serious as that in 1918.
(b) Estimating the expected value and variance of CI claims next year.
(c) Estimating the probability of insolvency due to an unforeseen AIDS epidemic.

2.5 Projection frequency and time period
The time period for calculating the cashflows in the projection needs to be chosen
bearing in mind that:
• the more frequently the cashflows are calculated the more reliable the
output from the model;
• the less frequently the cashflows are calculated the faster the model can
be run and results obtained (though this is a very marginal feature for
most modern computers).
Here “time period” is used to mean the basic unit of time inside the model, not the
period of time which the model needs to project. In practice the normal unit of time
chosen will be one month. This is because a year is not “fine” enough – the company
may want to look at its position on a monthly or quarterly basis if it is at all worried
about solvency. Alternatively, the company may want to project a 31 December
position from eg an end of June starting point. However, anything more detailed than a
monthly breakdown should not be necessary; the increase in information available with
weekly calculations will not be useful, and the gain in accuracy very slight.
The total projection period selected is another important decision. For models of the
whole company, the projection period chosen to look at in detail is normally three or
five years. Anything beyond that will be very exposed to the “funnel of doubt”,
especially as regards the level and mix of new business, but may usefully indicate
significant trends – especially as regards solvency. However, when examining
individual product cashflows for profit-testing purposes the projection period used will
be the policy term.
Note that the funnel of doubt will expand more rapidly the shorter the term of the
policies involved, because of the greater influence of the future new business and
non-renewal assumptions. For short-term insurances, projections beyond about three
years are therefore very unlikely to be accurate.
Question 13.7
List at least ten ways in which the model could be inaccurate.

Chapter 13 Summary
Different types of model
● Profit test model.

● New business model.
● Existing business model.
● Full model office.
Requirements of models
● The model must be valid, rigorous and adequately documented.

● The model points must represent the business accurately.
● The model must include all the necessary parameters.
● Those parameters must be set appropriately.
● Results should be verifiable and communicable to intended recipients.
● The model should not be overly complex, so that either the results become
difficult to interpret and communicate or the model becomes too long or
expensive to run.
Basic features of models
● Involves projecting cashflows.

● Cost of setting up supervisory reserves and required solvency margins (or capital
requirements) need to be allowed for in order to calculate profit flows.
● Include separate states: healthy, sick but not claiming, and claiming (latter by
benefit level, if appropriate).
● Allow for interactions and correlations between variables (dynamic links).

Stochastic versus deterministic
● Need to be able to run stochastically in order to value policy guarantees

properly, recognising the greater range of possible outcomes from morbidity
processes compared with mortality.
● Deterministic modelling with sensitivity testing can also be used to demonstrate
the vulnerability of results to unexpected future experience.

Solution 13.1
The information required will depend on the purpose of the investigation, and on the
assumed status of the policy: ie new (a future policy), existing not sick, or existing sick.
The following information would probably be needed for a new business model point:
● coding of product type
● (initial) level of annual benefit
● benefit escalation rate (if specified by the policy conditions)
● deferred period, waiting period, and linked-claims period
● premium
● term (or expiry age)
● age at entry
● sex
● smoker status
● occupational group
● commission level
● distribution channel (possibly).
For an in-force, not sick, model point we may additionally need:

● current level of benefit (if escalating)
● duration in force
● duration since end of last claim paid (if within the linked-claims period).
For an in-force, currently sick, model point we would also need:

● reason for sickness (may be required to calculate claims reserves)
● duration since sickness notification (if currently within the deferred period)
● duration since start of benefit payment (if currently claiming).
(It should actually be possible to manage without the last of these bullet points,
provided the sickness notification date is used to represent the official inception of
sickness. Sickness payments will then be starting (or will have already started) once the
deferred period has elapsed following that date.)

In addition, we may also need the expected number of policies issued (over a time
period) for each new business model point, and the actual numbers of policies (in force)
relating to each in-force model point.
Solution 13.2
You should be thinking along the lines of:

● claim incidence rates, claim recovery rates, rates of transfer between claim states
(latter for LTCI)
● mortality rates
● lapse and non-renewal rates
● average claim size (for PMI)
● future expense levels
● future expense inflation
● future benefit /claims inflation
● investment return
● volumes and mix of new business
● taxation basis.
Solution 13.3
Factors such as:

● the availability and power of computers
● the variability of contracts sold
● the complexity of the contracts in force
● the age of the company
● whether the model is stochastic or deterministic
● the purpose and importance of the investigation
● the time available
● the sensitivity of the results to using more or fewer model points.

Solution 13.4
One example is the case of unit-linked policies, where fund management charges are
proportionate to the unit fund values. In order to project these values, input from the
asset model would be needed (eg unit growth rate).
Another example might be inflation. Benefit levels are often inflation-linked, either
directly or by assumption. In practice many asset models include as output consistent
projections of economic indices, such as inflation, and these would be used to project
future benefit increases.
Solution 13.5
Sickness claim experience will be correlated with economic conditions, and so also with
inflation and investment returns.
For example, if inflation is assumed to be positively correlated with higher claim

incidence rates and lower claim termination rates, then the guaranteed benefits will cost
the company a lot more money than if there were no correlation. Failure to include the
correlation could significantly understate the cost.
Solution 13.6
(a) Probably deterministic, as only one answer is required.
(b) Stochastic, as a variance is involved, which necessitates a distribution.
(c) Stochastic, as a variance will be needed to assess the likelihood of not being able
to meet a specific fixed target.

Solution 13.7
● incorrect programming of product structure

● some products not modelled
● known imminent changes (to eg fiscal regime) not allowed for
● policy options ignored
● incorrect parameter choice
● interaction of inter-dependent variables not correctly dynamic
● new business assumptions wildly optimistic, or do not take account of imminent
product changes or launches
● model points based on incorrect data
● misrepresentative (badly selected) model points
● deterministic approach where stochastic approach required
● risk discount rate does not make adequate allowance for cashflow variance
● unit of time within model too big
● period of projection too long
● miscellaneous software bugs.
Stretching the point, you could also argue:

● misinterpretation of results by management because not communicated clearly.

ST1-14: Pricing (1) Page 1
Chapter 14
Pricing (1)
Syllabus objectives
– data availability
– equation of value
– formula approach
– cashflow techniques
– group risk assessments
– options
– guarantees
insurance:
∑ basic features
(The items in bold are covered in this chapter. See also Chapter 13.)

Page 2 ST1-14: Pricing (1)
0 Introduction
This and the next four chapters cover the pricing of health and care insurance contracts.
Pricing is one of the most important uses of actuarial models, so it is natural that this
forms a core section of the Subject ST1 course. Other aspects of modelling (Chapters
13 and 19), and the chapters on setting assumptions (Chapters 10-12 and 20) are all
relevant to this topic also.
In this chapter we describe the formula and cashflow approaches to product pricing,
noting that it is the second of these that is generally used in practice, at least for
long-term insurance contracts. We explain how the cashflow approach can be used on
specimen model points (or on a group of model points) to develop a set of premium or
charging rates for a contract, and we include a description of the various profit criteria
that might be used.
We also look at how full model office investigations are necessary in order for issues of
capital and solvency to be properly addressed.
The methodologies involved here (for long-term insurance products) are common also
to long-term life insurance, and those of you studying Subject ST2 as well will see
many similarities with that subject. The main areas of difference lie in the costing of
the benefit elements of the cashflows: these are dealt with in Chapter 15.
In Chapter 16 we deal with the pricing of all group risks, in Chapter 17 the pricing of
options, and in Chapter 18 we deal with some further general pricing principles.

1 Equation of value/formula approach

The calculation of any premium is an elaboration of the principle that income
must equal outgo, or that income must exceed outgo with the surplus belonging
to the persons who supplied the capital to finance the company. The premium to
be charged is thus the unknown which is derived from equating forecast income
against forecast outgo. This is our equation of value.
This is the method of calculating premiums according to the “equivalence principle”

that you may have already seen used for calculating gross premiums in Subject CT5.
This simple methodology would calculate a numerator as:
Value of outgo (claims, expenses, commission, taxes etc)
less
Value of non-premium income (investment yields).
It would then calculate a denominator as:
Value of 1 unit of monthly/annual/single premium.
While this looks a bit different from what you may be used to from earlier subjects, it is
essentially the same, ie:
{value of outgo} = {value of income} .

The above values would discount these items of income and outgo using a
suitable rate of interest equivalent to the return achievable by investing the
proceeds of the policy as they arise during its duration. The rate chosen will
vary between aggressive and conservative, as indeed may other assumptions,
depending on whether the premium result needs to be competitive or otherwise.
This last point is discussed further in Section 3.1 below.
Question 14.1
In order to make our premium result more “aggressive”, would we make the discount
rate of interest higher or lower?
Additional specific profit margins may be added.
The premium in units would be the quotient of numerator over denominator.

Value of claims
The value of claims would include the discounted value of all future claims outgo
over the duration of the policy. Claims expenses are likely to be included here.
Standard inflation assumptions would also be assumed. Where there were
different benefit escalation options, these would be costed separately.
Value of premiums
The value of one unit of premium income would be projected and discounted,
allowing for escalation as appropriate, withdrawals and premium holidays during
claim. Expenses, including commission, which relate directly to premium size
are likely to be included here.
Example
Say we have:
● annual premium = P
● initial commission = 40%
● renewal commission = 2.5%
we would value the premiums and commissions as:
P ax: n - 0.4 P - 0.025 P ax: n -1
(
= -0.375 + 0.975ax: n P )
assuming the life is aged x and the premium is payable annually in advance for a
maximum of n years. The term -0.375 + 0.975ax: n would be included in the
denominator of the formula.
Value of expenses
Expenses which are not directly related to one of the other “values” are
projected and discounted. Appropriate rates of inflation will apply.

Value of investment income
The cost of reserves is ignored in this method, though it could be included with
an extra layer of complexity. Hence this value will allow purely for the timing
difference between items being received by the company during the year,
against the annual outgo, with the balance being invested to the year-end, prior
to being “distributed”.
Let’s sort out exactly what’s going on here. We’ll illustrate how the Core Reading
formula works – and how the investment income bit fits in – using a simple numerical
example.
Example
Suppose we have a (rather simplified) stand-alone critical illness insurance contract,

which has only a 2-year term. Our assumptions for morbidity and expenses have led to
the following valuations:
Year 1 Year 2
Expected cost of claims arising: £600 £700
Expected cost of expenses incurred: £300 £50
For the sake of simplicity, we will ignore mortality and any other modes of exit.
First we ignore any investment income earned during the year. Using an assumed
discount rate of 4% pa, we would calculate the annual premium from:
{expected present value of benefits} + {expected present value of expenses}

= {expected present value of premiums}
700 + 50 Ê 1 ˆ
fi 600 + 300 + = P Á1 +
1.04 Ë 1.04 ˜¯
1, 621.15
fi P= = £826
1.9615

Now we allow for investment income. Suppose we know (or rather, assume) that
claims are settled on average three-quarters of the way through each policy year, and
that expenses are incurred at the start of each policy year. This should (approximately)
mean that the annual premium, net of expenses, will earn interest for the company for
the first 9 months of the year. Once claims have been paid, any “balance”,
ie (premiums plus investment income) less (expenses and claims), will earn interest for
the remaining 3 months of the year.
The amount of interest will depend on the calculated annual premium. We don’t know
precisely what this is yet, but it will clearly be less than the £826 we calculated
previously. We will assume an arbitrary £800 in order to get an approximate answer.
Using the same rate of investment return (4%), the amount of interest earned will be
(approximately):
Year 1 (first 9 months): (800 - 300) ¥ 0.04 ¥ 0.75 = £15

Year 1 (last 3 months): (800 + 15 - 300 - 600) ¥ 0.04 ¥ 0.25 = -£0.85
Year 2 (first 9 months): (800 - 50) ¥ 0.04 ¥ 0.75 = £22.50
Year 2 (last 3 months): (800 + 22.50 - 50 - 700) ¥ 0.04 ¥ 0.25 = £0.72
So we can recalculate the premium now as:
(22.50 + 0.72)
1, 621.15 - (15 - 0.85) -
P= 1.04 = £807.89
1.9615
This is now a direct representation of the Core Reading formula given at the start of this
section. (Repeating the above calculation using this premium instead of £800, would
give a revised premium of £807.56. Several reiterations could be performed to get a
more precise result. Alternatively you could replace the 800 by P, end up with a big
formula, then solve for P. In any case don’t worry too much about the detail here, we
just wanted to illustrate how the Core Reading formula could work!)
This may be best handled by applying different interest adjustments to the

factors applying to premiums and those applying to claims (and to expenses),
depending on the anticipated incidence.
So this means, rather than including an explicit cashflow for investment income, we
adjust the discount factors used for the other cashflow items to allow for their incidence
during the year.

Example
Thus in our example, no adjustment will be required for premiums and expenses as
these occur at the start of each year. Claims, however, need to be discounted for an
additional three-quarters of a year: ie their value needs to be multiplied by v0.75 . So we
get:
300 + 50v + (600 + 700v)v0.75

P=
1+ v
Using v = 1.04-1 we get P = £807.65 .
You should recognise this now as the traditional formula approach that you may have
learned in Subject CT5. This formula results directly from equating expected present
values of income and outgo allowing explicitly for the average timing of cashflows.
Note that the only difference between the two approaches is that the first method
assumes simple interest within policy years, whereas the traditional approach assumes
compound interest throughout. The impact, in terms of accuracy, is trivial.
Remember that the cost of reserves is ignored in the formula method – but we learned in
the previous chapter that the cost of reserves should be taken into account. So this
method must be only of limited practical use.
Value of tax and other outgo
This is also normally best handled by adjusting the discount rate, though explicit
allowance may be made for the impact of tax on other specific elements of the
basis eg expenses or profit.
Value of profit to insurer
The formula above can be altered to include a specific profit objective to which
the discounted values are targeted eg 50% of an annual premium. This latter
criterion would be incorporated by subtracting 0.5 from the value of the
denominator.

So here our equation of value might become:
( -0.375 + 0.975ax: n ) P = value (benefits, expenses, etc) + 0.5P
value (benefits, expenses, etc)

P=
-0.375 + 0.975ax: n - 0.5
Drawbacks of formula approach
The above method has considerable attraction in the simplicity with which it
estimates the required premium; however with the advent of modern computer
processing power and the development of software packages, a more
informative approach can be easily undertaken. The formula approach:
• does not allow for the proper timing of events
For example, the assumption made about claim payments (above).
• does not allow for the accumulation of reserves

In fact, reserves are ignored completely when using this approach.
• does not allow for the impact of net negative cashflows in any period
In effect we assume that any capital needed can be borrowed at the discount rate
used.
• does not allow for separate inspection of premium related flows

We cannot track expenses, claims, premiums etc separately each year.
• does not allow for the variation in returns

The approach uses one fixed discount rate.
• does not properly allow for capital needs.

This is because reserves are not included in the formula approach.
Looking at the above list of drawbacks, it will be seen that most of them are only of
major concern when pricing long-term contracts. The formula approach can therefore
be useful for pricing short-term contracts.

2 Cashflow techniques
Cashflow techniques using spreadsheets were developed to overcome the
problems outlined in section 1. They now form the mainstay of insurance
company premium calculation, although they are not widespread for the private
medical insurance market if the policy term is the traditional one-year.
In some sophisticated territories, commercial software packages are now in

widespread use for healthcare products to handle both premium calculations
and reserve setting.
Sensitivity tests can be performed simply by varying the assumptions and

iterations can be incorporated to produce the premium that meets the
shareholders’ profit criterion. (See Section 3.4.)
Question 14.2
Why do you think cashflow techniques are not generally used when calculating
premiums for policies of one-year duration?
Short-term contracts
For short-term annually renewable products, a formula approach is likely to be used in

order to determine the premium required to meet expected outgo (and required profit)
during the policy year. Investment return may be allowed for, but this will be relatively
insignificant and may be ignored.
However, cashflow techniques may be used for other purposes:
● PMI business incurs higher expenses when a policy is first sold compared with
its renewal, and it is usual to spread the cost of the high initial expenses over the
expected number of renewals of the policy. Cashflow modelling is sometimes
used to quantify this.
● Once a premium structure has been determined for a short-term product,

cashflow techniques may also be employed to assess the adequacy of the
proposed premiums over a longer term. For example, the company may have a
long-term profit criterion (eg based on the expected present value of future
profits at a given risk discount rate) so the above techniques could be used over,
say, a ten-year period. Assumptions will be required for expected future renewal
rates and premium increases. This would be useful if the insurer wishes to limit
premium increases to a given percentage each year, for example.

Other than as referred to above, the rest of this section on cashflow pricing techniques is
relevant to long-term contracts only. There are more specific details on the pricing of
short-term products in Chapter 15.
Structure of a cashflow model
Each significant item of cashflow is projected and the interactions examined.

Typical elements of cashflow will include:
• premiums
• expenses
• commission
• claims
• contributions to unit reserves
• contribution to statutory reserves
• contribution to solvency margin
• interest on reserves
• yield on units
• policy fees
• management charges
• risk charge deductions
• tax.
You have met these techniques in earlier subjects. Don’t forget the different approaches
required for conventional (non-linked) contracts and for unit-linked. It is also important
to distinguish between physical cashflow (monies actually received or paid out) as
opposed to the notional flows arising from the supervisory reserving requirements.
Question 14.3
List the elements of physical cashflow that you would expect to see in a profit test
(pricing) model of the following contracts, identifying clearly which elements are
income and which are outgo:
(i) A regular premium conventional stand-alone critical illness policy.
(ii) A unit-linked stand-alone critical illness policy.
We consider in detail how we would quantify the expected claim costs for the different
healthcare insurance policies in the next chapter.

Question 14.4
Assume we have calculated the in-force expected cashflow for policy year t as:
CFt = {income for year t } - {outgo for year t }
which will include the relevant cashflows listed in the solution to Question 14.3. State
how the cashflows need adjusting to allow for the impact of the supervisory reserves,
both for conventional and unit-linked contracts.
The net cashflow will be investigated for the possibility of negative flows and
hence the need for additional reserves.
Question 14.5
The net cashflow will also be analysed to assess the adequacy of the premium in
producing the desired return for shareholders.
This is essentially what we do in order to calculate a premium using cashflow methods

– as we now describe in the following section.
2.1 Pricing
Here we examine how the model can be used for profit testing work on individual
products, thereby assisting in product pricing.
The model can be used to determine a premium, or charging, structure for a new
or existing product that will meet an insurance company’s profit requirement.
The insurance company should be continually monitoring the validity of premium rates
on existing business. The rates will need to be re-examined if the expected future
experience has changed from that foreseen when the premium basis was originally
devised.
A number of model points will be chosen to represent the expected new

business under the product. In the case of an existing product, the profile of the
existing business, modified to allow for any expected changes in future, can be
used to obtain the model points. For a new product, the profile of any similar
existing product combined with advice from the company’s marketing
department would be used.

The existing business used for model point selection will be that written recently. We
should then consider whether this mix of business is likely to change in the near future.
Question 14.6
One of your (newer!) actuarial colleagues has tested the profitability of an existing
contract on currently expected parameter values but has used the last ten years of new
business as a basis for model point generation. He argues that this gives a larger and
hence more valid data base from which to group policies. What significant influence on
product profitability is likely to have been misrepresented?
For each model point, cashflows would be projected, allowing for reserving and
solvency margin requirements, on the basis of a set of base values for the
parameters in the model.
Question 14.7
“If a company has the money to back the solvency margin for another policy then it can
write it, otherwise it can’t. I don’t see how else solvency margin considerations can be
relevant for a new product cashflow.” Comment.
The net projected cashflows will then be discounted at a rate of interest, the risk
discount rate, that allows for:
• the return required by the company; and
• the level of statistical risk attaching to the cashflows under the particular
contract, ie their variation about the mean as represented by the
cashflows themselves.
In other words, you would calculate the present value of the future profits generated by
the model, which will be the expected present value of the future profits (from a single
model point) and which is usually just referred to as the net present value.
Net in this context means that all positive and negative cashflows are combined to give
the profit for each time period of the projection. These profits should also be net of
appropriate taxation. Hence the company’s required return is also net of tax.
We have discussed how the risk discount rate is determined in Chapter 12.

Level of calculation
Individual policy level (model point)
The premium or charges for the model point can then be set so as to produce the
profit required by the company.
This implies a charging structure such that each model point satisfies the profit
criterion. For example, this might be to set the premium or charges such that the net
present value of the product is equal to, say, some desired proportion of the initial
commission payable under the contract. (We cover this fully in Section 2.2.)
The actuary can focus on particular model point products to fine-tune the
assumptions and produce the required premium levels. The model produced
can then be applied to other policies to achieve a rate of premium.
The problem with this approach is that it can generate very uncompetitive prices for
small policies.
Cohort level
Policies can be grouped or banded and average assumptions applied to the

cohort.
Thus the actuary may instead target total profitability, looking at the totality of model
points representing the expected new business mix for the product, accepting some
cross-subsidy inside that group of model points. (Note that a new-business model
would be required for this purpose – see Chapter 13.)
Office projections
At a higher level still, the actuary will want to be sure that the pricing of the product
will have a beneficial effect on the company’s overall financial position.
The actuary will use the flows obtained from the policies investigated and, using
estimated volume projections, build the policy projections into flows for the
product line and for the future office as a whole. The actuary will thus have
estimates of company revenues against which he/she can analyse future
solvency and investigate capital requirements.
We shall pursue this further in Section 3.2 below.
We will now look in detail at the profit criteria used for pricing.

2.2 Profit criteria
A profit criterion is often a single figure which tries to summarise the relative
efficiency of contracts with different profit signatures. By applying a profit
criterion to different contracts with different profit signatures and, by ranking the
results in order, it may be possible to say with confidence which contract makes
most efficient use of a company’s capital.
The profit signature of a contract is the sequence of profits over time from inception to
termination. You would normally present it graphically. The profit signature itself is
the “definitive guide” to a product’s profitability but is unwieldy to use (especially
when comparing different products), and to present.
Among the profit criteria that could be used are:

• net present value, expressed in different ways
• internal rate of return
• discounted payback period.
Net present value
Discounting the profit signature at the risk discount rate produces a “net present
value”. Given a choice between the future cashflows from two different
investments, economic theory states that an investor should choose the one
with the higher net present value. This choice is optimal, and cannot be
bettered. Another way to put this is that the first priority for the managers of any
company is to maximise the net present worth of the company.
This implies that net present value is the best profit criterion to use, and that if
any other profit criterion disagrees with it a company should go with the net
present value.
This important result depends on several assumptions including:

• It assumes that there is a perfectly free and efficient capital market.
• It assumes that when two risky investments are compared each is
discounted at a risk discount rate appropriate to its riskiness.
Question 14.8
How does the second point translate into the world of a healthcare insurance pricing
actuary?

There are also some practical points to bear in mind when using net present
value, including:
• It is subject to the law of diminishing returns. If it were not, then a
company which could sell one policy with positive net present value
could sell an unlimited number of policies and increase the value of the
firm without limit.
This can be illustrated by thinking about how it might apply in a real world context.
Suppose your company is selling a product with a net present value of £100. What is to
stop you selling this to the entire population of the country? Or selling more and more
of the same product to existing policyholders? The problem is this: after you have sold
the product to all those who actively wanted it, you then have to seek out other
customers and persuade them to purchase it. This will increase sale costs and reduce the
net present value of the policies. Eventually, as the market becomes more and more
saturated, the sale costs increase to the extent that the net present value of new policies
is zero.
• It says nothing about competition. There is no point in designing a

contract with a high net present value if it cannot be sold.
This is true, but it is also true about the other profit criteria here. Another way to think
about this is to say that you only want to study the profitability of saleable contracts.
How should net present values be expressed?
The net present value is by itself telling you relatively little – for instance, you could
double the net present value of some specimen contract by doubling the premiums of
the model points used in the profit test (in fact, if some of the expenses involved are
fixed, the net present value should more than double). In order to use net present value
results to compare different product designs, it is therefore necessary to find some
measuring standard by which the products’ results can meaningfully be compared.
Having said that, looking at the net present value in isolation can indicate one very
important thing.
Question 14.9
What important aspect does it indicate?
One approach is to express net present values in a way that reflects the effort
expended on selling a policy. One such measure is the amount of initial
commission paid to reward the salesperson.

This ties in with the intuitive approach that the sales motivator, commission (or
whatever sales costs apply to the distribution channel), should be in line with the
profitability of the contract that you are trying to sell. This will mean that both
insurance company and salesperson are rewarded in proportion to the amount of effort
the salesperson makes. It also means that, provided all products are priced to the same
criterion, the insurance company’s profits will still be in the same proportion to the
effort expended.
However the market for any insurance product is finite, and any one company
can probably capture only a small share of the total market. The policyholder
measures the cost of insurance in terms of the premiums he or she pays, and
industry trade associations often measure the size of market in terms of the
premium income of insurance companies – among other things. So another
useful measure of profit is in terms of the premium income, since this relates to
the size of the market.
The net present value can, therefore, be expressed as a percentage of the

present value of the premiums which will be paid under the policy. All other
things being equal, if a company can sell the same volume of premiums,
ie capture the same market share, for a higher net present value it should aim to
do so.
An advantage of this method is that it enables the company to focus its efforts on
increasing its market share, in the knowledge that the overall profitability of the
company will be appropriately increased as a result.
Question 14.10
“When measuring net present value in relation to premium size, you use total
discounted future premium income. So when measuring net present value in relation to
sales effort, you should use total discounted future commissions rather than just the
initial commission.” Comment.
Internal rate of return
This is defined as the rate of return at which the discounted value of the
cashflows is zero. All other things being equal, a company should prefer a
contract which has a higher internal rate of return. However, the internal rate of
return does not always agree with net present value.
The last statement means that a set of cashflows that has a higher internal rate of return
than another set of cashflows will not necessarily have the higher net present value.

Net present value may be more reliable in some cases, for example
• If there is more than one change of sign in the stream of profits in the
profit signature, there is not generally a unique internal rate of return.
• The net present value can be related to useful indicators of the policy's
worth to the company, in terms of sales effort or market share. There is
no way to do this with the internal rate of return.
• If a policy makes profits from the outset then the internal rate of return
may not even exist. The net present value always exists, however.
This last point is true, but apart from very short-term policies (including recurring single
premium types) it is unfortunately rare for profits to be made from the outset. In all
other cases contracts will have an internal rate of return. The most important feature
here is the fact that the net present value can be related to other measures, while the
internal rate of return cannot.
There is also the point that the internal rate of return is not actually telling you much
that the net present value does not. The net present value already tells you if the
product’s rate of return equals (or exceeds) the risk discount rate target. Knowing by
how much the internal rate of return exceeds that target is arguably not very useful
information.
On the other hand, the internal rate of return is a concept that may be generally easier to
understand.
Discounted payback period
The discounted payback period is the policy duration at which the profits which
have emerged so far have present value zero, ie it is the time it takes for the
company to recover its initial investment with interest at the risk discount rate.
A company with limited capital might prefer to sell contracts with the shortest
payback periods possible.
The discounted payback period will not usually agree with the net present value
as it ignores completely all the cash-flows after the discounted payback period.
That is, if you are comparing two streams of cashflows, the one with the shorter
discounted payback period will not necessarily have the greater net present value.

Which criterion?
Of the three criteria examined, the net present value is the most frequently used. Its
advantages over the internal rate of return have already been mentioned. The
discounted payback period does not by itself contain much information.
A common approach would be to use the net present value (expressed in terms of initial
sales costs) as the prime criterion, and also to make reference to the discounted payback
period. Hence, for a given net present value, you would choose the product design
which had the shortest discounted payback period. The discounted payback period is
therefore more use as a criterion in product design than in product pricing, though in
practice the two things (ie design and pricing) would very often be performed at the
same time, using the same models.

3 Other pricing considerations
3.1 Marketability
The premiums, or charges, produced need to be considered for marketability.

This might lead to a reconsideration of
• the design of the product, so as either to remove features that increase
the riskiness of the net cashflows, or to include features that will
differentiate the product from those of competing companies;
• the distribution channel to be used, if that would permit either a revision
of the assumptions to be used in the model, or a higher premium, or
charges, to be used without loss of marketability;
• the company’s profit requirement;
• whether to proceed with marketing the product.
The above considerations would also include re-examination of the assumed expenses
involved, notably the acquisition costs (eg commission), the marginal administration
costs and the required expense contribution to fixed overheads.
3.2 Model offices and capital requirements
The net cashflows in respect of the model points, appropriately scaled up for the
expected new business under the product, will be incorporated into a model of
the business of the whole company.
“Scaled up” here means multiplied up in order that the individual model point results
represent the expected new business. A full model office (as described in Chapter 13) is
required for this purpose.
It is possible for the desired level of profitability to be reached in aggregate,

without requiring every single model point to be profitable in its own right. If
certain model points are unprofitable the aggregate profitability of the business
is then exposed to changes in mix and volume of the contracts sold.
The actuary can further assess the impact in capital management terms of
writing the product, by observing the modelled amount and timing of cashflows.
This may, if capital is a problem, lead to a reconsideration of the design of the
product so as to reduce, or amend the timing of, its financing requirement.
Both the new business and full office models will be useful for this purpose. The
capital requirement should also allow for any supervisory minimum solvency margin
needed.

Question 14.11
Write down at least three disadvantages of writing capital intensive business.
Once acceptable premiums, or charges, have been determined for the model
points, premiums or charges for all contract variations can be determined.
For instance, the insurance company might use the model point cashflow approach for
pricing critical illness insurance policies with terms of 5, 10, 15 and 20 years for a
variety of ages (say 20, 30, 40, 50) and premium sizes (£20, £50, £150, £250, £500).
Intervening terms are then derived by interpolation. The company ends up with a set of
premium rates that should satisfy the profit criterion for every term, without the need to
profit-test all combinations of term, age and premium.
3.3 Return on capital
The net cashflows for the model points described in Section 2.1 can be grossed
up for the expected new business and used to assess the amount of capital that
will be required to write the product. This can be compared with the profits
expected to emerge from the product so as to determine the expected return on
that capital.
This is equivalent to the work performed on one model point in the above pricing
context, but here a group of model points is examined in order to quantify the capital
requirement and the return on that capital for all of the production expected from that
contract. Again, a new-business model will be used for this.
3.4 Sensitivity testing
Sensitivity tests should be performed at all stages of the pricing process, before deciding
finally on any pricing structure. It is necessary for the company to be confident that
different future scenarios from that expected will not lead the company into serious
financial difficulties.
This topic is fully covered in Chapter 19.

Chapter 14 Summary
Formula approach to pricing
Use equation of value. Discount cashflows by the rate of return expected on future
investment. Value all cashflows either:
● assuming they occur at the start of each year, but include an explicit cashflow for
investment income to adjust for timing differences, or
● allowing explicitly for their timing (the investment cashflow is then not needed).
Simple approach but has disadvantages, in particular does not allow for the cost of
capital. Used mainly for short-term contracts.
Cashflow pricing techniques
Used for long-term contracts.
Use single policy model on individual model points, or use a cohort approach and
accept some cross-subsidy (eg between large and small policies).
Find price by finding premiums (or charges) that satisfy the company’s profit criteria.
Profit criteria
These are usually based on single figure functions of the profit signature. Three
commonly used functions are:
• net present value (which can be expressed in different ways – see below)
• internal rate of return
• discounted payback period.
Net present value
The net present value of a profit signature is calculated by discounting it at the risk
discount rate. Economic theory implies that net present value is the best profit criterion
to use. However it is dependent on the risk discount rate being appropriate for the
inherent risk.
Net present value is normally expressed in relative terms such as:

● in proportion to initial sales costs
● in proportion to total discounted premium income.

This is defined as the rate of return at which the discounted value of the cashflow is
zero. It suffers from some disadvantages in comparison with the net present value as a
profitability criterion:
● It might not exist.
● It might not be unique.
● It can not be related to other indicators such as sales cost or premium income.
This is defined as the policy duration at which the profits that have emerged so far have
a present value of zero.
It is a useful reference for companies eager to recoup their initial capital investment in
as short a time as possible.
Which criterion?
The most widely used profitability criterion is net present value. In addition the
discounted payback period may be a useful measure if capital is particularly scarce, and
this can assist in designing capital-efficient products.
Other pricing considerations
Price must also be considered for:

● marketability
● whether the company has sufficient capital to finance expected sales volume
● whether the return on capital for the business as a whole is satisfactory.
Model office and new business models can be used to assess the last two points.
It is also essential that all prices are sensitivity tested at all stages of modelling.

Solution 14.1
To make the premium more aggressive, we need it to be cheaper. For this to be possible
we will need to earn a higher rate of return on our invested money. So a higher interest
rate will be “aggressive”.
Solution 14.2
They are not necessary! The premium for the year will be essentially the expected
present value of the benefits and expenses for the year of cover, plus appropriate
margins. (In addition, investment income will be relatively insignificant for short-tailed
business and may be ignored.)
The result is basically what you would get anyway if you did a cashflow projection for a
policy with a term of one year!
Solution 14.3
(i) Conventional policy
Income: premiums, interest.
Outgo: expenses, commission, expected claim costs, tax.
Note that the interest included here is only the return earned on the investment of the
other net cashflows during the year: it does not include interest that may be earned on
the supervisory reserves held.
(ii) Unit-linked policy
Income: premiums less bid value of units bought by premiums (ie premiums less cost of
allocation), monetary administration charges, charges to pay for cost of benefits, fund
management charges, interest (earned during year on non-unit cashflows).
Outgo: expenses, commission, expected cost of paying claims in excess of unit fund
value at date of claim, tax.
For both types of policy, expenses would be separately identified according to whether
they were initial, renewal or claim expenses, and commission as to whether it was initial
or renewal.

Solution 14.4
For conventional products the cashflow is adjusted to give the following profit flow for
year t:
PROt = CFt - D tV + i t -1V
where: D tV = increase in supervisory reserves over year t
= px +t -1 tV - t -1V
px +t -1 = probability that a policy in force at the start of year t is still in force at

the end of the year (assuming age x at entry)
tV = supervisory reserve for a policy in force at the end of year t
i = interest rate (expected return on assets), net of tax if appropriate.
For a unit-linked policy the formula is the same, but the reserves refer to the non-unit
reserves only (if any), and i is the interest on the non-unit assets.
Solution 14.5
All policies must be self-financing once they have come into force. All future negative
cashflows must therefore be covered by holding adequate (non-unit) reserves in advance
of them. By assessing the size of any negative future cashflows (using prudent
assumptions), we can assess the amount of reserves required in order to give us a high
probability of avoiding the need for additional finance for the policy in the future.
Solution 14.6
The main risk here is that the average assumed policy size will be wrong (too low in a
non-zero inflationary environment). Given a certain level of fixed per-policy
administration expenses, product profitability will be understated.
You could argue that the 10 years of data could form a better basis if you were to allow
explicitly for inflation. This is true as far as the average premium for all policies is
concerned. However it will misrepresent reality if the premiums for certain age groups
or “term groups” (or any other sections of the data) have changed relative to the other
new business premiums.

Solution 14.7
Holding a solvency margin for a policy will impinge significantly on the rate of return
earned on the capital required to write a policy. This arises from the assets underlying
the solvency margin earning less than the rate of return required to be earned by the
policy (ie the risk discount rate). That difference is often referred to as “cost of
solvency margin”.
For example, consider a single premium policy with premium 100. The acquisition
expenses and the difference between premium and valuation basis are such that the
reserves are 100 and the capital required to write the business is 10 (pre-statutory
solvency margin). The policy earns a return of 12% pa on this capital. The assets
supporting the policy reserves earn 6% net of tax.
What is the impact of holding a solvency margin set at 4% of reserves ? (Assuming that
the reserves conveniently remain at 100 for the policy duration.)
The capital required to write the business is now 14. The impact on the rate of return
depends entirely on what the solvency margin assets earn:
● If they earn 12% then the rate of return of the policy net of cost of solvency
margin remains 12%. However if the company can earn the same rate on normal
investments as it can on writing insurance business then it should stop writing
insurance business!
● If they earn 6% (net of tax) then the total rate of return is 10.3%. (An
investment of 10 earning 12% plus an investment of 4 earning 6% make an
investment of 14 earning 10.3%).
● If they earn 4% (net of tax) then the total rate of return is 9.7%.
In practice the situation will often be akin to the third scenario, where solvency margin
assets earn a similar gross rate to the assets underlying the basic policy reserves but
that income is then fully taxed.
Solution 14.8
This means that different products should be valued using different risk discount rates
appropriate to their inherent riskiness.

Solution 14.9
The sign of the net present value will immediately show if the cashflow has met the risk
discount rate target. If the net present value is positive (or zero) then the rate of return
on the cashflow exceeds (or is equal to) the risk discount rate.
Solution 14.10
In theory the statement is correct. However, it is much easier to use just the initial
commission rather than undergoing any discounting palaver. The loss in “accuracy” is
very slight for the following two reasons:
● Normally, the initial commission is much greater than renewal commission. So
commission payments subsequent to the initial commission are much less
significant than are the post-initial premium payments relative to the initial
premium.
● When using premium as a measuring standard, discounting future premiums
gives a relatively steady relationship “net present value/discounted future
premiums” as term varies. Now the initial commission will itself normally
reflect the term of the policy. Thus a longer term policy with more premiums
from which to generate profit will also have a larger commission. The
relationship “NPV/initial commission” should therefore be reasonably stable
with varying term.

Solution 14.11
All other things being equal, capital intensive business will give a lower rate of return.
(But this answer does not really count since the question implied “at parity of rate of
return”.)
It could lead directly to a problem with supervisory solvency.
Even if solvency is not immediately threatened, the reduction of capital could weaken
the company’s resilience to falls in the value of assets.
It will reduce the company’s apparent financial strength (often measured simply as free
assets in relation to the reserves).
It represents an opportunity cost, in that the company could use the same amount of
capital to write more business which is less capital intensive.
It could lead unexpectedly to a problem with statutory solvency if the company sells
much more of the business than anticipated.
Putting eggs in one basket – or rather too small a number of baskets. In theory, the
company will be less at risk of adverse experience if it uses capital to finance a large
number of non-capital intensive policies than if it uses it for a smaller number of more
capital intensive policies.




using the course.

Chapter 15
Pricing (2)
Syllabus objectives
– data availability
– equation of value
– formula approach
– cashflow techniques
– group risk assessments
– options
– guarantees
insurance:
∑ basic features
(The items in bold are partly covered in this chapter (see also Chapter 14).)

0 Introduction
In this chapter we cover the models used specifically to value the benefits payable under
the major health and care insurance contracts: income protection, accident and sickness
policies, critical illness, long-term care insurance, private medical insurance and cash
plans. The values obtained are then used within the pricing models described in the
previous chapter, either using the equation of value approach or cashflow modelling.
The pricing of group contracts is described in Chapter 16.
Other aspects of modelling (Chapters 13 and 19), and the chapters on setting
assumptions (Chapters 10-12 and 20) are all relevant to this topic also.

1 Income protection
Income protection is most commonly costed on an inception/disabled life
annuity approach.
We describe this method in Sections 1.3 and 1.4 below.
1.1 Multi-state modelling – introduction
The method described in Sections 1.3 and 1.4 is a simplification of a more

complex methodology, multi-state modelling, whereby policyholders are
separately tracked through the various stages of healthy and claiming as
follows:
• healthy premium payers
• lives falling sick within deferred period
• lives becoming claimants following deferred period
• lives recovering, reverting to premium payers
• lives dying
• etc.
Each subclass will have its own set of transition probabilities: sickness
inception, lapse, mortality, recovery, policy expiry. Depending on the
sophistication of the model, probabilities may vary according to the number of
previous times that the cohort has been ill and all transition rates may be a
function of the duration within that stage.
This kind of modelling should be fully familiar to you from Subject CT4. The
following is to revise the main things you need to know for Subject ST1.
Question 15.1
Draw a diagram showing all the necessary states and transitions for modelling the
process described by the above Core Reading.
You will remember that the modelling process requires assumptions for the transition
intensities between states. In general we can write a transition intensity as:
m xij = transition intensity at exact age x from state i to state j ( i π j ).

Question 15.2
Define precisely what m xij represents.
Additionally, some of the most important transition intensities have been given specific
symbols, by convention. For example:
s x = m xHS
where H = healthy, and S = sick.
Question 15.3
Define m x , r x and n x in terms of m xij notation, using H = healthy, S = sick and

D = dead (revision!).
You should also recall the notation used for the relevant probabilities. The following
example will remind you of the notation used.

Example
Interpret the following probabilities:
(a) t p xHH HD
(b) 5 p30 DS
(c) 5 p30 (d) t p xDD SS
(e) 3 p50
Solution
(a) t p xHH is the probability that a healthy life now aged exactly x will be healthy in
t years’ time. (Note that the life may have been disabled at some point in
between.)
HD
(b) 5 p30 is the probability that a healthy life now aged exactly 30 will be dead in
5 years’ time.
DS
(c) 5 p30 is the probability that a dead person now aged exactly 30 will be disabled
in 5 years’ time – so it will have a value of zero.
(d) t pxDD is the probability that a dead person now aged exactly x will be dead in
t years’ time – so it will have a value of one.
SS
(e) 3 p50 is the probability that a sick person now aged 50 stays continuously sick
until at least age 53.
1.2 Multi-state modelling – practice
Pricing using a multiple state modelling approach will be effected by determining

the proportion of lives in each status, using the relevant duration-based
intensities. The value of claims outgo will thus depend on the number of lives
within (one of) the benefit-receiving subcohorts, in a given month, multiplied by
the relevant average sum insured. Against this will be balanced the premium
coming from those in a premium-paying state plus the investment income, less
all relevant expenses and other outgoings in the appropriate month. Transition
intensities will be applied to each status to determine the numbers appropriate to
various cells for the next month.
The following question is a simple example of the calculations we might do.

Question 15.4
You are given the following transition probabilities, that apply for x = 55, 56, 57 :
HS HD
1 px = 0.020 1 px = 0.008
SH SD
1 px = 0.700 1 px = 0.150
(i) Calculate the projected numbers of healthy and sick lives at the end of each of
the next 3 years, for a population of 10,000 healthy people all aged exactly 55.
(ii) An IP contract is issued to a life aged 55 for a three-year term. A benefit of

£20,000 pa is payable during all periods of sickness. A level annual premium is
payable at the start of each year, ceasing after three years or on earlier death.
Premiums are waived during periods of sickness. Assume that sickness benefits
are payable continuously.
Calculate the annual premium, by a formula approach, using the following basis:
– sickness and mortality experience as defined in part (i)
– interest 5% pa
– ignore expenses.
(iii) You are given that the company holds the following reserves for the policy in
part (ii), which are expressed per (relevant) policy in force at the end of each
year, immediately before the payment of any premium that may then be due:
End of year: 1 2
Reserve per healthy policyholder 500 100
Reserve per sick policyholder 40,000 20,000
Calculate the profit signature for the policy, assuming:

– sickness and mortality experience as defined in part (i)
– rate of return on assets (during each policy year) of 7% pa
– ignore expenses.
We do not expect you to have to perform numerical examples of this length in the
Subject ST1 exam. The idea of the above (simple!) examples is to illustrate the kinds of
projections you would need to perform, in practice, in order to project IP cashflows
using multi-state modelling. You will, however, be expected to describe how you
would do these things, so the numbers should help you sort out what’s going on.

The calculations could be performed quite easily on a spreadsheet, although when doing
things by hand – as here – the number crunching can be significant.
In theory, the model could be very complex, with hundreds of subcohorts open
at any time.
Question 15.5
In Question 15.4, we only ever had two states “open” at each age – healthy and sick.
Explain where the “hundreds of subcohorts” referred to in the Core Reading might
come from, giving possible examples.
In practice, the lack of detailed statistics to estimate all of the transition

intensities and the avoidance of spurious accuracy will necessitate a more
straightforward and meaningful approach, such as the combination of various
subcohorts and reduction of number of transition intensities required.
The main thing is to avoid spurious accuracy. Care must be taken to ensure that the
results of any model we use are not heavily dependent on parameters that have very
little credibility.
Even with these approximations, the multi-state model will provide significant
insight into the robustness of any rating and reserving structure and allow
sensitivity testing to be performed – the latter is difficult with the
incidence/annuity approach.
The value of sensitivity testing as an actuarial tool should never be underestimated.

Even if we don’t have much confidence about any single projected outcome, the effect
on the outcome of varying the parameter assumptions can be extremely illuminating.

1.3 Valuing disability benefits using rates of claim inception and

claim termination: formula approach
(This is also called the inception and disability annuity approach.)
As we stated at the beginning of Section 1.1, this method is a simplification of the

multiple state model approach. It requires us to convert our multiple state model into a
multiple decrement table format.
This approach can be formalised using two double decrement tables. One table
relates to healthy policyholders and has decrements falling sick and dying. The
dependent initial rate of falling sick at age x , (aq )ix , is called the inception rate
for disability. This double decrement table is estimated so as to allow for
recovery and subsequent sickness.
(The disability inception rate is needed for when we need to use a cashflow modelling
approach: we cover this in Section 1.4 below.)
Assume that all lives are healthy at exact age x, and there are (al ) x of these lives.
During the year of age [ x + t , x + t + 1] (t integer) we will have:
● (ad ) dx +t lives dying from healthy
● (ad )ix +t lives becoming sick from healthy (using i for “inception” of sickness)
● (ar ) x +t lives becoming healthy from sick (using r for “recovery”)
So:
(al ) x +t +1 = (al ) x +t - (ad )dx +t - (ad )ix +t + (ar ) x +t
There are two very important things to notice here:

● lives who recover from sickness re-enter the healthy (and hence exposed-to-risk)
population
● individual lives can be counted more than once in either or both of (ad )ix +t and
(ar ) x +t , both in the same year of age and (more commonly) in different years of
age.
So, as stated in the last sentence of the previous Core Reading paragraph, the table
allows for lives to become sick and recover again any number of times over any given
range of age.

Now consider the force of transition from healthy to sick, which in multi-state notation
is usually written as s x +t . Because we are now in a multiple decrement world, we need
to express s x +t using appropriate multiple decrement notation, ie:
s x +t = (a m )ix +t
Question 15.6
Write down an integral expression for (ad )ix +t , using symbols defined in this section.
The second table (of the two multiple decrement tables) relates to policyholders
receiving disability benefits, and has decrements of recovery from disability and dying
(while disabled). The “survival” (ie neither-recovering-nor-dying) probabilities from
this double decrement table are used to determine the present value of a disability
annuity, payable until the policyholder dies or recovers, or until the expiry of a specified
number of years, whichever occurs first.
We might write the disability annuity value (for a continuously payable sickness benefit
of £1 pa) as a xi : n , with i representing a currently sick (“ill”) life, x is the current age and
n is the maximum number of years of sickness payments. a xi : n is sometimes called a

current claim annuity value, because it only includes sickness benefits payable for the
future duration of the current period of sickness. A presently sick life may have several
future periods of sickness (separated by healthy periods), but none of the subsequent
bouts are included in this annuity value.
Example
Write down integral expressions for the expected present value (EPV) of a sickness
benefit of £1 pa, payable to a currently sick life aged 40, including “current claim”
benefits only:
(a) assuming benefits are paid for the whole of life
(b) assuming all benefits cease at age 65 (or on earlier death).

Solution
Using multiple state notation (as defined in Section 1.1) we would have:
•
(a) i
EPV = a40 = Ú vt t p40
SS
dt
0
25
(b) i
EPV = a40:25 = Ú vt t p40
SS
dt
0
The examination tables tabulate sample values for disability benefits.
You will find examples of the current claim annuities of type (b) (ie with benefits
ceasing at age 65) in the section of the S(ID) Tables on page 139, under the heading of
“current status = sick”. However, you will also see that these values are specific to the
current duration of sickness, z.
We need to worry about duration because many disability contracts only pay benefits
for a limited duration. You may also come across a number of types of period during
which no benefit is payable (eg deferred period).
Question 15.7
Give two examples of why we might need to take duration of sickness into account
when valuing policy benefits.
Question 15.8
i
Using the Tables, write down the value of a40:25 for a life who has:
(a) just become sick

(b) already been sick for exactly one year
and comment on the differences.
From here on, unless stated otherwise, when we use axi or a xi : n we will be referring to a
life who has just become sick at age x (ie who has current duration of sickness 0 years).
Now let’s value disability benefits for a healthy life.

The value of a disability benefit of £1 pa payable continuously to a healthy life

now aged x is:
t =•
(al ) x + t
Ú (al ) x
(a m )ix + t .v t a xi + t dt
t =0
This integral is a simple composition of four elements:

(al ) x +t
● the probability that x is alive and well at time t ie
(al ) x
● the probability of falling sick in time interval d t ie (a m )ix +t d t
● the value of the annuity then payable on sickness a xi +t
● discounting factor v t .
Summing over all future periods and letting the time interval d t Æ 0 gives us the
integral as shown.
In practice, benefits payable under long-term sickness insurance contracts will usually
cease at retirement.
Question 15.9
Write down an integral formula for the expected present value of a sickness benefit of
£5,000 pa, for a healthy life aged exactly 40, where all benefits cease at age 65 or on
earlier death. Assume there is no deferred period under the policy.
You will find functions that will enable you to evaluate formulae of the type you
constructed in Question 15.9 in the Tables, on Page 139. We need to look under:
● “current status = healthy” and
● “deferred period d = 0”.
Question 15.10
Calculate the expected present value of the benefit described in Question 15.9, assuming
S(ID) sickness and mortality experience, and 6% pa interest.

In the Tables, the value of the disability annuity ceasing at age 65 is written as
axHS (0 / all ) , whereas a more general notation would be a HS (0 / all ) , indicating that
x: n
benefits cease after n years or on earlier death. Using this more general notation, the
tabulated values are actually a HS (0 / all ) .
x:65- x
Question 15.11
Explain any differences between the values of the following functions:
HH
(a) 5 p40
(al )45
(b) for a population assumed to be all healthy at age 40
(al ) 40
(al )45
(c) for a population assumed to be all healthy at age 35.
(al ) 40
So, when valuing disability benefits, we will need a different multiple decrement table
for healthy lives depending on the age at entry (at which point all the policyholders
must be healthy). This is the idea that is followed in the Tables.

Question 15.12
A disability insurance policy pays a benefit of £6,000 pa while the policyholder is sick.
There are no deferred or waiting periods and all benefits cease on reaching age 65 or on
earlier death. Premiums are waived (that is, they are not payable) while the
policyholder is sick. Otherwise, level annual premiums can be assumed to be payable
continuously until age 65 or until earlier death.
Calculate the annual rate of premium payable by a new policyholder aged 45, according
to the following basis:
● Sickness: as defined by the S(ID) Tables
● Interest: 6% pa
● Mortality: ELT15 (Males)
● Expenses: initial: 60% of the annual rate of premium
regular: £20 pa, assumed incurred continuously in all years
including the first
claim: 1.5% of all sickness benefits while in payment.
(You can assume that the mortality underlying the S(ID) tables is consistent with
ELT15 (Males).)
Approximate calculation of the integral
Recall the expected present value of the disability annuity payable for the whole of life
to an initially healthy life (x):
• (al ) x +t
Ú0 (al ) x
(a m )ix +t vt a xi +t dt
The usual method of calculating the value of such benefits is to assume that
lives becoming disabled in ( x + t , x + t + 1) do so on average at age x + t + ½ (for
all integral x and t ) and to approximate this integral using:
t =• (ad )ix +t v x + t + ½ a xi +t + ½
Â (al ) x v x
t =0
This enables commutation functions to be defined and used for the valuation of these
benefits (but these are not required knowledge for the ST1 exam!).

Valuing benefits that vary by duration of sickness
For example, using the notation of the S(ID) tables, we can define:
a HS ( d / all )
x: n
to be the expected present value of a disability annuity of £1 pa, payable for n years or
until earlier death, to a healthy life now aged x, where only benefits paid at durations of
longer than d years are included. d is the duration of sickness measured from the time
of first becoming sick.
We can also define functions of the form:
a HS ( a / b)
x: n
to represent the expected present value of a disability benefit of £1 pa paid only for
durations of disability of between a and b years, ceasing at age x + n or on earlier death.
For example, a possible integral formula for a HS ( d / all ) is:

x:65- x
65- x - d (al ) x +t
a HS ( d / all ) = Ú (a m )ix +t d p xSS+t vt + d axi +t + d :65- x -t - d , d dt
x:65- x 0 (al ) x
where:
d p xSS+t = “survival” probability in the sick lives’ double decrement table
a xi +t + d :65- x -t - d , d = the value of the “current claim” sickness annuity for sick lives
(ceasing not later than age 65), with current (starting) sickness
duration of exactly d years).
In Subject ST1 it is important that you can understand the figures presented in the
Tables and to be able to use them to calculate numerical solutions to simple problems.
It is unlikely that you will be required to construct the above integral in the exam:
however understanding how the tabulated functions are constructed should help you to
use them properly in numerical questions. So, if you are happy with where the formula
has come from, skip the next two paragraphs. Otherwise, read on …

Let’s go through this carefully. The probability that the healthy life aged x becomes
sick at exact age x + t is (approximately, assuming d t is a very small finite time
interval):
(al ) x +t
(a m )ix +t d t
(al ) x
The probability that this life is still sick d years later is d p xSS+t . The present value of the
benefits (that will start at age x + t + d provided both of the above things happen) is
a xi +t + d :65- x -t - d , d discounted for t + d years. Multiplying the present value by the
probabilities, summing over all possible values of t between age x and age 65 - d , and
taking the limit d t Æ 0 + gives the above formula.
Example values of this function (for d = 0,1, 2 and n = 65 - x ) are given in the S(ID)
tables, which we can use to calculate values as in the following example and question.
Example
A disability insurance policy pays the following rates of benefits while sick:
● first 12 months of continuous sickness: nothing
● second 12 months of continuous sickness: £6,000 pa
● all continuous periods of sickness in excess of 24 months: £11,000 pa.
Use the assumptions of the S(ID) tables to calculate the expected present value of these
benefits to a new policyholder aged exactly 50 (assuming all benefits cease at age 65 or
on earlier death).
Solution
The EPV is: 6, 000 a HS (1/ all ) + 5, 000 a HS (2 / all )

50:15 50:15
which reads as:

“the value of £6,000 pa payable at all sickness durations of 1 year or more”
+ “the value of £5,000 pa payable at all sickness durations of 2 years or more”
(so that, at durations of 2 years or more, the total benefit valued is at the rate of £11,000
pa, as required).
\ EPV = 6, 000 ¥ 0.247810 + 5, 000 ¥ 0.184025 = £2, 406.99 .

Question 15.13
Calculate the value of the following disability annuities, all payable to age 65 or to
earlier death, and all to a healthy life currently aged 40.
(i) £5,000 pa payable at all sickness durations exceeding 2 years.
(ii) £6,000 pa payable at all sickness durations of less than 2 years.
(iii) £7,000 pa payable at all sickness durations of between 1 and 2 years.
So we see from Solution 15.13 that:
a HS ( a / b) = a HS ( a / all ) - a HS (b / all )
x: n x: n x: n
1.4 Inception/disabled life annuity approach: cashflow method
The approach described in Section 1.3 is appropriate for calculating premiums using the
formula method. The inception and disability annuity methodology is, however, also
suited to pricing income protection policies using cashflow techniques.
As its name suggests, it considers two functions, namely the claim inception
rate and the disabled life annuity.
The claim inception rate, i dx , is the probability that a claim will become payable
to an individual in the year of age x to x + 1 . Thus the individual will have
become sick d weeks or months (or years) earlier and remained so to benefit
commencement.
“Claim inception rates” are derived from “sickness inception rates” by

multiplying the probability of sickness inception by the probability of remaining
sick throughout the deferred period.

In full, this claim inception rate would be accurately defined as:
1 ( al ) x - d + r
ixd = Ú (a m )ix - d + r d p xSS- d + r dr
0 (al ) x - d
using our earlier notation, where:

● lives are assumed to be all healthy at some initial age x0
● claim inceptions are commencing in the year of age [ x, x + 1] .
This can be approximated by:
È 1 (al ) x - d + r ˘
ixd Í Ú (a m )ix - d + r dr ˙ d pxSS- d +½
Î 0 (al ) x - d ˚
Now:
1 ( al ) x - d + r(a m )ix - d + r dr (ad )ix - d

Ú0 (al ) x - d
=
(al ) x - d
= (aq)ix - d
ie the disability inception rate defined in the Core Reading at the start of Section 1.3.
So our claim inception rate can be written as:
ixd (aq )ix - d d p xSS- d +½
ie as the product of a sickness inception rate and the probability of remaining sick
during the deferred period – as stated in the Core Reading.
The following is then the expected number of claim inceptions of deferred period d
years, arising in the year of age [ x + t , x + t + 1] , per policy taken out at age x:
(al ) x +t - d d
ix + t
(al ) x
We now need to multiply this by the appropriate disability annuity value.

The disabled life annuity is the present value at the date of claim inception of
expected claim payments to individuals disabled after the deferred period until
policy expiry. Allowance is made for any escalation of the claim amount, interest
and the probabilities of death and recovery between the end of the deferred
period and expiry date.
Claim inceptions will occur, on average, half way through the year of age. So the
expected present value of the cost of claim inceptions occurring in the year of age
[ x + t , x + t + 1] , valued at the middle of the year per initial policyholder aged x, would
be:
(al ) x +t - d d
EC x +t = ix +t B a xi +t +½:65- x -t -½ , d
(al ) x
where B is the annual amount of sickness benefit (payable continuously), d is the

deferred period, and it is assumed that benefits cease at age 65.
Within the cashflow programme then, the claims outgo in any period is taken as
the lump sum value of the benefit (annual amount multiplied by disabled life
annuity) multiplied by the probability of becoming eligible for claim (claim
inception rate).
Using the S(ID) Tables, and linkages between CMIR12 and Exam
Tables booklet
There are several valid, but slightly different, approaches to the claim inception and
disability annuity method. The Formulae and Tables S(ID) approach uses central rates
of claim inception, which are based on the rates published in The Continuous Mortality
Investigation Bureau Report (Institute and Faculty of Actuaries) No. 12.
The Core Reading in this subsection has two purposes:

(1) to explain the functions that are tabulated in the S(ID) tables, so that you can use
them for simple numerical calculations
(2) to provide a background to the claim inception rates given in the S(ID) tables by
referring back to their source (CMIR12), and relating these to the claim
inception rates we have looked at so far.
In the exam, you would not be expected to demonstrate any further knowledge of
CMIR12, other than the facts contained in the Core Reading in this subsection.

Formulae and tables for the examinations
Leaving aside its foray into the Manchester Unity method, which is outside the
scope of this course, the exam tables booklet produces three tables, based on
the results presented in CMIR12. These are:
● claim inception rates
● present values of current claim sickness annuities
● present values of annuities during sickness for lives currently healthy.
We have defined (and used) the two tables of annuity rates already in Section 1.3. The
following paragraph provides a summary of what you should now already know.
The annuity values relate to sickness benefits payable continuously and ceasing
on death, recovery or attainment of 65. They are dependent on deferred period,
for premium calculation, or on current duration of sickness, for reserve
calculation. The former allow for all future episodes of sickness; but the latter
annuities estimate the value of the current benefit only. The survival
probabilities from the double decrement table are combined with an appropriate
interest rate to determine the relevant present value.
(Note that, as earlier, the “survival” probabilities referred to above are the probabilities
of “not leaving” by either cause of decrement.)
The inception rates are, however, different.
The claim inception rates are central rates, tabulated by age at claim
commencement, x, and prior deferred periods, d, in years. Thus the age at
commencement of sickness will be x - d . These are denoted by (ia ) x , d . They
will be applied to an exposed to risk comprising all lives living between ages x
and x + 1 , to be consistent with the approach in CMIR12.
So:
1
Ú (al ) x-d +r (a m ) x -d +r d px -d + r dr
i SS
(ia) x, d = 0 1
Ú0 lx +r dr
where l x is the expected number of survivors (healthy and sick lives combined) out of
l x0 lives who were initially all healthy at age x0 .

We would approximate:
1
Ú (al ) x -d +r (a m ) x -d +r d px -d +r dr
i SS
(ia) x, d 0
l x +½
where the numerator is:

● the number of claim inceptions during [ x, x + 1] for which sickness commenced
d years earlier
and the denominator is:

● the number of lives surviving to age x + ½ .
These rates are shown on page 138 of the S(ID) Tables, for x0 = 30 (only).
Thus for an initially healthy life aged 30, the expected number of claim inceptions of
deferred period d years occurring in the year of age [ x + t , x + t + 1] would be:
t +½ p30 (ia )30 +t , d
where t +½ p30 is just the probability of (30) surviving for at least t + ½ years.
So, using these central claim inception rates, the expected present value of the cost of
claim inceptions occurring in the year of age [ x + t , x + t + 1] , valued at the middle of the
year per initial policyholder aged x, would be:
EC x +t = t +½ p x (ia ) x +t , d B a xi +t +½:65- x -t -½ , d
where B is the annual amount of sickness benefit (payable continuously), d is the

deferred period, and benefits are assumed to cease at age 65, as before.

Example
You are given the following policy details and basis:
Deferred period: 1 year.

Ï£25, 000 pa for first year of sickness after expiry of deferred period
Benefit: Ì
Ó£15, 000 pa for all subsequent periods of continuous sickness
Entry age: 30
Expiry age: 65
Morbidity: S(ID) in the Tables
Mortality: English Life Tables No. 15 (Males)
Interest: 6% pa.
Lapses: Ignore
Calculate the expected claim cost, per policy issued, for the fourth and fifth years of this
policy. Express your answer in mid-year values.
Solution
In general, for the year [t , t + 1] the value is:
i
t +½ p30 (ia )30 +t ,1 a30½ +t:34½ -t ,1 ¥ 25, 000
i
- v t +1½ p30 (ia )31+t , 2 a31½ +t:33½ -t ,2
¥ 10, 000
(Note that the first part of the formula includes £10,000 pa too much benefit for
sickness durations of more than two years, which is why we need the deduction in the
second line.) The calculations are as follows:
Item Year 4 ( t = 3 ) Year 5 ( t = 4 ) Notes
t +½ p30 0.996687 0.995663 (1)

(ia)30+t ,1 0.000641 0.000709
i
a30½ +t:34½ -t ,1
3.8909 3.9843 (1)
t +1½ p30 0.995663 0.994557 (1)

(ia)31+t ,2 0.000371 0.000416
i
a31½ +t:33½ -t ,2
5.8021 5.8831 (1)

So the expected mid-year values of the claim costs, per policy in force at the start of
each year, are:
Year Expected mid-year value
0.996687 ¥ 0.000641 ¥ 3.8909 ¥ 25,000

4 0.995663
- ¥ 0.000371 ¥ 5.8021 ¥ 10,000 = 41.93
1.06
0.995663 ¥ 0.000709 ¥ 3.9843 ¥ 25, 000

5 0.994557
- ¥ 0.000416 ¥ 5.8831 ¥ 10, 000 = 47.35
1.06
Notes
(1) These have been calculated by interpolating between the values of the adjacent
integer ages.
Question 15.14
Calculate the expected mid-year claim costs for the first three years of this policy, per
policy issued.
This approach (ie using central claim inception rates as defined in the Tables) gets more
complicated if we wish to allow for lapses. If, in the Subject ST1 exam, you are
required to include lapses as well, you would be unlikely to be given such a complicated
example.

CMIR12
The CMIR12 model flits from sickness inception intensities to claim inceptions
with little signal; students are warned to watch for references. CMIR12 defines
two claim inception rates, type (a) and type (b):
ca( x , d )
ia( x , d ) =
Lx
and
cb( x , d )
ib( x , d ) =
Lx
where
ca ( x , d ) = the expected number of periods of sickness which pass through

duration d between attained ages x and x + 1 (sickness
commencing between ages x - d and x + 1 - d )
cb( x , d ) = the expected number of periods of sickness which pass

through duration d between attained ages x + d and x + d + 1
(sickness commencing between ages x and x + 1 )
Lx = the average number living (healthy and sick) between ages x

and x + 1 .
So ib( x, d ) differs from ia ( x, d ) in that we are referring to lives who become sick in the
year of age [ x, x + 1] , as opposed to those whose claims begin in that year.
It is important that the rates ia( x , d ) and ib( x , d ) are applied to the entire in-
force, not just those premium paying – otherwise adjustments must be made.
The exam tables above have used the type (a) probabilities (rewriting them as
(ia ) x , d ).
Similarly it would be consistent for us to write ib( x, d ) as (ib) x, d .

Question 15.15
(i) Write down an integral expression for (ib) x, d , equivalent to the one we defined
for (ia) x, d earlier in this section.
(ii) If B is the annual benefit level paid continuously, d is the deferred period and 65
the expiry age, write down a formula for EC x +t : the expected present value of
the cost of claim inceptions occurring in the year of age [ x + t , x + t + 1] , valued
at the middle of the year per initial policyholder aged x. Your answer should
include the function (ib) x, d .
1.5 Comparison of methods used to cost IP benefits
So, in summary, IP benefits can be costed either using cashflow techniques or

formula-based techniques. These were described in Chapter 14.
A cashflow technique considers each future time period separately. It can be used:
● to identify the expected benefit payment (and other cashflow items) during each
future time period, using a multi-state model approach (described in Sections 1.1
and 1.2), or
● to identify the expected present value of future payments in respect of claims
that incept during each future time period – this is the cashflow approach to the
claim inception / disability annuity method (described in Section 1.4).
Alternatively, a formula approach can be used, where the present value of future claims
over all future time periods is used – for example, the formula approach to the claim
inception / disability annuity method (described in Section 1.3).

2 Critical illness
The approach for critical illness is much simpler than for income protection, as the
benefit is a lump sum rather than an income.
A relatively simple approximation for risk premium rates for an accelerated

critical illness policy (ie one where the benefit is paid out on the earlier of death
or critical illness) can be derived:
i x + (1 - k x ) q x
where
ix is critical illness incidence rate

kx is proportion of deaths due to critical illness
qx is mortality rate
These all relate to expected experience over the year of age [ x, x + 1] for a life currently
aged x.
By general reasoning we can feel comfortable with this formula, the expression
‘ k x q x ’ reduces the critical illness incidence rate to allow for those deaths that
were caused by a critical illness and are already included within the mortality
rate.
You can equally well think of this the other way round: the expression (1 - k x ) qx
reduces the mortality rate to allow for those deaths that were caused by a critical illness
and are already included within the critical illness incidence rate.
Similarly we should express the stand-alone cost as a rate. It is simply
i x ¥ {probability of surviving the survival period}
Question 15.16
Explain this formula.
These formulae are applied to each critical illness definition separately, and then
combined to provide the overall risk premium for critical illness cover.
By “critical illness definition” we mean “cause of claim”. We saw this in Chapter 10

when we considered how to determine the critical illness assumptions.

Thus we might have:
ixd = critical illness incidence rate due to cause d
where d might include:

hd: heart disease
s: stroke
c: cancers
o: other causes.
So the overall critical illness incidence rate would then be:
ix = ixhd + ixs + ixc + ixo
and this would then be used in the formula for the accelerated death benefit or stand-
alone policy as appropriate.
The expected claim cost is then found by multiplying the claim incidence rate by the
critical illness sum assured of the policy.
Overlaps in incidence of certain critical illnesses may be allowed for explicitly.
Overlaps arise where more than one allowable critical illness cause underlies the same
individual claim. Thus it is possible for a person to suffer both from cancer and from
heart disease, for example, but only one claim will be paid under the policy. This
should be automatically taken care of if the assumptions for the incidence rates have
been derived by analysing claim experience data, provided care is taken to attribute each
observed claim to a single (ie main) cause only.
The situation is harder, though, if we are using population medical records to estimate
future claim rates. The medical data may record disease incidence (by cause) without
necessarily indicating whether other diseases are present at the same time. Double
counting is therefore possible.
Question 15.17
Why should the company be not too concerned about double counting for stand-alone
critical illness rates?

Question 15.18
Explain how double-counting could cause problems for the claim-accelerated CI

contract.
This process can be used in any profit-testing methodology, whether single-state

or multi-state. Note that the derivations of the above formulae are not required
of students taking Subject ST1.
However, everything included in the preceding pages is required!

Example
You have estimated the following critical illness incidence rates for lives aged 50 from
population data:
Cause of illness Rate

Heart disease 0.00080
Stroke 0.00005
Cancer 0.00100
Other causes 0.00035
You are told that 10% of all heart disease cases were also included in the cancer data.
The causes of death for the year of age 50 to 51 in the general population are assumed to
be as follows:
Cause of death in year of age [50, 51] due to: % of deaths at age [50, 51]
Critical illness incepted in year of age [50, 51] 5%
Critical illness incepted prior to age 47 3%
Calculate the claim inception rate at age 50 for:

(a) a stand-alone critical illness policy
(b) an accelerated critical illness policy
if:
(i) it is the first year of the policy

(ii) it is the second year of the policy
(iii) it is the third year of the policy.
Assume a mortality rate (all causes) of q50 = 0.0025 , and that all lives are initially
healthy when they take out a policy. Ignore the survivorship requirement for the stand-
alone critical illness policy. State any other assumptions you make.

Solution
(a) Stand-alone policy
The stand-alone critical illness inception rate will be the same for all policy durations at
age 50 (provided there are no temporary initial selection effects on critical illness rates).
This will be:
i50 = 0.00080 + 0.00005 + 0.00100 + 0.00035 - 0.1 ¥ 0.0008
= 0.00212
(b) Accelerated critical illness policy
This is a bit of a catch question! We need:
i50 + (1 - k50 ) q50
such that (1 - k50 ) is the proportion of deaths due to all causes other than critical illness.
So:
k50 = 0.05 + 0.15 + 0.25 + 0.10 + 0.03
= 0.58
So the claim inception rate (for any policy duration) is:
0.00212 + (1 - 0.58) ¥ 0.0025 = 0.00317
This also assumes that critical illness incidence rates, and mortality from all other
causes, do not vary by policy duration.
(This is an extremely unlikely situation, but given the information available in the
question, there is little else that can be done here!)

3 Long-term care insurance

The approach to pricing LTCI is very similar to that of income protection in
section 1 above – one can chose between the inception-annuity methodology or
multi-state modelling.
Question 15.19
A long-term care insurance policy has three different benefit levels:
(1) £20 per day if requiring a certain level of care in order to continue living in own
home.
(2) £50 per day if requiring residential (non-nursing) home care.
(3) £150 per day if requiring residential nursing home care.
Define a suitable multiple state model, and give an integral formula for the expected
present value of the benefits for an initially healthy policyholder aged 70. Define the
symbols you use.
You can assume that it is not possible for someone to move from one benefit level to a
lower one.
Question 15.20
Describe how an inception and disability annuity approach could be used to value the
policy benefits defined in Question 15.19, for a new policyholder aged 70. You should
additionally assume that all lives who claim under the policy move between benefit
levels in order of increasing payment (ie it is not possible to start claiming at benefit
level (2) without first receiving benefit at level (1), for example).

4 Private medical insurance

The risk premium of a short-term insurance policy is the element of the premium
required to cover only the expected claim amount. It includes no allowance for
expenses, profit, etc. These are added in later.
The process involved in deriving a risk premium is as follows:

● Choose a base period over which to collect claims and exposure data.
● Collect data, checking the accuracy and appropriateness of the data.
● Split data into homogeneous groups.
● Analyse the data, eg to identify trends, etc.
● Adjust and project forward to obtain future risk premiums, ie the expected claim
amount over the period that policies covered by the premium rates will be in
force.
Risk premiums will be calculated for each product and level of cover (eg hospital band).
Private medical insurance is priced on an incidence x average claim cost basis.

More formally,
Risk Premium (age, sex) = Â ik ¥ ACk
where ik is the incidence rate for benefit/procedure class k

and ACk is the average claim cost for benefit/procedure class k.
ik and ACk are specific to each age and sex.
The summation is over all classes k.
Risk factors in addition to age and sex may also be built into the above formula. For
example, incidence rates may also differ according to location, occupation, and the
number of people covered by the policy. Age bands (eg 5-year or 10-year bands) may
be used rather than individual ages in order to ensure there are sufficient data in each
cell, or perhaps because the product is priced in these age bands.
The formula above will be adjusted for excesses and the presence of a No Claim
Discount rating structure, if one exists.
Question 15.21
Explain the terms “excess” and “no claims discount (NCD) rating structure” (without
looking them up in the glossary!).

Question 15.22
Suggest how you might allow for an excess in calculating the risk premium.
Additional modelling would be required to determine the long-term effect of an NCD

rating structure.
Multi-state modelling will be used if long-term guarantees are present.
If premiums are guaranteed for a period longer than one year, the approach to pricing
may be similar to that of a long-term product.
Ultimately the sex-specific premiums may be combined in the office premium

calculation.
We would want to do this if we wished to charge the same premium rates to males and
females. To do this, we would have to weight the sex-specific rates in proportion to the
expected ratio of males to females amongst the people taking out policies.
Question 15.23
Can you suggest a possible problem with this approach to pricing?
Depending on market practice, available information and risk aspects in

particular territories, the risk premium determinants may be extended beyond
age and sex, eg location, hospital band, smoker status, occupation.
What competitors do in this respect is often the most significant driving force towards
having more risk classification factors.

5 Accident and sickness

We described these policies in Chapter 1.
Short-term accident and sickness insurance is often provided (in conjunction

with life and unemployment benefits) to protect loan repayments. As with
Income Protection, the rating method often follows the inception/annuity
approach. However, an average rate is often agreed for a particular lender/
scheme, and this brings another layer of complexity to the rating formula. Large
schemes tend to be rated using the “group” techniques described in the next
chapter.
Remember that accident and sickness policies will only provide regular payments for a
few years (usually less than five), but otherwise are very similar to the income
protection design.
The idea of an “average rate” applicable to the lender or scheme is to charge the same
premium rate (ie per £ of loan) to all policyholders, regardless of their age, sex, etc.
The “group techniques” referred to include such things as experience rating (described
in the next chapter).

6 Cash plans
Cash plan premiums are calculated by first calculating the expected claims for
each of the benefits – typically an inception rate multiplied by average benefit
expected to be paid. The expected benefit will take account of any excesses or
co-insurance factors that apply.
Question 15.24
List the benefits that would be provided on a typical cash plan contract.
Some benefits will provide indemnity of costs up to a maximum annual limit. For
example, the cash plan may reimburse 50% of physiotherapy treatment costs up to a
maximum of £200 in any one year. In this case, the expected average cost of the benefit
would be used in the premium calculation, rather than the benefit amount. The use of
co-insurance (with the policyholder) is common in order to reduce anti-selection and
keep premiums at an affordable level.
Excess or co-insurance (with the policyholder) can also apply to benefits that are fixed
in amount by the policy conditions. These can occur because, while the amounts of
benefit may be fixed, the total number of payments associated with a single claim event
might not be. For example, these plans often provide a fixed payment per day spent in
hospital. So an excess might apply such that the policyholder only receives benefits for
(eg) the fourth and subsequent consecutive days of hospital stay.
For many of the benefits approximations are made, depending largely on the
company’s previous claim experience. Difficulties can arise in establishing a
suitable age (range) estimate on which to determine a flat rate.
This is because the same rates of premium are charged for these contracts over broad
ranges of ages, even though claim incidence may vary significantly by age for some
benefits.
The total calculated is then adjusted to take account of ‘inertia’ – that is people’s
propensity NOT to claim even when they are entitled to. This arises for two
(related) reasons. The first is that individuals may buy the plan with a particular
benefit in mind, and tend to forget the rest of the cover provided by the policy.
The second is that the size of the benefits in absolute terms tends to be small –
and this combined with ‘customer apathy’ lead to many otherwise valid
payments NOT being claimed.

Of course, if the “inertia” is already in the claims experience data (eg the company’s
own claims data are used), no further adjustment would be required – unless the extent
of the inertia has changed or is expected to do so. The level of inertia might change if,
for example, the product was marketed differently or there was a change in the market
making people more aware of cash plan benefits.

7 End of Part 2
Review
Before looking at the Question and Answer Bank we recommend that you briefly
review the key areas of Part 2, or maybe re-read the summaries at the end of Chapters 9
to 15.
Assignments
Reminder
If you have not yet booked a tutorial, then maybe now is the time to do so.

Chapter 15 Summary
Income protection
IP benefits can be costed either using cashflow techniques or formula-based techniques.
A cashflow technique considers each future time period separately. It can be used:
● to identify the expected benefit payment (and other cashflow items) during each
future time period, using a multi-state model approach, or
● to identify the expected present value of future payments in respect of claims
that incept during each future time period – this is the cashflow approach to the
claim inception / disability annuity method.
Alternatively, a formula approach can be used, where the present value of future claims
over all future time periods is used.
Income protection – multi-state modelling
Policyholders are separately tracked through the different states of healthy, sick within
the deferred period, sick and claiming, dead, and lapsed. Assumed forces of transition
between states are used to project the probabilities of being in particular states at
particular future times. These probabilities can then be used to value benefit and
premium payments.
This can lead to many subcohorts, subject to different assumed transition probabilities –
this may lead to spurious accuracy. Appropriate combinations of subcohorts would be
made, allowing fewer but more reliable transition probabilities to be used.
Superior tool for sensitivity testing.
Income protection – claim inception and disability annuity approach
Cost of claims incepted in each future policy year (the expected claims cashflow)
worked out from:
{survival probability} ¥ {claim inception rate} ¥ {disability annuity}
producing mid-year values.

The disability annuity value is for current claims only, ceasing on recovery, death, or
policy expiry. It is based on a double decrement table (decrements of death and
recovery) for sick lives. The annuity value will vary depending on the duration of
sickness at the start of claim payments (ie the deferred period).
Claim inception rates are broadly equal to a sickness inception rate multiplied by the
probability of sick lives surviving sick for the deferred period.
Three variations of the claim inception rate are described:
(1) An initial claim inception rate, ix, d , which is the probability of claim inceptions
(following deferred period d) occurring during the year of age [ x, x + 1] , arising
from sickness inceptions of healthy lives during the year of age [ x - d , x + 1 - d ] .
The relevant survival probability is the probability of being healthy at exact
age x - d .
(2) A central claim inception rate, (ia) x, d , which is the expected number of claim
inceptions occurring over the year of age [ x, x + 1] (following deferred period d),
relative to the average number of lives (healthy and sick) alive during that year of age.
The relevant survival probability is the probability of being alive at (average) age
x +½ .
(3) A central claim inception rate, (ib) x, d , which is the expected number of sickness
inceptions occurring over the year of age [ x, x + 1] , which ultimately become
claim inceptions d years later, relative to the average number of lives (healthy
and sick) alive during that year of age. The relevant survival probability is the
probability of being alive at (average) age x + ½ .
CMIR12 derives inception rates of types (2) and (3).
The S(ID) Tables include:

(a) inception rates of type (2)
(b) current claim disability annuity values
(c) expected present value of sickness annuities for currently healthy lives.

The healthy lives annuity value is based on:
65- x - d (al ) x +t
a HS ( d / all ) = Ú (a m )ix +t d pxSS+t vt + d axi +t + d ,65- x -t - d , d dt
x:65- x 0 (al ) x
which relates to current age x, expiry age 65, and deferred period d.
Tables (a) and (b) can be used to calculate expected claims cashflows (for initially
healthy lives aged 30), and table (c) can be used to calculate costs of benefits and
premiums using a formula approach (for policies with expiry age 65).
Critical illness
Critical illness incidence rate is of the form: ix = ixhd + ixs + ixc + ixo , where hd, s, c and o
indicate causes of claim: heart disease, stroke, cancers and other.
Critical illness claim inception rate is ix ¥ {probability of surviving the survival period} .
Accelerated critical illness claim inception rate is: ix + (1 - k x ) qx , where k x is the

proportion of deaths over [ x, x + 1] that are due to critical illness.
Use multiple state or inception/annuity methods to value the benefits.
Calculate risk premium (by age, sex, etc) as: RPx, s = Â ik ACk
k
where ik is the claim incidence rate for benefit or procedure class k, and ACk is the
expected cost of the claim of that benefit or procedure class.
Accident and sickness
Similar to IP but shorter term; may have some experience rating (see Chapter 16).

Cash plans
Similar to PMI except the cost of some benefit classes is defined by a fixed
(contractual) amount per treatment, or per day of care (hospital stay). For latter will
need to estimate expected number of days of treatment in order to calculate ACk .
These policies will often have a coinsurance or excess element.

Solution 15.1
Including all the relevant states mentioned in the Core Reading we get the following:
Lapsed
Sick but not Sick and

Healthy
claiming claiming
Dead
The “sick and not claiming” state includes people who have been sick for a continuous
period shorter than the deferred period, while the “sick and claiming” state includes
only those whose current duration of sickness exceeds the length of the deferred period.
However we can model the process adequately (for the purpose of valuing the benefits)
by ignoring the “sick but not claiming” state from the model, and allowing for the
deferred period by explicit adjustments for the time spent sick. So we would then have:
Lapsed
Healthy Sick
Dead
(Either version would be correct.)
Note that we do not need a separate state “policy expired”, because we can simply stop
the process when we get to the end of the policy term.

Solution 15.2
It is the annual rate at which lives are moving from state i to state j at exact age x.
Solution 15.3
The definitions are:
m x = m xHD r x = m xSH n x = m xSD .
Solution 15.4
(i) Projecting expected numbers
Call the numbers at age x who are healthy and sick respectively as H x and S x . From
the given information, we also know that (for x = 55, 56, 57 ):
HH
1 px = 1 - 0.020 - 0.008 = 0.972
SS
1 px = 1 - 0.700 - 0.150 = 0.150
So:
HH
H 56 = 10, 000 ¥ 1 p55 = 9, 720
HS
S56 = 10, 000 ¥ 1 p55 = 200
HH SH
H 57 = 9, 720 ¥ 1 p56 + 200 ¥ 1 p56 = 9, 587.84
HS SS
S57 = 9, 720 ¥ 1 p56 + 200 ¥ 1 p56 = 224.40
HH SH
H 58 = 9, 587.84 ¥ 1 p57 + 224.40 ¥ 1 p57 = 9, 476.46
HS SS
S58 = 9,587.84 ¥ 1 p57 + 224.40 ¥ 1 p57 = 225.42

(ii) Calculating the annual premium
In the first year, the average number of sick lives during the year is:
1
2 ( S55 + S56 ) = 100 ( = S55½ , say) .
The values for the other two years are:
S56½ = 1
2 ( S56 + S57 ) = 212.20
S57½ = 1
2 ( S57 + S58 ) = 224.91
So the expected present value (EPV) of the claim cost will be (approximately):
Ê 100v½ + 212.20v1½ + 224.91v 2½ ˆ

20, 000 Á
10, 000 ˜ = 987.80
Ë ¯
The EPV of the premiums is:
Ê H 55 + H 56 v + H 57 v 2 ˆ
PÁ
H 55 ˜ = 2.79536 P
Ë ¯
Equating the EPVs of the benefits and premiums, and solving for P, we get:
987.80
P= = £353.37
2.79536
(iii) Calculating the profit signature
The profit signature is the vector of expected profits, for each future year, expressed per
initial policy issued. The profit for each year is calculated as:
{reserves at start of year} + {income} - {outgo} - {reserves at end of year}
So the year 1 profit is:
353.37 ¥ H 55 ¥ 1.07 - 20, 000 ¥ S55½ ¥ 1.07½ - 500 ¥ H 56 - 40, 000 ¥ S56
H 55
= -1,115

The year 2 profit is:
1
{
È(500 + 353.37 ) ¥ H 56 + 40, 000 ¥ S56 ˘˚ ¥ 1.07
H 55 Î
-20, 000 ¥ S56½ ¥ 1.07½ - 100 ¥ H 57 - 20, 000 ¥ S57 }

= 760
And in year 3 it is:
ÈÎ(100 + 353.37 ) ¥ H 57 + 20, 000 ¥ S57 ˘˚ ¥ 1.07 - 20, 000 ¥ S57½ ¥ 1.07½
H 55
= 480
So the profit signature is ( -1,115, 760, 480) .
Solution 15.5
Our example was very simple. For instance, it assumed that transition probabilities
were independent of duration sick (and of the duration of the policy in force). So, by
the end of year 2, we could have the following different cohorts:
● healthy
● sick for less than one year
● sick for less than two years but for more than one year.
Further, we might wish each sick category to be subdivided by major category of

sickness or disability (so we could apply different claim termination probabilities to
them), and the healthy state we might further subdivide by:
● number of years in force
● never been sick/been sick at least once previously.
And, of course, at all stages we are also going to be subdividing by age, sex, and other
risk factors like smoker status and occupation.
So we can see that the number of cohorts being tracked, and the variety of different
transition probabilities required, could easily get very large indeed.

Whilst the model could be criticised for getting very complex, the above illustrates the
power of the multi-state modelling approach compared to other, more approximate,
methods. For example, we could use the model as suggested above to investigate the
effect of assuming different claim incidence rates for the groups in the last bullet point.
Solution 15.6
We have:
1
(ad )ix +t = Ú (al ) x +t + r (a m )ix +t + r dr
0
Solution 15.7
Two examples are:
(1) Policies with deferred periods only pay benefits after the deferred period has
elapsed (with the policyholder remaining sick continuously throughout).
(2) Some policies only provide short-term sickness benefits (for example, accident
and sickness policies). After a set duration of continuous sickness the benefits
may reduce, or (maybe after a further period of sickness) stop being paid
altogether.
Solution 15.8
(a) We have:
i
a40:25 , d =0
(ie for current sickness duration 0)
SS
= 0.0603 (The notation used for this in the Tables is a40,0 )
(b) We have:
i
a40:25 , d =1
(ie for current sickness duration 1 year)
SS
= 4.4889 (The notation used for this in the Tables is a40,1 ).

Comment
Most single bouts of sickness are of very short duration, nearly all lasting less than one
year. The value in (a) is the “average” value of benefits paid on such bouts of sickness,
so its value is small.
People who have already been sick for a year are the exceptions, and are much less
likely to recover in the short-term future compared with a newly-sick person. So the
expected duration of sickness claim is much longer for someone who has already been
sick for one year, and so the annuity value is much greater.
Solution 15.9
The expected present value is:
t = 25 ( al ) 40 +t
Út =0 (a m )i40+t vt 5, 000 a40
i
+t:25-t , d = 0
dt
(al ) 40
Remember that the annuity is payable from the exact age of claim inception (40 + t )
and continues until age 65 (so the maximum duration of the annuity payments is 25 - t
years).
Solution 15.10
Looking up the appropriate value in the Tables, we calculate the expected present value
as:
5, 000 ¥ 0.420352 = £2,101.76
Solution 15.11
There is no difference between (a) and (b).
In (c), (al )45 will include some recoveries from lives who were sick at age 40, whereas
these would not exist in (b). So (c) > (b).

Solution 15.12
Using P for the level annual rate of premium, the equation of value is:
( )
P a45:20 - a HS (0 / all ) = 6,000 ¥ 1.015 a HS (0 / all ) + 0.6 P + 20 a45:20
45:20 45:20
6, 090 a HS (0 / all ) + 20 a45:20

45:20
\ P=
a45:20 - a HS (0 / all ) - 0.6
45:20
6, 090 ¥ 0.454221 + 20 ¥ 11.299

= = £292.07
11.299 - 0.454221 - 0.6
Solution 15.13
(i) The EPV is:
5, 000 a HS (2 / all ) = 5, 000 ¥ 0.166111 = £830.56

40:25
(ii) The EPV is:
40:25 (
6, 000 a HS (0 / 2) = 6, 000 a HS (0 / all ) - a HS (2 / all )
40:25 40:25 )
= 6, 000 (0.420352 - 0.166111) = £1, 525.45
(iii) The EPV is:
40:25 (
7, 000 a HS (1/ 2) = 7, 000 a HS (1/ all ) - a HS (2 / all )
40:25 40:25 )
= 7, 000 (0.213550 - 0.166111) = £332.07

Solution 15.14
We use the same formula as before for the mid-year claim cost in year [t , t + 1] :
i
t +½ p30 (ia )30 +t ,1 a30½ +t:34½ -t ,1 ¥ 25, 000
i
- v t +1½ p30 (ia)31+t , 2 a31½ +t:33½ -t ,2
¥ 10, 000
but noting that, for t = 0 , (ia )30+t ,1 = 0 and (ia)31+t , 2 = 0 . So the claim cost in the first
year is zero.
For the other years, the calculations are:
Item Year 2 ( t = 1 ) Year 3 ( t = 2 )
t +½ p30 0.998623 0.997670

(ia)30+t ,1 0.000521 0.000578
i
a30½ +t:34½ -t ,1
3.7062 3.7981
t +1½ p30 0.997670 0.996687

(ia)31+t ,2 0.000294 0.000330
i
a31½ +t:33½ -t ,2
5.6342 5.7190
So, the expected mid-year value of the claim costs for year 2, per policy issued, is:
0.998623 ¥ 0.000521 ¥ 3.7062 ¥ 25, 000

0.997670
- ¥ 0.000294 ¥ 5.6342 ¥ 10,000 = £32.62
1.06
and for year 3 is:
0.997670 ¥ 0.000578 ¥ 3.7981 ¥ 25, 000

0.996687
- ¥ 0.000330 ¥ 5.7190 ¥ 10, 000 = £37.01
1.06

Solution 15.15
(i) Expression for ( ib ) x , d
The required expression is:
1
Ú (al ) x +r (a m ) x+r d px +r dr
i SS
(ib) x, d = 0 1
Ú0 lx +r dr
with definitions as before.
(ii) Expression for EC x + t
The required formula is:
EC x +t = t - d +½ p x (ib) x +t - d , d B axi +t +½:65- x -t -½ , d
using the usual symbols.
Solution 15.16
A stand-alone critical illness policy will only pay a claim to a policyholder who
survives the defined survival period. So, if ix is the incidence rate of critical illness,
then to give us the claim incidence rate we need to multiply by the probability that these
illnesses lead to claims – ie that they fulfil the survivorship conditions under the policy.
Solution 15.17
Double counting will lead to an overestimate of claim incidence rates, which is a more
acceptable (less solvency-threatening) error than understating the rates. (Of course, too
much conservatism can be a bad thing, as it can lead to uncompetitive premiums.)

Solution 15.18
Recall the formula for the incidence rate at age x for this contract:
= ix + (1 - k x ) qx
Here we do not want to overstate the proportion k x of deaths that are also critical illness
claims. This would understate the cost of claims and could lead to inadequate
premiums or reserves.
Solution 15.19
The model is shown in the following diagram:
State 0 State 1 State 2 State 3

Benefit Benefit Benefit
Healthy
level 1 level 2 level 3
State 4
Dead
Define:
t pijx = probability that a life in state i aged x is in state j at age x + t ( j ≥ i ).
The expected present value of the benefits is:
• • •
365.25 ¥ ÈÍ 20 Ú vt t p70
01
dt + 50Ú vt t p70
02 03 ˘
dt + 150 Ú vt t p70 dt ˙
Î 0 0 0 ˚
• • •
= 7,305Ú vt t p70
01
dt + 18, 262.5Ú vt t p70
02
dt + 54, 787.5Ú vt t p70
03
dt
0 0 0

Solution 15.20
We need rates of claim inception at each future age 70 + t . There would be three rates
of claim inception at each age, relating to claims starting at each benefit level.
It would probably be easiest to use central rates of claim inception for this purpose. We
would then need to multiply by the probability of (70) surviving to the middle of year
[70 + t , 70 + t + 1] to give the probability of (70) claiming in that year (again, for each
benefit level separately).
The probability of claiming at each future age for each benefit level would then need to
be multiplied by the appropriate current-claim disability annuity values, and by the
projected increase in benefit level at the time of commencement of (or increase in)
claim. So we would need three tables of these annuity values: one for each benefit level
and each subdivided by age at claim inception. These would be whole life disability
annuities, with payments ceasing on death (assuming recovery is impossible).
The annuity functions would include appropriate allowance for future inflation of
benefit payments in each case.
The projected mid-year values would then need to be discounted to the start of the
policy.
Finally, we would calculate, for each year t = 0,1, 2,...
{probability of surviving to time t + ½} ¥ vt +½

È {claim inception rate to level (1)} ¥ {level (1) annuity value} ¥ 20 ˘
Í ˙
¥ + {claim inception rate to level (2)} ¥ {level (2) annuity value} ¥ 30 ˙ ¥ 365.25
Í
Í ˙
Í ˙
ÎÍ + {claim inception rate to level (3)} ¥ {level (3) annuity value} ¥ 100 ˚˙
and sum over all future years t, to obtain the expected present value of the benefits
under this policy.
Note that we value £30 per day additional benefit for level (2), because we have
assumed the £20 payable under the first level continues until death (and hence into all
subsequent levels of sickness, if they occur). A similar argument applies for the £100
assumed for level (3).

Solution 15.21
The insurance policy will only pay claim amounts to the extent that they exceed the
“excess” specified under the policy. So, if an excess of £150 applies, a policyholder
who incurs medical costs of £800 will receive £650 from his or her insurance policy.
A no claims discount is a reduction made to the premium payable in recognition of a

policyholder’s good recent claim experience. So, for example, no (or sufficiently few)
claims over the past five years may qualify a policyholder for the maximum possible
discount, with a sliding (ie reducing) discount for fewer years of “no” claims. The full
premium might be payable for anyone who has made a significant claim over the past
two years, say. (You will probably be more familiar with this system as it applies to
motor insurance – but the principle is identical.)
Solution 15.22
One way would be only to use data on policies with the same level of excess (possibly
adjusted for inflation) to derive the incidence rates and average claims costs in the risk
premium calculation.
Alternatively we could use data where no excess applied and adjust as follows:
● Reduce the incidence to allow only for the proportion of claims expected to
exceed the excess amount. We may need to assume that claim amounts follow a
particular probability distribution in order to help assess this.
● Reduce the incidence further to allow for the fact that the excess acts as a
disincentive to claiming, especially if the excess is voluntary. This reduction
may be arbitrary or based on previous experience.
● Adjust the average claims cost to allow for the excess. The reduction won’t be
the full excess amount as some of the claims would have been for less than the
excess. (Again this could be deduced with the aid of an assumed claim amount
distribution.)

Solution 15.23
If the sex-specific price would have been significantly cheaper say, for males than for
females, the average price would be cheap for females and expensive for males. This
may lead to anti-selection – more females and less males taking out policies than
expected, making the actual average claim experience heavier than assumed in the
pricing basis. This will be made worse if competitors charge different premiums to the
two sexes.
Solution 15.24
A typical cash plan product might provide some or all of the following benefits:
● daily cash payment whilst in hospital
● daily nursing care allowance whilst recuperating
● refund of physiotherapy, osteopathy and chiropractic fees
● refund of acupuncture, homeopathy and herbal medicine fees
● refund of chiropody/podiatry fees
● dental cover
● optical cover (eye tests, glasses and contact lenses)
● specialist consultation fees and diagnostic tests
● health screening.
Typically, each of the above benefits will have limits on the number of payments or
total amount payable in each year.




using the course.

ST1-16: Pricing (3) – Group risk assessments Page 1
Chapter 16
Pricing (3) – Group risk assessments
Syllabus objectives
– Options
– Guarantees.
(The item in bold is covered in this chapter.)
0 Introduction
Much of the discussion so far on pricing healthcare insurance products has
centred around individual products. While the same risk principles apply to the
choice of assumptions when we look at group products, the market practices are
somewhat different. These will be explored now.

Page 2 ST1-16: Pricing (3) – Group risk assessments
1 Special characteristics of group risks
1.1 Free cover
This concept was introduced in Chapter 1, in the context of group IP schemes.
The notion of free cover is the process where a certain level of benefits is
available to all members of a group without individual underwriting; only those
seeking benefits above the limit need to provide medical information or undergo
tests.
You may also hear of this being referred to as a non-selection limit.
Question 16.1
Discuss whether free cover limits are appropriate on:

● group IP schemes
● group CI schemes
● group PMI schemes.
This will apply to certain large groups where the number of risk units covered is
sufficiently big to allow the insurer to treat it as a separate insurance unit, with
no single insured being significant. Typically the insurer will require that all
insured members are “actively at work” on the day that the cover commences
and may also insist that a moratorium applies, that is that there is a short period
after the start of cover for a new entrant during which no claim is paid.
Do make sure you are clear about the meaning of this concept: it does not mean the
cover is provided free of charge! It actually means that the standard rate of premium
will be charged to any member having benefits that do not exceed the free cover limit
without the need for that person to go through the underwriting (medical screening)
process.
The “actively at work” requirement is vital to the success of insurance without

underwriting. The idea is that the employer will employ only healthy people, so that the
required medical screening is achieved through the employer’s recruitment process
rather than explicitly by the insurer’s underwriting.
Anti-selection can still occur for group insurances and its extent will depend, in part, on
the particular rules for acceptance that apply.

Question 16.2
Comment on the relative levels of anti-selection you would find in the following group
IP schemes. “Active” employees are all those who are currently working (ie not absent
from work through sickness or disability).
(1) Active employees can obtain cover up to the free cover limit at any time during
their employment.
(2) Active employees can obtain cover up to the free cover limit provided they apply
within 3 years of taking up their employment.
(3) All employees are automatically issued with the maximum amount of free cover
one year after taking up employment (provided they are then actively at work).
(4) All employees are automatically issued with the maximum amount of free cover
on the day they start work.
The terms of any free cover are actually aspects of product design. From a pricing point
of view it is necessary to take into account the effect of any anti-selection associated
with the design. Provided the scheme has been running for a number of years the past
experience should be an adequate guide. For a new scheme (or one for which the rules
have recently been changed) more care will need to be taken; the experience of any
similar schemes would be used as a basis.
Question 16.3
List the main factors that would be used to determine the free cover limit for a typical
group CI scheme.
1.2 Limited insured information
One of the risks involved in group healthcare products is that the detail of
individual lives insured (numbers, ages, sexes, benefits) is often not known by
the insurer at the time when the period of insurance begins.
This is becoming less of a problem recently, however, with full membership

information usually being supplied at the quotation stage.
The insurer, in such circumstances (ie when the full information is not available),
will make an estimate of the premium to serve as a deposit. This will be adjusted
up or down at the end of the period, when the details are known exactly.

Even where full details are known at the start of cover, retrospective adjustments will
need to be made to reflect staff changes over the period.
These are often referred to as “deposit and adjustment premiums”.
1.3 Newcomers / Leavers
The actuary will be particularly concerned about significant changes in the

numbers and profile of lives that comprise the group from one year to the next.
Of people leaving a particular employee group, it is arguable that the fittest lives
do so, assuming them not to be the ill-health retirees, and thus the body of lives
remaining are, on average, higher risk.
On the other hand, if most of the leavers are ill-health retirees, then the opposite can be
the case – ie the remaining workforce are, on average, of lower risk. This is a
contributing factor to the “healthy worker” effect found with some group policy
experiences.
Question 16.4
An employer provides an insurance-based income protection benefit for his employees.

Explain whether a “healthy” or “unhealthy” worker effect is most likely for this group.
An exodus of lives might indicate a down-sizing of workforce, which might

prompt more lives to claim for healthcare insurance while they are still covered.
An increase in numbers within the group is generally a good feature of a scheme

– newcomers are often younger and fitter. Care should be taken where a
takeover has produced the influx, or where there has been a merger of schemes.
The actuary should try to discover if there is a claims history available for this
incoming group of lives; it might be significantly different from the experience of
the host scheme.
1.4 Control of intermediary
Quite often, the broker or intermediary will exert influence over the information
available. The scheme information may be channelled through the broker as
might the revenues for premiums and claims. The actuary will want to be sure
that the information is as accurate as possible and that he/she is getting the
same level of detail as other companies who may also be pricing and quoting.

There are further risk problems with the degree to which the insurer can
influence the employer’s attitude to risk and initial claims management, when all
communication is required to be passed through the broker. This, however, is
not directly a pricing issue.
The broker may be wary of threatening his or her relationship with the client by
“imposing unpopular measures”, such as requests for detailed information or carrying
out regular risk assessments. Though not directly a pricing issue, the actuary should
reflect any factor that increases either the level of, or the uncertainty around, future
claims (the latter being important for the size of margins to include in the basis).
1.5 Cafeteria (or flex or menu) style
Some group products these days are designed to offer each employee a range of
alternative benefits, in place of mandatory life and healthcare covers. These
could embrace many aspects of the employee package and not just insurances.
As well as insurance benefits, the items on offer might include such things as buying
more holiday out of salary or making additional pension contributions.
From a pricing viewpoint, the actuary will need to be vigilant that the selection
effect does not permit advantage to be taken of the insurer, by dint of the covers
and amounts chosen. Limits will generally be placed and statements of good
health may be requested also.
Again it’s the opportunity for individual choice – ie whether to take out insurance and
for what levels of cover – that leads to the anti-selection effect, as we discussed in the
answer to Question 16.2 above.

2 Using the experience
2.1 Experience rating
Experience rating is the phrase given to the practice whereby the healthcare
premium for a group contract depends wholly or partially on the past experience
of that group. The peculiarities of a specific workplace, the working processes
and the employer’s attitude to safety and healthcare can make a “book rate”
assessment of a company’s employee healthcare contract inappropriate. The
particular risk proclivities (tendencies) are possibly best demonstrated by that
group’s past claims history, suitably adjusted to make it relevant to the coming
policy term.
Essentially the claim experience from a group contract is very much influenced by the
particular characteristics of the group, for example by the nature of the occupation or
occupations involved. Changes in economic conditions can affect group claims
experience differently for different employers, depending on which sectors of the
economy are most affected and also on how the particular employer chooses (or is able)
to deal with a particular situation.
The big advantage of a group contract to the insurer is that, despite a group having its
own (possibly unique) set of risk characteristics, it has a much bigger body of data that
relate solely to its own circumstances. So, as the Core Reading says, generally the most
successful way of judging the effect of the group’s risk characteristics is to look at that
group’s past claims experience.
Credibility
The term credibility relates to the factor, between 0 and 1, which represents the
proportion of the final risk premium which is derived from past experience, the
balance coming from book rates. The value of the factor depends on the size of
the scheme and a very large body of experience would be needed to justify a
factor of 1 ie the premium is 100% based on past claims history. However,
commercial pressures and market practices in many territories have given full
credibility to many schemes for group PMI, where less than 100 man-years of
information are available; group IP demands somewhat more for full credibility.
So if E is the insurer’s standard risk premium (or “book rate”) for PMI benefits for the
group, and A is the equivalent risk premium based on the past experience of the group,
then the risk premium charged would be calculated as:
RP = Z ¥ A + (1 - Z ) ¥ E
where Z is the credibility factor for this group scheme (0 £ Z £ 1) .

As the Core Reading says, the value of Z will depend mostly on the size of the scheme
(and hence on the credibility of the past data upon which the value of A is based),
though other factors may be involved if these affect the reliability with which the future
experience of a group scheme can be predicted from its past data, or if they affect the
relevance of the data to predicting future experience. Sometimes an insurer will move
away from its theoretical credibility values for competitive reasons, and will in any case
be likely have a similar approach to its experience rating to the other main players in the
group market.
The terms of the experience-rating structure will usually be specified in the conditions
of the group insurance scheme, including the method for calculating the experience risk
premiums from the data and the historical time period that will be used for the
assessment. The time period chosen obviously becomes one year more recent for each
year’s new premium calculation. The credibility factor may also change in future years
(ie the insurer will generally wish to keep the factor under review). The factor could
even be specified to be a function of experience volume.
2.2 Burning cost
The burning cost is the accumulation of claims in a recent year which might be
taken as a first measure of premium adequacy.
The following definition appears in the glossary:
“Typically burning cost is the estimated cost of claims in the forthcoming

insurance period, calculated from previous years’ experience adjusted for
changes in the numbers insured, the nature of cover and medical inflation. The
term can also be used to describe the historic cost of claims only.”
So, in checking premium adequacy, the burning cost needs to be compared against the
(risk) premiums paid for the relevant period.
The burning cost would need to include also estimates of all claims reported but
not settled and claims incurred but not reported. The concept has more
application for group PMI and group CI than it has for group IP where claims are
paid out over several years from a single incidence – though it can be used for IP
if an estimate for claims in payment is included, ie if the expected future claims
can be capitalised.
That is, for IP we would have to include the expected present value of all future claim
payments arising from sickness inceptions occurring during the relevant year.
Burning cost calculations provide the earliest possible feedback on the adequacy of the
insurance company’s current risk premium rates.

Example
Ignoring adjustments for changes in exposure, inflation, etc, estimate the burning cost
for claims occurring in the year 2007, based on the following information:
2007 2006
Claims paid during year 5,000 4,000
Reserve for claims reported but not settled (RBNS) 500 400
Reserve for claims incurred but not reported (IBNR) 200 150
Solution
The burning cost for 2007 is:
{claims paid} + RBNS2007 + IBNR 2007 - RBNS2006 - IBNR 2006

= 5,000 + 500 + 200 - 400 - 150
= £5,150
The total claims would often be divided by an appropriate exposure measure to obtain a
starting point for calculating the risk premiums. Suitable exposure measures would be:
● for PMI: the number of people covered
● for CI: the total sum assured (ie to obtain a rate per £1,000 sum assured)
● for IP/LTCI: the total benefit payable (per annum), or sometimes expressed as a
percentage of salary for IP.
Question 16.5
Explain why we add the RBNS and IBNR reserves for the current year, but deduct the
previous year’s values, in the burning cost calculation.
2.3 Relevance of previous experience
The pricing actuary will look at the past claims history available to judge the
extent to which it might be considered a good proxy to the future risk
experience. Significant changes of personnel, changes of location, changes of
work practices and changes in the cover required are among the factors that can
alter the applicability of past experience to the future. The actuary will have to
make suitable adjustments to the data before using it as a base for pricing.

These are considerations the actuary will normally make when deciding how to use any
past experience data for setting pricing assumptions. A difference with group contracts
(as we mentioned earlier) is how we can often look at the experience of the particular
group policy itself to assess the pricing assumption. Note the key factors that need to be
monitored for changes, when considering any adjustment to the past experience that
may need to be made.
Question 16.6
State how the subject of this section differs from “experience rating” as described in
Section 2.1 above.

3 Calculation of the overall premium

We now turn to the calculation of the standard risk premium (or “book rate”) that would
be charged under a group healthcare insurance contract. This would be the value of E
that we defined in Section 2.1 above. This will be used in the experience-rating formula
where this applies, but for non experience-rated contracts it will be the risk premium
itself.
3.1 Risk cells
The book rates for a given portfolio should be consistent with individual product
premiums, though overall the group collectively may warrant a better risk than
the sum of the individuals.
So what do we mean by “consistent” here? We are comparing the risk premium the
insurer would charge to a private individual taking out, say, an IP policy, compared with
the rate that would be charged to the employer for providing identical cover for
employees having the same risk characteristics. The Core Reading is saying that, while
the rates may not be the same for the two cases – the group-insured rates may well be
cheaper – they should be consistent. This means that the relationships between the
prices charged for the different risk groups (males/females, etc) should be similar for
group and individual business.
The cost will be derived by splitting a relevant body of experience into pertinent
risk cells. Some of the main risk determinants were listed above in Chapter 10.
For each risk cell, a historic risk cost or rate will be derived. This will then be
adjusted so that it is as appropriate as possible to the future body of lives. A
final adjustment will make the numbers appropriate to the future period of risk,
ie adjusting for trends in potential to claim and for trends in monetary values
(inflation).
These last steps are common to all assumption setting, as described in Chapter 10.
Smoothing (graduation) adjustments will also be made in order that the rates are
consistent between cells.
The overall premium that will be charged to a group policyholder (by whom we mean
the employer), for a particular year of cover, will be calculated essentially as follows:
P = RP + L
RP will have been calculated either simply as a book rate, or as an experience-rated

calculation as described in Section 2.1 above. L is a loading for expenses and profit.

Group schemes are usually one- or two-year renewable, with the total premium being
recalculated each (or every other) year.
Question 16.7
Write down a possible formula for a group critical illness policy providing lump sum
benefits to employees on critical illness diagnosis only. Under the policy, all insured
employees are entitled to critical illness benefits equal to four times the rate of salary
being earned at the time of diagnosis. Assume that the policy is not experience rated.
3.2 Rating factors
Rating factors provide a means by which an insurance company can assess the correct
book premium to charge for any risk, or set of risks. These would be the factors,
relating to the risk presented by the individual policy, according to which the premium
rate charged might be caused to differ from that charged to others. For example, an
individual CI policy might be considered to have rating factors of age, sex, smoker
status, and (possibly) occupation.
For group policies, the risk premium needs to reflect the overall risk characteristics of
the group of lives to be covered under the policy. Group-level rating factors may
therefore also be applied. These will include such things as industry and location.
A system of multiple regression or other techniques will produce factors that will
enable the various “exposure” to risk factors, as exhibited by a proposing group
scheme, to be converted to the relevant book premium. The rating factors may
be as simple as 1 or 0 (present or absent) or numerically more complex. A
computer algorithm will combine the factors to produce the premium.


Chapter 16 Summary
Free cover and anti-selection
Free cover, whereby a certain level of benefits is available without individual

underwriting, may be offered through group schemes because of reduced anti-selection
risk.
Eligibility to start cover is typically conditional on an employee being “actively at

work”.
Cafeteria style of employee benefit provision can increase the potential for
anti-selection through increased choice.
Limited information
The insurer needs details of the employees covered throughout the year in order to
calculate a premium for the group, but this is not fully known in advance. A
retrospective adjustment premium is usually paid.
Changes in workforce
Significant changes to the workforce can alter the riskiness of a group scheme:
● leavers: depends on whether relatively healthy or unhealthy
● joiners: probably healthy if young.
Also, mergers/acquisitions among group policies could significantly change the risk
characteristics of a group.
Effect of intermediary
An intermediary may influence the data available to the insurer. The insurer would like
to exert some influence over group policyholders in order to reduce work-related health
risks and encourage claimants back to work: however, this may be impeded by the
intermediary.

Premium calculation
The premiums charged for group policies are dependent on their risk characteristics,
which will be defined in terms of their rating factors. A group premium will reflect the
combined effect of the risk characteristics of the individuals making up the group (such
as their distribution by age and sex) and of group-level characteristics such as industry
and location.
The overall risk premium for a group is obtained from:
RP = Z ¥ A + (1 - Z ) ¥ E
where E is the insurer’s book premium for the group, A is the risk premium based on a
specified period of the group’s past experience data, and Z is the credibility factor for
the group (0 £ Z £ 1) . The credibility factor will be a function of the volume (and
reliability) of the group experience data. Premiums calculated for which Z > 0 are
experience rated.
The overall premium for a group policy can be represented as:
P = RP + L
where L is an expense/profit loading.
Using experience data to determine assumptions for book prices
The usual procedures apply:

● judge data for relevance to future experience
● subdivide data into homogeneous risk cells for analysis
● make adjustments to make appropriate for future experience (both in terms of
claim incidence and claim size – eg due to inflation)
● smooth between adjacent risk cells to produce consistency.
Yearly burning cost calculations can be used to compare emerging claim costs over the
year against the risk premiums paid. These provide the earliest possible feedback on
premium adequacy.

Solution 16.1
Free cover really only applies where members of the scheme can have different levels of
benefits, so that some members (those above the free cover limit) will be underwritten
and others will not.
This is appropriate for group IP where members will have different levels of benefit,
which is usually based on a percentage of their salary. Similarly, it is appropriate for
group CI where members will have different sum insured levels, which is usually based
on a multiple their salary.
However, benefits under group PMI are indemnity-based, and so the actual level of
benefit is unknown (until a claim is made). It would therefore be impossible to
ascertain which members should be underwritten or not, and so having a free cover limit
would not work.
Arguably, the concept of free cover might be applied to a group PMI where members
were entitled to various levels of benefit. For example, where some staff got
comprehensive cover (and are underwritten), but others only got budget cover (but are
not underwritten). However, in practice, the term free cover is not used in PMI.
Solution 16.2
(1) This will have one of the highest anti-selection risks, as people have a free
choice about whether (and when) to take out health insurance cover, and how
much to take out (up to a maximum limit). People who suspect they may have a
medical problem could easily take out the cover before seeking medical advice,
without failing the “actively at work” principle. The cost to the insurer could be
considerable.
(2) This is considerably less risky for the insurer, as many of the most serious
medical conditions tend to be associated with older ages and, most likely, with
people who have been at work for more than three years. There is still a
potential risk from older new employees, though most of a firm’s new recruits
are likely to be young anyway.
(3) This is probably the least risky approach. Covering all employees will mean that
the average claim experience will reflect that of the workforce as a whole, and
will not be concentrated on those lives presenting the highest risk. Delaying
cover for one year means that all applicants for cover are likely to be genuinely
good employment (and hence healthy) prospects.

(4) Better than (1) and (2) but worse than (3). The latter is because the scheme does
provide a way for unhealthy lives to “take up” work for a very short period
before being able to claim under the group insurance scheme.
(The moratorium requirement mentioned in the Core Reading is designed also to reduce
this same problem.)
Solution 16.3
The level of free cover would typically depend on:

● the size of the scheme, ie number of lives covered
● whether membership is compulsory or voluntary
● the proportion of employees taking up cover (if voluntary)
● the total and average sum insured.
Solution 16.4
All else being equal, probably unhealthy. People who leave the scheme are generally
healthier than average, leaving the unhealthy employees. This may be due to healthier
people being more likely to change jobs in order to progress their careers. At the same
time, the employer is paying good money for the sickness insurance benefits it is
providing. So, where possible, it would prefer any sick employees to receive benefits
from the insurance company, rather than ill-health retirement benefits from its pension
fund.
(On the other hand, the insurance policy may be heavily experience rated, so that heavy
claims experience may feed back into higher premium rates in future years. This will
tend to discourage the employer from channelling too many of its sick employees into
claiming from the IP policies. Don’t worry if you hadn’t considered this point when
you first attempted this question, as you have not yet read about experience rating! –
see Section 2.1.)
This question also gives an example of how moral hazard can be a factor influencing the
experience of group insurance policies.

Solution 16.5
The RBNS and IBNR reserves represent future expected claims costs as at the end of
the relevant year. They should be included in the burning cost for that year because
they relate to that year of exposure (so we can correctly relate all claims to the
appropriate exposure measure).
The previous year’s RBNS and IBNR must be deducted, because the claims to which
they relate will all be included again (only more accurately), in one of:
● claims paid during the year
● RBNS claims at the end of the year
● IBNR claims at the end of the year.
Hence if they are not deducted, they will be double-counted.
Solution 16.6
If experience rating is used, then there will be an explicit formula for the incorporation
of the actual past experience rates into the risk premium calculation.
On the other hand, in this section we are just considering how the actuary might use past
experience data to assess future assumptions. Without experience rating, the insurance
company has no contractual obligation to charge future risk premiums as a function of
the group’s past experience (whereas with an experience-rating structure the
dependence of future rates on past experience is explicitly – and contractually –
defined).

Solution 16.7
A possible structure for the premium might be:
n
P g = 4Â ixg , s Si + E
i i
i =1
where:
ixg , s = the claim incidence rate, under group scheme g, applicable to the i’th
i i
employee (aged xi and of sex si )
Si = the expected annual rate of salary increase for life i half way through the
year.
E= loading for expenses and profit.

ST1-17: Costs of options Page 1
Chapter 17
Costs of options under health and
care insurance contracts
Syllabus objective:
– Options
– Guarantees
(The item shown in bold is covered in this chapter.)
0 Introduction
In this chapter we shall consider mortality and morbidity options. These are situations
where the policyholder can choose to extend the term or increase the level of cover at
normal premium rates but without providing further medical evidence. To the extent
that the option might be exercised by someone in poor health, the insurance company
will bear a cost: the difference between the ordinary premium rate granted under the
terms of the option and that which would have been granted had the life been
underwritten.
The pricing of options in healthcare insurance is complex and an idea of the

problems and solutions will be given here. Options have little impact on a
one-year contract (PMI), if the terms and acceptances are variable every year, so
the discussion below will concentrate on long-term insurances.

Page 2 ST1-17: Costs of options
1 Mortality/morbidity options
1.1 Terms and conditions for options
It is common for long-term insurance policies to include options:

• to purchase additional assurance without providing further evidence of
health at the normal premium rates (for a life of that particular age) at the
date on which the option is exercised
• to renew a long-term insurance policy, eg a term critical illness insurance
at the end of its original term without providing additional evidence of
health
• to reinstate mortality cover after an accelerated critical illness plan has
paid out on a specified disease event (buy-back option).
The terms and conditions under which the option can be exercised are clearly
set out in the original policy. Sometimes an option can only be exercised at
fixed points of time, eg at the end of every five years of a twenty-year term
insurance, or at anytime providing a qualifying event has occurred, eg the birth
of a child, taking up a new job at a higher salary. The extent of the option will
also be specified, eg the additional sum insured cannot exceed the original sum
insured.
The terms and conditions for the exercise of the option are designed to prevent
“selection against the office”, ie an excess of lives in poor health using the
options to obtain large amounts of long-term insurance at premium rates that do
not reflect their expected mortality/morbidity.
This is just another example of anti-selection, such as we have already discussed

elsewhere in the course.
There are differences in the kinds of terms and conditions for exercising a health
insurance option compared with those of a pure life insurance option. For example, an
option to take out further life insurance (death benefits) can be exercised provided the
policyholder is alive at the option date, regardless of the state of health. For an option
providing further income protection cover, the insurer must not allow someone who is
currently receiving benefits (or within a deferred or linked-claim period) to exercise an
option – ie someone already having a condition that would trigger a claim payment.
(The life insurance equivalent would be to allow an already dead person to take out
more life insurance!) However, someone who recovers might then be eligible to
exercise future options – depending on the terms and conditions of the particular case.

Question 17.1
So if people can’t exercise health insurance options if they are sick, why doesn’t this
defeat the object of having the option, and make it worthless to the policyholder?
Question 17.2
Why does restricting the points of time at which the option can be exercised reduce the
risk of anti-selection?
1.2 The cost of options
The cost of an option is the value of the excess of the premium that should, in
the light of full underwriting information, have been charged for the additional
insurance over the normal premium rate that is charged. For some lives the
option will have no cost.
People who satisfy the underwriting criteria (or would do, if they were subjected to
them) are referred to as select lives (as described in Subject CT5).
If a life, who is in good health and who would be expected to satisfy normal
underwriting requirements, exercises the option, the option will generate little
additional cost. The exercise of the option by lives in poor health will generate
considerable additional costs.
So the exercise of an option by a currently “select” life incurs the company in little extra
cost.
The total expected additional costs of an option depend on the health status of
those who choose to exercise the option, and the proportion of lives who
choose to exercise the option.
In general, the smaller the proportion who exercise the option, the worse will be
the subsequent mortality/morbidity experience of those exercising the option. If
a substantial proportion exercise the option, then their subsequent mortality/
morbidity experience will on average be less extreme.
(We will refer to a mortality/morbidity option simply as a “health option”.)

So the cost of a health option is (roughly speaking) the product:
{proportion of lives exercising option}

¥ {average extent that health of lives exercising option is worse than normal}
Question 17.3
Which is worse to the company: every single person with worse-than-select morbidity
taking up the option, or if just the small number of very high risk lives take up the
option?
Question 17.4
Does the option cost more to the company if every single eligible life takes up the
option, or if only those that have higher than select morbidity do so?
Some factors affecting health options are:
• The term of the policy with the option. The longer the term, the longer the
policyholder will have the option, and the more likely it is that, at some time, his
or her health will deteriorate, thus making the option appear worthwhile.
• The number of times the policyholder gets the chance to exercise the option. For
example, every five years, on every policy anniversary or at any time
whatsoever.
• Conditions attaching to exercising the option. For instance, limiting the size of
the option or restricting the choice of contracts available under the option.
• The encouragement given to policyholders to exercise the option. As discussed

in the Core Reading, if take up of the option is low it tends to be only those who
have most to gain who exercise the option. As explained in Question 17.3
above, this can be a good thing, as it could keep the total cost of the option low.
On the other hand, encouraging more of the healthy lives to exercise the option
will not cause any additional expected loss, and should contribute to the
company’s total profit as the company will essentially be issuing lots of new
policies to lots of good risks, which should be a profitable proposition.

Publicising the option more widely can achieve greater take up by healthy lives,
but care should be taken that the benefit (from future profits) is not outweighed
by the risk of attracting a bigger proportion of the loss-making high risk lives
from taking up the option as well.
• The extra cost to the policyholder who exercises the option. If the option
involves a steep increase in premiums, then the healthier lives might shop around
to try to get the same cover cheaper elsewhere. This means that the company
will lose out on the potential profit that these policyholders would have
generated.
• Selective withdrawals. A healthy life may cancel a ten-year renewable term

insurance policy after two years because he or she discovers that the cover
without options is much cheaper. The company has not in this case collected the
option loading from this person for very long, but is still left with the unhealthy
lives who are more likely to exercise the option to the cost of the company.
This is important to understand. Withdrawal by healthy lives before the option

date reduces the income (extra premiums) that we would have expected to
receive from the whole risk pool. If only healthy lives withdraw, then the cost of
the option (which depends only on unhealthy lives) will be little altered. This
loss of income could therefore constitute a significant risk in the management of
option costs.
Anti-selection and policyholder lethargy
While the actuary will be conscious of any particular threat where a one-way
option can act against the best interests of the insurer, anti-selection through
options rarely proves to be a serious problem unless the facility gets
considerable public attention. It is more usual that such options remain
dormant, despite their flexibility value being welcomed at the point of sale.
So it would appear that many potential option costs are not realised, simply through
policyholder lethargy or perhaps through lack of awareness at the time of exercise. As
we discussed above, while this reduces the cost of the option it perhaps does not
maximise the potential for future profit that might have been generated from more of the
healthy lives taking up the option.

1.3 Constant monitoring
Whatever the current experience, the value of options must be kept under
constant review. It would not be unthinkable for a healthcare option to come
“into the money”, much as annuity options did on some deferred pension
policies in recent years (despite being relatively worthless at time of sale). For
example, the widespread onset of a particular disease might make any option to
increase coverage without underwriting particularly costly to the insurer.
The comparison here is being made with a financial option, in which the option cost
under all policies would turn out to be zero (if interest rates exceeded a particular
guaranteed level) or significantly positive (if interest rates were lower than a particular
guaranteed level).
Health options don’t appear to have such a stark all-or-nothing type of profile.
Statistically we expect some proportion of lives to be “in the money” at the option date
– because of their worsened health – and while we will expect uncertainty over the size
of the proportion and the intensity of the additional morbidity risk, it seems very
unlikely that this proportion could actually reach 100%.
Nevertheless it is possible that some dramatic change to future conditions – such as a

much increased prevalence of a particular disease – may give value to the option for
many more people than originally anticipated, thereby far exceeding the expected total
cost for which the option was originally priced.
Question 17.5
Suggest possible courses of action that an insurance company could follow if it found
itself having to honour particularly onerous health options in the way suggested above.

2 Valuing a mortality/morbidity option

Valuing a mortality/morbidity option requires two extra assumptions as part of
the pricing basis:
• the probability that the option will be exercised, and
• the expected mortality/morbidity of the lives who choose to exercise the
option.
There are two methods in common use; the “North American experience”
method and the “conventional” method.
2.1 North American method
This method requires two additional items in the pricing basis:
• A double (or triple) decrement table for lives who have not yet exercised
the option with decrements of death/disability and exercising the option
represented by dependent rates of decrement at age x of (aq ) dx and
(aq )w
x – displayed in a double decrement table as (ad )dx and (ad )w
x
numbers of decrements out of (al ) x lives.
• A mortality/morbidity table for lives who have exercised the option

represented by mortality rates, q ′x .
q¢x is then the expected proportion of lives, aged x, who will claim (from death or
disability) over the following year of age. (This is essentially the claim inception rate
for accelerated critical illness that we defined in Chapter 15.)
Example
A ten-year insurance with sum assured of S payable at the end of the year of
death or critical illness event includes an option on each policy anniversary
including the maturity date to extend the term to 20 years from the original date
of issue at the then current rate of premium (without requiring any evidence of
health).

The expected present value of the benefits is:
9 9
(ad )dx + t t +1 (ad )w
Â S
(al ) x
v + Â x +t
(al ) x
v t + 1 Ax¢ + t + 1:20 - t - 1
t =0 t =0
n -1
where Ax¢ : n = Â S t p x¢ q x¢ + t v t +1
t =0
The expected present value of premium income is:
9
(ad )w
x :10 +
Pa Â Px¢ +t +1 x + t t +1
(al ) x
v a x¢ + t + 1:20 - t -1
t =0
9 n -1
x :10 =
where a Â t (ap ) x v
t x¢ : n =
and a Â ¢
t px vt
t =0 t =0
and Px′ is the premium rate for the term insurance at the date on which the
option is effected.
Question 17.6
Explain the formula for the expected present value of the benefits verbally (whilst
sober!).
Question 17.7 below is a numerical example of the North American method. We also
work through another example in detail at the end of the chapter.
It is often difficult to obtain sufficient data to estimate all the decrement rates
required to use the North American method. For a new line of business there
will be no direct experience. For these reasons the conventional method is
often the preferred choice.
The only detailed published statistics relating to take-up rates and option morbidity are
North American (giving the method its name). These statistics are unlikely to be
suitable outside North America because of different underwriting standards, sales
methods, target markets and policy conditions. Where a company has offered options
for some time it may well have its own detailed statistics, but this will not be the case
for new lines of business.

2.2 Conventional method
The assumptions underlying the conventional method are:

• all lives eligible to take up the option will do so,
• the mortality/morbidity experience of those who take up the option will be
the Ultimate experience which corresponds to the Select experience that
would have been used as a basis if underwriting had been completed as
normal when the option was exercised.
The mortality/morbidity basis used is not usually assumed to change over time,
so the only data required are the Select and Ultimate mortality/morbidity tables
used in the original pricing basis.
Example
A ten-year term insurance has an option on the fifth policy anniversary to

increase the sum assured of S by 100%. The premium payable for additional
insurance will be the then in force rate. Death/critical illness benefits are paid at
the end of the year of claim.
Using the conventional method assumptions the expected present value of the
benefits is:
ÏÔ 1 D 1 ¸Ô
S Ì A[ x ]:10 + x + 5 Ax + 5:5 ˝
ÔÓ D[ x ] Ô˛
The expected present value of the premium income is:
Ê 1 ˆ Ê 1 ˆ D x + 5
P Á A[ x ]:10 ˜ a [ x ]:10 + P Á A[ x + 5]:5 ˜ a
Ë ¯ Ë ¯ D[ x ] x + 5:5
Remember that the q-rates used to calculate these assurance and annuity functions are
rates of claim (critical illness or death combined), not just of mortality.
It is not possible to use this method when there are many possible dates on
which an option may be exercised, or at some (or all) of the option dates there is
a choice from several alternative options, one or more of which may be chosen.
The approach here is usually to assume that the worst option from the financial
point of view of the company is chosen with probability one.

( )
Note that in the equation above, P A[ 1x ]:10| means the premium payable on a 10-year
term insurance with unit sum assured using the select claim experience basis. It is not a
premium multiplied by an assurance factor. Similarly for the other P term.
Let us now look at a numerical example, which involves calculating the additional
premium for an option using the conventional method.
Example
A ten-year accelerated CI insurance policy for a sum assured of £100,000 is to be issued

to a person aged 45. At the fifth policy anniversary there is the option to increase the
sum insured to £200,000. For those taking up the option, the additional premiums
would be calculated on the company’s normal premium basis and would be payable for
the remaining 5 years of the policy. The office calculates its normal premium rates at
4% pa interest, assuming the total claim incidence rates are equal to the mortality rates
in the AM92 Select mortality table, but for ages 10 years older than the actual age.
Benefits are payable at the end of the year of claim. Find:
(i) the basic premium for the original policy without the option
(ii) the expected present value of the option benefits as at the option date
(iii) the additional amount that should be charged for the option, assuming that this is
spread over the first 5 years of the policy. Assume annual premiums and ignore
expenses and other loadings.
Solution
(i) The basic premium for a policy without the option is Pbas , where:
c
Pbas a[45]:10 = 100, 000 Ac 1
[45]:10
where c indicates functions that are calculated using the assumed total claim
incidence rates.
In terms of the AM92 mortality functions this translates to:
Ê l ˆ
Pbas a[55]:10 = 100, 000 A 1 = 100, 000 Á A[55] - v10 65 A65 ˜
[55]:10 l[55]
Ë ¯
This gives a premium of: Pbas = 100, 000 ¥ 0.05926 / 8.228 = £720.22 .

(ii) To find the value of the option benefits, we need to look at the value of the
additional benefits incurred by taking out the option, and the value of the
additional premiums charged.
The amount of the additional premium charged to cover the additional benefits is
Padd where:
c
Padd a[50]:5 = 100, 000 Ac 1
[50]:5
Ê l ˆ
ie Padd a[60]:5 = 100,000 A 1 = 100, 000 Á A[60] - v5 65 A65 ˜
[60]:5 l[60]
Ë ¯
This gives a premium of £919.81. Note that we use the select claim basis here,
because we will charge a premium for the additional benefits based on normal
rates (ie select rates).
The actual expected present value of these additional premiums (which means
assuming that policyholders experience ultimate claim experience), is:
c
919.81a50:5 = 919.81a60:5 = 4,185.14
The value of the additional benefits is (again using ultimate claim experience):
Ê l ˆ
100, 000 Ac 1 = 100, 000 A 1 = 100, 000 Á A60 - v5 65 A65 ˜ = 4, 430.52
50:5 60:5 Ë l60 ¯
So the value of the option is the amount by which the expected present value of
the benefits accrued exceeds that of the premiums to be paid, ie:
4, 430.52 - 4,185.14 = 245.38
So the value of the option benefits at age 50 (when the option can be exercised)
is £245.38.

(iii) We need to discount this value back to age 45:
c
l50 l60
245.38 ¥ v5 c
= 245.38 ¥ v5 = 245.38 ¥ 0.799646 = 196.22
l[45] l[55]
We now want to spread the premium for these benefits over 5 years. So the
additional extra premium payable is Pex , where:
c
Pex a[45]:5 = 196.22
ie Pex a[55]:5 = 196.22
This gives the additional annual premium for a policy with the option as £43 pa.
Be very careful with questions of this type. There are rather a lot of different types of
premiums flying around, and you need to be clear in your mind which premium is
which.
Question 17.7
Find the additional annual premium for the above example, this time using the North
American Experience method, with the following additional assumptions:
• 30% of all policyholders who survive to the fifth policy anniversary take up the
option
• the claim experience of those who take up the option, following the option date,
follows the AM92 Ultimate table assuming lives are aged 15 years older than
their actual age
• the claim experience of those who do not take up the option, following the
option date, follows the AM92 Ultimate table assuming lives are aged 10 years
older than their actual age (ie the same as the original ultimate basis).
The assumption under the conventional method that everyone will exercise the option is
obviously unlikely to be borne out in practice. However, this does not make the
method ineffective, and in particular it can be used to give a prudent result at the same
time as requiring fewer (possibly speculative) assumptions than the North American
method. The result should be prudent because it assumes that all of the eligible
impaired lives take up the option, while in reality not all of them may do so.

In summary:
• at the option date the eligible lives can be thought of as split into two groups:
– group (1), whose claim experience is select
– group (2), whose claim experience is considerably higher than ultimate
• group (1) incurs the company no expected cost by exercising the option, and
should actually increase the company’s profits by taking out further cover on
profitable terms
• group (2) incurs the company in expected losses by exercising the option, but
these losses should covered by the option premiums paid under the original
contracts
• any in group (2) that do not take up the option will increase the profitability of
the option premiums
• the conventional method will be conservative:
– in that it allows for all the expected losses that would be incurred from
the whole of group (2) taking up the option
– provided it does not take credit for any of the expected profits expected
from group (1) taking up the option.
This last point will be met provided we exclude all profit margins from the premium
assumed for the new policy taken up under the option (eg from the Padd premium shown
in the previous example).
2.3 Stochastic modelling
The core cost of options can be established through stochastic modelling where
the future experience is projected as numbers effecting the various options are
analysed and their subsequent claim propensity is investigated. A number of
simulations will be tested and the cost of the option will be calculated with a
particular statistical degree of adequacy.
The model would have to subdivide the population of policyholders into different risk
categories, such as groups (1) and (2) as defined in the previous section, and quite
possibly including additional subgroups within these. The proportions ending up in
each risk group and also the average claim experience of each risk group at the option
date could be modelled as stochastic variables. We would therefore need appropriate
probability distributions for these.

Question 17.8
Suggest briefly how we could model the effects of the kinds of large changes to option
costs described in Section 1.3, eg as a result of a significant increase in the prevalence of
a particular disease.

2.4 Detailed example – Income Protection using North American

method
This example is longer than any single question you might expect in the exam. Our
purpose in including it here is to take you through the thought processes involved in
costing health insurance options using the North American experience method. In doing
so we include modelling techniques that you will have seen in earlier chapters (eg the
claim inception/disability annuity method) and this serves as important additional
practice in using those methods.
Question
A health and care insurance company is to issue a three-year income protection policy to
a man aged exactly 62, payable by single premium. The policy pays a benefit of
£15,000 pa continuously while sick and unable to work, with no deferred period. All
benefits cease at age 65 or on earlier death.
For an additional single premium payable at the start of the policy, the following option
will be included:
• to increase the annual income benefit by £7,500 at either of the first or second
policy anniversaries (but not both), for which the standard rates of additional
single premium would be charged, without further evidence of health.
Calculate the additional single premium required to pay for this option, using the North
American experience method with the following assumptions:
• Mortality of all lives: ELT 15 (Males)
• Central rates of claim inception (as defined in Chapter 15):
– standard lives: 0.3 pa at each age
– lives after exercising option: 0.6 pa at each age
• Morbidity for all lives while receiving benefits: S(ID)
• Proportion of eligible lives taking up the option:
– at first policy anniversary: 35%
– at second policy anniversary: 20%
• Interest: 6% pa
• Expenses and other loadings: Ignore

Solution
We will work through this carefully. We will need to work out:

• the standard single premium for the contract at age 62
• the standard single premium for the additional policy taken out at age 63 by
those then exercising the option
• the standard single premium for the additional policy taken out at age 64 by
those then exercising the option.
We will then need to calculate:

• the expected present value (EPV) of all the benefits payable
• the EPV of all the standard premiums receivable.
Finally, taking the difference between these two values will give the additional cost of
the option, which will be the required additional single premium.
Standard premium for the contract, ignoring options
This is equal to the EPV of the benefits assuming standard mortality and morbidity.
This is:
HS
15, 000 a62:3
= 15, 000 ¥ 0.3 { ½ SS

½ p62 v a62½:2½ + 1½ p62 v1½ a63½:1½
SS
+ 2½ p62 v 2½ a64½:½
SS
}
Using ELT 15 (Males) we have:
• ½ p62 = 1 - 12 q62 = 0.991255
• 1½ p62 =
l63
l62
( )
1 - 12 q63 = 0.972859
• 2½ p62 =
l64
l62
( )
1 - 12 q64 = 0.952616

From the S(ID) Tables, and interpolating, we get:
•
SS
a62½:2½ = 1
2 (0.2134 + 0.1875) = 0.20045
SS
• a63½:1½ = 0.16520
SS
• a64½:½ = 0.07145
Using these values and interest at 6% we get the single premium to be:
15, 000 ¥ 0.119729 = £1, 795.93
Question 17.9
Calculate the standard single premiums for the two additional policies (taken out at ages
63 and 64).
Calculating the EPV of the benefits
For this we need to construct a double decrement table with decrements of death (d) and
exercising the option (w). We then require to calculate:
15, 000 ¥ 0.3 { ½ SS

½ ( ap )62 v a62½:2½
SS
+ 1½ (ap )62 v1½ a63½:1½ SS
+ 2½ (ap)62 v 2½ a64½:½ }
+
22,500
(al )62{ w
(ad )62 ¢ HS + (ad )63
v a63:2 w 2 HS
¢
v a64:1 }
noting that:
• any life will have total benefits in force of £22,500 pa after taking up the option
HS
• a x¢ :65 -x
is the expected present value of a sickness benefit of £1 pa for a healthy
life aged x, who has just exercised the option, benefits ceasing at age 65.

The double decrement table can be constructed as follows. Choosing (al )62 = 10, 000 :
x (al ) x (ad ) dx (ad ) wx
62 10,000 174.900 3,438.785
63 6,386.315 125.491 1,252.165
64 5,008.659 110.140 0
where, for example:
d
(ad )63 = (al )63 ¥ q63
w
(ad )63 = È (al )63 - (ad )63
d ˘
¥ 0.2
Î ˚
d w
(al )64 = (al )63 - (ad )63 - (ad )63
Question 17.10
Complete the calculations begun above and hence compute the EPV of the benefits,
including the cost of the option.
Question 17.11
Calculate the EPV of all the standard premiums payable and hence calculate the
additional single premium required to cover the option offered under the policy.

Chapter 17 Summary
Mortality/morbidity (health) options
Many health and care insurance contracts contain options whereby the policyholder can
choose to extend the term or increase the level of cover at normal premium rates
ie without providing further medical evidence. To the extent that the option might be
exercised by someone in poor health, the assurance company will bear a cost: the
difference between the ordinary premium rate granted under the terms of the option and
that which would have been granted had the life been underwritten.
There are two main methods used to value health options:

• The North American method. This method requires extra data on the likelihood
of the option being exercised and the morbidity of those who do so.
• The conventional method. This method assumes that all lives eligible to take up
the option will do so and that these lives will experience Ultimate morbidity
compared to the Select morbidity they would have displayed had they been
underwritten. The conventional method copes less easily with multiple options.
In addition, it may be possible to value the cost by modelling the claim experience
stochastically, using stochastically generated proportions of lives in the various risk
groups, and their (stochastically generated) expected morbidity experience.
The smaller the proportion of lives exercising an option, the worse will be their average
morbidity experience.
The total option cost is a function of:
{proportion of lives exercising option} × {average health of lives exercising option}
The total cost is highest if all lives with higher than select morbidity/mortality exercise
the option.
There will be a loss of future profit where healthy (and especially super-healthy) lives
do not exercise the option.
Mostly, due to policyholder lethargy and/or unawareness, options tend to be

under-exercised, which generally lightens the option cost but also reduces potential
future profits from healthy lives exercising the option.
Experience must be monitored in order to identify potential large risk threats that could
dramatically increase health option costs.

summaries together as a revision tool.

Solution 17.1
The option would only be worthless if there were only two types of individual – those in
perfectly good health (normal select lives), and those who were claiming benefits.
There is a third (and significant) category: those who currently have an increased risk of
claiming in the future, but who are not yet ill (enough) to qualify for a claim at the
present time.
An example of someone who would benefit from exercising an option would be an

applicant who is in good health at policy entry, who takes out a critical illness insurance
with an option to increase benefits after ten years, without further medical evidence. By
ten years time the person may have developed hypertension (high blood pressure), with
much increased risk of stroke, but he or she can still take out the increased cover on
standard terms under the option.
Solution 17.2
The policyholder cannot then immediately exercise the option on discovering that he is a
poor risk, eg when he has just discovered that he has extremely high blood pressure.
Solution 17.3
The first is worst – if everyone with higher than select morbidity takes up the option.
This means that the maximum possible total amount of gain has been made by the
policyholders. This will include the cost to the company of insuring the few very high
risk lives at standard premiums, plus the costs of insuring the other medium-high risks
on the same terms.
Solution 17.4
The company is actually better off if all the healthy lives take up the option as well as
the unhealthy ones. This is because the healthy lives will be paying a premium that
should be appropriate to their expected select morbidity, and (provided the company’s
standard premium rates are profitable) this should create additional profits for the
company.

Solution 17.5
Some ideas for courses of action include:

• remove the options from new business
• increase the current standard rates of premium so that the policies being effected
under the option recoup some of the extra option cost, and/or make the option
less attractive and so reduce the amount of take up
• in the extreme, the company could stop issuing the type of policies that are being
taken out under the option, though this could seriously upset the policyholders
involved
• it may be possible to reinsure some of the increased risk
• reduce the encouragement given to policyholders to exercise the option, eg stop
reminding policyholders about it when they reach the exercise date.
Solution 17.6
Consider the first summation in the present value. Each term in the summation
represents the probability that the policyholder will claim in that year without having
exercised the option, multiplied by the discounted value of the sum insured S (payable at
the end of the year of claim). The summation is over the 10 years of the original policy
term.
The second part of the equation is again a summation. Each term in the summation
represents the probability in any year that the policyholder will exercise the option
(ad ) wx +t
(represented by ) multiplied by the value of the benefits payable once the
(al ) x
option has been exercised. The benefits are valued at the end of the year in which the
option is exercised since the exercise occurs at the policy anniversary. At the point of
exercise, the value of the benefits is S ¥ A¢ 1 : -t -1 ie the value of an accelerated CI
x +t +120
insurance with sum insured S for the remainder of the 20-year period since the original
policy inception. The insurance function is evaluated allowing for the claim rates, q x′
(comprising of both mortality and CI claims), of the lives who have exercised the
option. The value of the insurance function is then discounted back to time 0 to obtain a
present value. The product of the probability of exercising the option each year
multiplied by the present value of the benefits is then summed over the years in which
the option can be exercised.

Solution 17.7
(Throughout this solution functions labelled “c” are based on the total claim incidence
basis; unlabelled functions are calculated using AM92 mortality, at the adjusted ages
shown, to represent the claim incidence basis.)
We first need to work out:
EPV (total outgo) - EPV (total standard premiums)
Now:
{0.7 ¥ 100, 000 A

c
l50
EPV (outgo) = 100, 000 Ac 1 +v 5
c
c1
[45]:5 l[45] 50:5
+ 0.3 ¥ 200, 000 A¢ c 1

50:5 }
where the primed function is calculated on the higher claim rate basis for lives who have
taken up the option. Translating into the AM92 mortality equivalent:
EPV (outgo) = 100, 000 A 1

[55]:5
+ v5
l60
l[55] {
0.7 ¥ 100, 000 A 1
60:5
+ 0.3 ¥ 200, 000 A 1

65:5 }
where:
l60 9, 287.2164
A1 = A[55] - v5 A60 = 0.38879 - 1.04 -5 ¥ ¥ 0.45640 = 0.023832
[55]:5 l[55] 9,545.9929
l65 8,821.2612
A1 = A60 - v5 A65 = 0.45640 - 1.04-5 ¥ ¥ 0.52786 = 0.044305
60:5 l60 9, 287.2164
l70 8, 054.0544
A1 = A65 - v5 A70 = 0.52786 - 1.04-5 ¥ ¥ 0.60097 = 0.076867
65:5 l65 8,821.2612
\ EPV (outgo) = 100, 000 ¥ 0.023832 + 0.799646 {70,000 ¥ 0.044305
+60, 000 ¥ 0.076867}
= 8,551.17

Now:
{0.7 ¥ 720.22 a

c
c l50
EPV (premiums) = 720.22 a[45]:5 + v5 c
c
50:5
l[45]
+0.3[720.22 + 919.81] a50:5

¢c }
which translated is:
EPV (premiums) = 720.22 a[55]:5 + v5

l60
l[55] {
0.7 ¥ 720.22 a60:5
+0.3 ¥ 1, 640.03 a65:5 }

where:
a[55]:5 = 4.590
a60:5 = 4.550
l70 8, 054.0544
a65:5 = a65 - v5 a70 = 12.276 - 1.04-5 ¥ ¥ 10.375 = 4.490
l65 8,821.2612
\ EPV (premiums) = 720.22 ¥ 4.590 + 0.799646 {0.7 ¥ 720.22 ¥ 4.550
+ 0.3 ¥ 1, 640.03 ¥ 4.490}
= 6,906.63
So the extra cost of the option is:
8, 551.17 - 6,906.63 = 1, 644.54
Finally the additional annual premium, for the first five years of the policy, is therefore:
1, 644.54 1, 644.54
c
= = £358
a[45]:5 a[55]:5

Solution 17.8
It is very difficult to include this degree of uncertainty in a stochastic model with any
confidence about the probability distributions that would need to be assumed. Instead
the stochastic model would probably be run several times incorporating major “what-if”
shifts to the underlying parameters of the assumed probability distributions.
So, for example, our assumption shifts could imply significant changes to the expected
proportions in each risk group, and to the expected morbidity of each group, and the
model would be rerun to see the effect this might have on the simulated distribution of
option costs and hence on the required option premium.
This is an example of sensitivity testing in a stochastic modelling context.
Solution 17.9
Standard single premium at age 63
This is:
HS
7,500 a63:2
= 7,500 ¥ 0.3 { ½ SS
½ p63 v a63½:1½ + 1½ p63 v1½ a64½:½
SS
}
Using ELT 15 (Males) we have:
• ½ p63 = 1 - 12 q63 = 0.990175
• 1½ p63 =
l64
l63
( )
1 - 12 q64 = 0.969572
Using the same annuity functions as before we get the single premium to be:
Ï 0.990175 ¥ 0.16520 0.969572 ¥ 0.07145 ¸

7,500 ¥ 0.3 Ì + ˝
Ó 1.06½ 1.061½ ˛
= 7,500 ¥ 0.066707
= £500.31

Standard single premium at age 64
This is:
HS
7,500 a64:1
= 7,500 ¥ 0.3 ¥ ½ p64 v½ a64½:½

SS
= 7,500 ¥ 0.3 ¥ 0.989005 ¥ 0.971286 ¥ 0.07145
= 7,500 ¥ 0.020591
= £154.43
Solution 17.10
From the previous table we can get:
10, 000 - ½ ¥ 174.900

½ ( ap ) 62 = = 0.991255
10, 000
6,386.315 - ½ ¥ 125.491
1½ ( ap ) 62 = = 0.632357
10, 000
5,008.659 - ½ ¥ 110.140
2½ ( ap )62 = = 0.495359
10, 000
We also need:
¢ HS = 0.6 ½ p64 v½ a64½:½

a64:1 SS HS
= 2 a64:1 = 2 ¥ 0.020591 = 0.041181
¢ HS = 2 a63:2
a63:2 HS
= 2 ¥ 0.066707 = 0.133414

So the EPV of the benefits is:
È 0.991255 ¥ 0.20045 0.632357 ¥ 0.16520 0.495359 ¥ 0.07145 ˘

15, 000 ¥ 0.3 Í + + ˙
Î 1.06½ 1.061½ 1.062½ ˚
22,500 È 3, 438.785 ¥ 0.133414 1, 252.165 ¥ 0.041181 ˘
+ +
10, 000 ÍÎ 1.06 1.062
˙
˚
= £2,514
Solution 17.11
The EPV of all the standard premiums is:
w w
(ad )62 (ad )63
1, 795.93 + v ¥ 500.31 + v 2 ¥ 154.43
(al )62 (al )62
0.3438785 ¥ 500.31 0.1252165 ¥ 154.43

= 1, 795.93 + +
1.06 1.062
= 1,975
Therefore the additional single premium required is:
2, 514 - 1,975 = £539




using the course.

Chapter 18
Pricing (4) – other considerations
Syllabus objectives
– Options
– Guarantees
(The item in bold is covered in this chapter. The other Core Reading included in this
chapter is general to the pricing process and does not relate to any of the above
subheadings in particular.)
0 Introduction
Here we finish our discussions on pricing by covering some of the important additional
considerations that need to be looked at before finally deciding on a price (or rather,
pricing scale) for a given product.
This chapter brings together quite a lot of points that are mentioned elsewhere in the
course, where they sometimes appear under different headings. The point is that we see
here all of these issues as they relate to the pricing process.

1 Guarantees
As indicated earlier, the offering of guarantees can be fraught with danger if
there is significant uncertainty about future risk experience, and this may be
especially true in health and care insurance. Nevertheless, some markets
demand premium and benefit guarantees and the actuary must produce
appropriate prices.
On the other hand, private insurers always have the option of withdrawing from a
particular market (ie line of business) if it is felt to be too risky.
1.1 Investment guarantees
Traditional insurance contracts transfer the mortality/morbidity, expense and

investment risk from the policyholder to the insurance company. More modern
contracts often leave the investment risk with the policyholder eg unit-linked
endowment insurance. While there may be some investment guarantees
provided by insurers under health and care policies, these are not the norm and
thus outside the scope of this subject. The student is advised to look at the
particular sections within subject ST2 if wanting to delve further.
Question 18.1
What do you consider to be the main reason why most healthcare insurance contracts do
not pose financially crippling investment guarantees on insurers?
Suggest a healthcare insurance contract that could pose the insurer with a significant
investment risk.
1.2 Resilience testing of premium rates
Premium rates need to be assessed on a resilience basis to judge whether, in the

absence of an ability to change the premium/benefit relationship, the premium
charged will be sufficient to meet all outgoings, with an agreed level of
confidence.
This is essentially the process of sensitivity testing, that we referred to at the end of
Chapter 14.
This will require the establishment of reserves in early years when the risk is
lower and more certain.

That is, the claim experience early in the policy term should have been fairly accurately
anticipated (ie have low volatility or low risk). However, the company needs to reserve
adequately at all times in order to cover potential adverse volatility from future claims,
which will be much less accurately predicted.
1.3 Adequacy of reserves in pricing
It is imperative that the actuary incorporates the cost of these reserves in the
pricing calculation. Otherwise some other party will be paying for the cost of
guarantees. If the true cost of guarantees appears in the premium, it may
encourage many to move to a reviewable contract, where the same benefits (but
without the guarantee) will cost considerably less.
Incorporating the cost of reserves was discussed also in Chapter 13. We discuss the
effect of reviewability in Section 2 below.
1.4 Regulatory approval
The local regulator will normally want to see evidence of the techniques
employed and their output, to judge the adequacy of the premiums and reserves
required.

2 Reviews
2.1 Regular monitoring of new business bases
The pricing of new business will require the most up-to-date information. The
actuary will keep all items in his assumption set under review. When any one of
these is no longer valid, the effect of this must be tested against the existing
premium tariff to see whether the charging rate for new business needs to be
changed. Information leading to changes in the assumptions may come from
internal “experience” sources or from outside influences.
This is a vital part of the actuarial control cycle, and is the means by which the actuary
keeps his or her pricing models up to date and valid. The Core Reading is pointing out
that not every change in the assumption set (or basis) will necessarily lead to a change
in the prices the company actually charges. Remember that changing prices incurs the
company in much expense, and also may have (possibly undesirable) effects on
marketability. These effects have to be weighed up against the changes in profitability
and risk caused by the altered conditions when deciding whether and/or how the rates
should be changed.
A related issue is how deviations in past experience from expected lead to changes in
the “assumption set” (by which we mean the company’s estimates of its future
experience). See Chapters 10 and 11 (Assumptions) and also Chapter 28 (Monitoring)
for more discussion about this.
2.2 Regular monitoring of reviewable premiums
The pricing actuary will also be involved in the estimating of premiums where
these are periodically reviewed as part of the contract terms. For long-term
healthcare products, the rates will require revision if the experience under the
portfolio has differed markedly from that assumed since the previous review.
The reason why the company needs to monitor its reviewable premium rates closely is
due to the much smaller margins that are typically included in such rates.
Question 18.2
Why do reviewable rates include lower margins than non-reviewable ones?

Reviewable unit-linked contracts have an additional layer of complication compared

with conventional product designs. For a conventional contract there is simply a
premium (possibly index-linked) that may rise or fall (in real terms) following a
premium rate review. This level of premium then continues until the next review date.
For unit-linked contracts, there are two aspects of review:
(1) a review of the charges being levied under the contract
(2) a review of the level of premium (or contribution) being paid into the policy by
the policyholder.
An in-force policy will be typically subject to regular charges, for example:

● a regular fund management charge (proportionate to the size of the unit fund)
● a regular monetary fee (deduction from units) to pay for administration costs
● a regular risk premium (deduction from units) to pay for the cost of the
insurance benefits.
(As an example of the third charge, a unit-linked income protection policy will have an
annual risk premium calculated using the {inception rate} ¥ {disability annuity value}
approach described in Chapter 15. This would therefore cover all the (future) claim
costs expected to arise out of this year’s sickness inceptions.)
So a review of type (1) may result in a change to one or more of these charging rates,
reflecting major shifts in expenses or expected future experience. As with reviewable
conventional contracts, this will affect all policies.
A type (2) review is to ensure that enough money is coming into the policy (between
this and the next review date) to cover all the charges that the company expects to
deduct from the unit fund over the period. The current level of unit fund would be
taken into account in this assessment. The company will therefore make a conservative
projection of the policy for the period, using low unit-growth assumptions in particular.
Using these projections the company should be able to determine the amount of regular
premium that will produce, with a high degree of confidence, at least the desired unit
fund level at the next review date. This review is performed at the individual policy
level.
You must remember that the purpose of a unit-linked structure for most healthcare
insurance contracts is to make the product cheaper to policyholders, by giving them
credit for good unit-fund growth. It is not usually designed as a savings vehicle (at least
when the contract is primarily designed to provide healthcare insurance), although any
residual unit-fund available at death, lapse or expiry may be returnable to the
policyholder.

Question 18.3
How will a policyholder benefit from good unit-fund growth other than through
receiving a higher residual payment on policy termination?
On a premium review the key thing for the company is to fix the level of premium
(fixed until the next review date) that leaves the policy with a very low probability of
producing negative unit fund values at any stage over the period.
Question 18.4
What is the problem with having negative unit-fund values?
Charging rate and premium rate reviews do not necessarily occur at the same time. For
example, individual contracts may specify premium reviews (ie type (2)) on every fifth
policy anniversary; however the company may have the discretion to alter the charging
rates (ie a type (1) review) at any time. When doing premium reviews, the company
would try to anticipate expected changes in charging rates that might occur before the
next premium review date.
Where an increase in premium (or charging rate) is called for, the actuary must be
careful not to encourage selective lapsing. The basis of his calculation will be
invalid, if as a result of the change, a significant proportion of the more healthy
lives decline to proceed, and the risk under the balance of the portfolio escalates
as a result. This is likely if lives can reapply to a competitor and thus reinstate
their coverage more cheaply.
The extent to which the effectiveness of this rate review may be compromised by
selective lapsing must therefore be taken into account when deciding by how much rates
should be increased. Increasing the rates by too much can backfire on the company, by
leaving it holding a smaller portfolio with a much higher per-policy expense cost than
before, negating some or all of the hoped-for beneficial effect of the rate rise.
In some territories, the regulator has given guidance as to what aspects of the
premium rate basis may be considered in order to justify a change in reviewable
premium rates.

Example
In the UK, there is significant guidance given to insurers regarding reviewability of

long-term insurance policies.
Among the conditions that insurers must adhere to are:

● the basis for reviewing premiums should be clearly set out in policy literature
● premiums can only be increased if the insurer changes one or more of the
relevant assumptions in this premium basis for “valid reason”
● where premiums are changed as a result of claims experience changes, it must be
clear that this does not relate to the experience of the individual policyholder but
to general claims experience for similar policies.
2.3 Premium adequacy tested for reserving purposes
Where a policy is sold at less than the full premium rate for the expected claims
and expense outgo, for portfolio development or cross-subsidy reasons,
reserves will need to be established for the extent to which the pricing basis is
inadequate. The size of the reserves will depend on the speed at which the
premium can be reviewed and its size upgraded to the full rate and on the
likelihood that policyholders will renew their contracts as the premium level is
being increased. However, where inadequate rates apply on long-term
insurances on guaranteed terms, there are serious considerations for the
actuary responsible; his/her course of action will depend on the codes of
professional guidance in the territory where he/she is operating.
Unless there are regulations that require minimum premiums and charges to be levied
for a particular policy, the company would be free to undercharge on its insurance
contracts for marketing or whatever reasons. At the same time, it would still have to
reserve adequately for the risks taken on allowing for the future premium that is
actually being paid. So if the premium is inadequate, the company will have to find
capital from other sources in order to set up the necessary reserves. The capital may
come from shareholders or from retained profits.
Question 18.5
Using your knowledge from Subject CT5 suggest whether a net premium or gross
premium valuation method would be the most appropriate, for a policy written with
guaranteed terms and for which inadequate premiums were being paid.

3 Competitiveness
3.1 Premium tariff tested against market
A close watch will normally be kept on the pricing approach of competitors with
similar products. Any significant discrepancies should be investigated, though
there could be many reasons, eg different target markets.
While a competitor’s cheaper price may reduce the insurer’s market share, more
importantly, it means that better lives, through more detailed risk selection, go to
the competitor and the insurer’s pricing assumptions are called into question.
There are two different factors involved here:
(1) the overall level of premiums charged compared with competitors (which will be
a function of how optimistic or conservative the pricing basis is), and
(2) the number and accuracy of rating factors involved.
For example, a company that uses the same (average) premium basis as another may
offer identical rates to smokers and non-smokers, while the competitor offers cheaper
rates to non-smokers and dearer rates to smokers (assuming that smokers are more
likely to claim!). The result is that our (first) company has a larger proportion of
applications from smokers, who will then be charged premiums that are based on a mix
of smokers and non-smokers taking up the policy. So the company makes a loss on the
business – it has suffered from anti-selection.
This is what the Core Reading means when it says that the insurer’s pricing assumptions
are called into question.
The above effects generally lead to all the companies in the market for a particular
contract using similar rating factors to each other, thereby avoiding the worst (market
driven) anti-selection effects.
3.2 Need for volume
In the pricing basis, the fixed expenses are charged to the policies in some
measure according to volume. If the latter is lower than the market norm, then
the proportionate expense charge may be relatively large and this could impact
on the competitiveness of premiums.

The existence of fixed expenses is one of the reasons why volume matters to the bottom
line of insurance companies. It is the economy of scale principle, common to any
business and not just to insurers. It helps lead to high sales volume being a company
aim, and can also fuel the desire for mergers with and/or acquisitions of other insurance
companies, as all of these lead to greater marginal revenue in proportion to fixed costs.
The net result (all else being equal) should be a higher return on capital for the
shareholders, as well as just increasing total profits.
Additionally, brokers and many members of the public prefer to deal with larger
insurance companies, deeming them more secure and more accommodating in
claims settling. To achieve this acceptability, many companies have market
share and corporate size as mission statements.
Margins
In the quest for competitive products and market share, the actuary may be in a
position of bartering with margins within contracts. Commercial decisions may
have to be taken to price a healthcare product closer to the expected cost than
would be strictly prudent, given the uncertainties of future claims experience.
Launching an over-cheap product with a view to increasing volume is sometimes

referred to as selling a “loss leader”.
It is crucial that other lines be costed with additional margins, to subsidise the
first class of policy if experience should deteriorate. This again is purely a
matter of taking a wider portfolio perspective of profitability. The actuary will
need to monitor the volumes in each class to ensure that, as new business is
taken on, the margins foregone in one line are adequately met in another.
Question 18.6
What is the risk with this cross-subsidy approach?
For a long-term product, state how you might wish to cover this risk before deciding to
launch a loss-leader.
In the fullness of time and in line with emerging experience, it is to be expected

that each line is put back on a footing to produce its own contribution to
designated profits. At this stage the profits on the product line will be largely
immune from volume fluctuations.

3.3 Overall return on capital
The key measure required is that when such adjustments have been made, the
required return on capital at each profit centre is met. If this does not happen,
then there are serious grounds for withdrawing from the particular class of
business. An excess return on capital indicates that the pricing basis in one or
more subsets can be relaxed to promote greater volume.
A profit centre can be any collection of business items that has a separate target for
contribution to company profit or revenue. At one extreme it could be very broadly
defined (eg all of the company’s broker produced business), or at the other extreme very
narrowly defined (eg the book of female stand-alone CI policies with buy-back options
sold by a tied aged in Banbury).
The various aspects of determining the return on capital have been discussed in
Chapters 12 and 14.

4 Regulator’s impact on pricing
4.1 Pricing freedom
This can be imposed on one or several of:

• bases
• rates
• differential premiums.
The role of the regulator varies by territory. Where the insurer is seen as playing
a role in the provision of welfare payments, it is likely that the pricing basis for
such insurances will be closely monitored by the supervisors – indeed the basis
may be totally prescribed.
Here the actuary may have to submit his basis and calculations to the
supervisory authority before the policies can be marketed.
Question 18.7
“Healthcare insurance operates in a highly competitive market so surely we can leave it

to market forces to keep prices at reasonable levels” – comment.
In other instances, only certain aspects of pricing may be restricted, eg a single

premium cost to all new subscribers (community rating) or the inability to
differentiate between risk cells (eg discrimination by sex).
By a “single premium” cost we mean a single rate of premium that would be applied to
all new policyholders. It does not mean the condition applies only to single premiums
(ie as opposed to monthly or annual ones).
The actuary will include such conditions in his premium calculations, as well as
using his expertise to explore ways as to how any consumer detriment in the
restrictions may be ameliorated.

4.2 Cost of regulation
Here we are referring to a slightly different aspect of possible regulatory control,

involving restrictions to the way the insurer can operate.
An example would be the restriction imposed in many territories on the kind of

information insurers can use for underwriting. Companies may be prevented from
taking into account the results of any genetic tests that insurance applicants may have
had.
Any restriction on commercial operations may impose a cost which needs to be

reflected in the premium assumptions. For example:
● a requirement to invest in “local” assets will impact the interest return
that can be included in the calculations
● the need for the insurer to collect premium taxes will also necessitate a
further expense loading in the premium basis.
Such additions to costs will affect all insurers in a market equally and thus
should not affect competitive positions.

5 Reinsurance impact on pricing
5.1 Cost of reinsurance
The role of reinsurance can be very important in the day-to-day management of

product development and profitability. It can provide a number of roles in this
area:
• technical assistance in data provision and pricing basis
• risk sharing and limiting overall exposure
• smoothing profitability
• providing financing to support new business strain
• tax arbitrage where the reinsurer is taxed on a different basis from the
insurer
• solvency margin arbitrage where the reinsurer is required to hold less
capital per unit of risk
• enabling the insurer to accept larger risks.
The first four and the last of these are fully described in Chapter 26 (reinsurance). We
will discuss the others in Section 5.2 below.
Where any of the above services are deemed to have a cost, ie situations where
the direct monetary gain is exceeded by the reduction in premium, the actuary
should include this as an item in his costing basis.
Unless some arbitrage is possible (as it often is) then the insurer will expect to make a
loss from the reinsurance it takes out, as the value of the reinsurance premiums paid will
be greater than the expected present value of the reinsurance benefits payable
(remember that the reinsurer has to cover its own expenses and profit). This loss, which
is effectively a reduction in the expected profits that would be earned from the policy
without reinsurance, would have to be included in the pricing model.
Assumptions would need to be made about the future mix of business (eg by policy
size) in order to assess the average amount of reinsurance per policy. Alternatively, and
especially if the amount of reinsurance increases with policy size, it may be possible to
have differential premiums or charging rates depending on the size of the benefits
provided under the policy.
Note that further discussion of the role of reinsurance can be found in

Chapter 26.

5.2 Benefit of reinsurance
Some kind of arbitrage is necessary for this to occur.
Tax arbitrage
The idea is that both companies (the insurer and reinsurer) can reduce their tax bills
through reinsurance, and so both companies’ profits (net of tax) would be increased as a
result. However, this will only work between companies that complement each other in
terms of their tax “requirements”.
Example
Depending on a company’s mix of business, and also upon the way it is taxed, a
company’s tax bill might be reduced by either:
(1) increasing income and/or reducing outgo, or
(2) reducing income and/or increasing outgo.
The first of these seems counter-intuitive. However, if a company has more outgo than
income, it might be making tax losses that won’t benefit the company in any way until
the time (if ever) when income first exceeds outgo. (1) will therefore enable the tax
losses to be credited to the company sooner, increasing their value.
Tax arbitrage will be achieved by a company of type (1) reinsuring with a company of
type (2), and/or vice versa, by transferring appropriate cashflows between them. For
example, a type (2) company could share some of its high income/low expenses
business with a type (1) company.
The details of this are beyond the scope of this subject, but are covered in Subject SA1.
Solvency margin arbitrage
This occurs when the reinsurer does not have to hold as much capital – eg as a
supervisory solvency margin – for a given unit of risk than the insurer does. The cost of
the capital required to manage the business will be less in the reinsurer’s hands, and part
of that saving can be transferred to the insurer by offering attractive (ie cheap)
reinsurance premium rates. (Alternatively some other compensation, such as higher
commission, could be paid). It should then be possible to pitch the reinsurer’s premium
rate at a level that will increase the insurer’s profits as well as those of the reinsurer.

Where the financial benefits of reinsurance exceed the expense increase or

premium loss, eg by tax arbitrage, the actuary is likely to want to price the
product on a net of reinsurance basis to ensure that premiums are as
competitive as possible.
This is really just the same as described in Section Error! Reference source not found.
above, except with the opposite financial effect.
5.3 Reinsurer approval
The relationship between insurer and reinsurer may be such that a large portion
of the risk is passed to the reinsurer by way of quota share. This may well arise
when the insurer has no expertise in the new product area and is depending
substantially on reinsurer expertise in the early years. Under these
circumstances, it is normal for the reinsurer to have a major say in the
production of premium tables, or at least to have the right to vary any
reinsurance commission payable, following a revision of tariffs.
Quota share reinsurance is where a fixed proportion of all premiums and claims under a
product line are transferred to the reinsurer.
Question 18.8
Why would the reinsurer expect the right to vary reinsurance commission in these
circumstances?


Chapter 18 Summary
Cost of guarantees
Claim and expense guarantees under healthcare insurance contracts can be onerous.
Investment guarantees are generally less of an issue except with LTCI.
Guarantees require larger risk margins to be included in product prices in order to cover
future outgo with adequate confidence.
Sensitivity testing of guaranteed premium rates should be performed under a range of

changed conditions, to ensure margins are large enough.
Reserves may need to be significantly increased for guaranteed products. The full cost
of these reserves must be included in the pricing model, increasing the cost of capital
and so further increasing the price of the product.
Reviewing prices for new business
Premium bases must be kept up to date through frequent experience monitoring.

Current premium rates should be tested against any changes to the current basis. Price
changes would be considered in the light of the financial impact of a basis change, but
bearing in mind other factors such as expense and marketability.
Premium reviewability
Many healthcare insurance products avoid the potentially large cost of guarantees by
having reviewable charging rates.
For conventional products the premium may be subject to review on a regular basis and
adjusted when overall experience is judged to have changed significantly.
For unit-linked policies, policy charges may be subject to review in this way.
In addition, for most unit-linked policies, the premium (contribution) rate will be
reviewed at set intervals to reflect changes in charges and in unit-growth rates.
Reviewability greatly reduces the margins needed in pricing and reserving.
However, reviewability increases the risk of selective lapsing, which may reduce the
beneficial effects.

Marketability and competitiveness
Volume is important to cover fixed expenses. Premiums may need to be reduced in

order to secure sufficient volumes against competition.
Rating factors need to be consistent with competition to avoid or reduce anti-selection

risk.
If inadequate premiums are charged – eg for a “loss-leading” product – fully prudent

reserves must be held that explicitly allow for any future premium shortfall. Gross
premium reserving methods provide a suitable methodology for this.
Loss-leader products must be compensated by larger margins in other lines of business,

and should be reviewable so that they can become profitable later. Free assets should be
available to cover the risk of a permanent shortfall.
A product line should aim to meet return on capital requirements, taking all
cross-subsidies into account.
Regulatory constraints
Pricing bases, premium rates, or rating factors can be put under direct control of the
regulator.
The regulator can also affect pricing bases indirectly by restricting insurer operation
(eg through constraints on investment strategy or underwriting). These will affect the
pricing assumptions and hence the price that will be charged.
Reinsurance impact
Reinsurance can alter expected profitability. Any material impact needs to be

incorporated in the pricing.
Insurers often receive pricing advice from their reinsurers, who then earn a right to
influence the prices the insurer can charge. This is particularly true when original terms
reinsurance is used – where the insurer and reinsurer have proportionate shares of
premiums received and claims paid.

Solution 18.1
Most healthcare insurance products are protection rather than savings contracts, in
which the main risk to the insurer arises from the incidence and (in some cases) duration
of claims. While the claim payment may be both large and guaranteed, the policy
reserves are usually so small relative to the size of the benefit that even if investment
returns (on those reserves) are much lower than expected, the financial impact on the
company will be small.
Pre-funded long-term care insurance is the one healthcare contract that does usually
require large reserves, and for which a fall in investment returns could pose a significant
risk. Whether or not it does pose a risk will then depend on the extent to which the
policy is written on guaranteed terms. If all benefits and premiums/charges are fully
guaranteed, then the investment risk could be large.
Solution 18.2
Reviewable rates do not have such large margins in the basis because any significant
deterioration in future experience should be covered by future rate rises.
Non-reviewable rates do not permit this luxury and therefore need much larger margins
to cover possible future adverse experience (that may occur only in many years’ time).
Generally, the size of the margins will depend on how frequently reviews are carried
out.
Solution 18.3
By producing a higher unit-fund value at the premium review date, the policyholder
should be able to pay a lower premium over the next period. So, good unit growth over
the whole policy term will reduce the total amount of premium the policyholder has to
pay.
Solution 18.4
A negative unit fund implies that the policyholder owes the company money. So if the
policy were to lapse at such a point, then the company makes a loss.

Solution 18.5
The gross premium method would be best. The gross premium reserve is calculated as:
EPV {future benefits and expenses} - EPV {future actual premiums}
By taking credit only for the actual (inadequate) future premiums, the total reserve value
is increased.
On the other hand, the net premium reserve values a theoretical net premium, calculated
on the reserving basis, and takes no account at all of the size of the actual premium
payable.
Solution 18.6
The risk is that the mix of business will differ adversely from expected. For example,
the company may find it easier to sell the (possibly loss-making) cheaper product, so
sell more of it, while volumes of the more expensive product may be inadequate to
cover the shortfall.
The risk may be partly covered by having reviewable premiums on the loss-leading
product or, more definitely, by having adequate free assets to cover the potential
shortfall.
Solution 18.7
Disadvantages of leaving it to market forces
It is still possible for the industry to organise cartels to keep prices of contracts at
artificially high levels, to the detriment of consumers.
Market forces may drive prices down to very low levels, resulting in either a poor
standard of insurance service (in order to keep costs down), or the threat of insolvency
of the insurer (and it not being able to pay claims).
If left to themselves, insurance companies may opt not to sell certain lines of business
that they feel are unprofitable or too risky. Even if the regulator requires them to offer a
product (with no further regulation), there would be nothing to stop companies from
charging ridiculously prohibitive prices thereby effectively making the products
unavailable. (This would leave customers unprotected, in which case the State may be
forced to step in and provide a service.)

At a less extreme level, popular contracts will be more keenly priced than less popular
ones. So customers with minority needs (ie requiring the less popular benefit types)
will have to pay more. This would be avoided if prices were fixed by the regulator.
Changes in market structure (eg companies dropping out, mergers and acquisitions) can
quickly change the competitive effectiveness of a market.
Advantages of leaving it to market forces
It can lead to better value for money for customers if the market is competitive.
Regulator-imposed prices could lead to companies making larger profits for the
shareholders, and/or it could lead to companies operating with poor efficiency, thereby
making the consumer pay more. (Essentially the regulator may get the pricing level
incorrect.)
Complying with regulation incurs costs, so it should be possible to pass on cost savings
to policyholders.
Market-driven prices allow companies to react much more swiftly to relevant changes in
experience, particularly claims experience. If prices are imposed by the regulator, then
it will be much harder for companies to negotiate a rate rise and, meanwhile, significant
losses may have been occurring. In this case many insurers might leave the market
altogether, possibly significantly reducing the insurance provision that the state is so
keen to promote.
Solution 18.8
The reinsurer will have initially agreed with the company what it considers to be an
appropriate premium scale for the business. The reinsurer’s commission (ie paid by the
reinsurer to the insurer) is in fair compensation for the underwriting, marketing and
selling costs that the insurer incurs on the reinsurer’s behalf, and this would also be
agreed initially.
Should the insurer now wish to reduce (say) its premium rates (eg for competitive
reasons), it will affect the premiums received by the reinsurer in proportion to the
percentage reinsured. In order to leave the reinsurer in the same financial position as
before the change, the reinsurer would probably demand a reduction in the commission
payable to compensate.
Don’t worry if you didn’t really sort this question on your first attempt. You will find
out more about reinsurance later in the course – so it may be worth you having another
go at this question later, once you have read the relevant chapter.




using the course.

Chapter 19
Models (2)
Syllabus objectives
insurance:
∑ basic features
(The items in bold are covered – or partly covered – in this chapter.)
0 Introduction
This chapter looks at aspects of modelling other than pricing. In particular we consider:
● estimating the profitability of in-force business, and
● sensitivity testing.
The general requirements that have to be satisfied by all models were described in
Chapter 13, and modelling for pricing purposes was covered in Chapter 14.

1 Profitability of existing business
1.1 Embedded value
This section discusses the measurement of the total expected future profits from the
policy portfolio in force, using an “existing business” model. This is done in order to
calculate the embedded value of a health insurance company. Although this section is
concerned purely with the mechanics of quantifying the value of the expected future
profits from the in-force policy portfolio, it is useful to touch briefly on the concept of
embedded value. The embedded value may be defined as:
“the value of the future profit stream from the company’s existing business together
with the value of any net assets separately attributable to shareholders”.
Although this definition refers to proprietary companies, an embedded value can also be
determined for a mutual in a similar way, but you do not need to know the details of the
latter for the ST1 exam.
Because the embedded value represents the sum worth of both the existing free assets
net of liabilities and the future profits expected from in-force business, it is often
regarded as the best measure of a company’s real worth for purposes other than sale.
(At a potential sale stage the value of future new business – ie goodwill – becomes
important, and is added to the embedded value to give what’s known as the appraisal
value.)
It will therefore be measured regularly (for example, quarterly) to see how the company
is progressing – ie how the management is increasing its worth to shareholders. If
possible the embedded value will be broken down into distribution channels, or
subsidiaries, to measure their progress and so also the extent to which their management
is contributing to the company. Projected embedded values will be used as a criterion in
assessing any financial or strategic management decisions – for example, the choice
between two strategies will be heavily weighted in favour of that which generates the
higher projected embedded value.
1.2 Use of model points
To assess the profitability of existing business, model points are chosen to

represent that business. The model points used for any previous assessment
may form a starting point, modified to allow for changes due to the new
business taken on by the company and the business going off (ie through policies
terminating).

Another and more common approach is to redo the model point generation process from
scratch based on the policy portfolio as it appears now. This will be much less prone to
error than adjusting previous model point files.
The suitability of the points chosen should be checked. Where, as will usually
be the case, the profitability of the business is being assessed at the same point
of time as the supervisory reserves are calculated, one check is to use the
model points to determine the supervisory reserves and then compare this value
with the published value.
For each model point, the present value of projected cashflows can be obtained
as in Section 2.1 of Chapter 14. The discounting would be done using an
appropriate risk discount rate, although again in theory a different rate should
be used for each stream of cashflows.
The risk discount rate to use for this purpose would normally be less than that used for
product pricing, or in a new business model. This is because some of the risks are
reduced, in particular those due to new business volume and mix.
Scaling up the results of each model point and totalling these will then give the
expected profit from the existing business.
1.3 Present value of future profits
The discounted value of these future profits is often referred to as “present value of
future profits”. Its prime use is in conjunction with the net asset value of the company
to give the embedded value. It is of limited use in isolation, although when broken
down between product lines it may be of some interest. Simply checking that the
present value of future profits for a product is positive rather than negative will give an
indication that nothing is going badly wrong with the financial management of that
product.
Question 19.1
Explain why you would expect the present value of future profit for existing business to
be positive for each of the following:
(a) long-term contracts
(b) short-term (ie one-year renewable) contracts.

It can be useful to look at the present values of future profits at the following levels of
breakdown:
● by product
● by product classes (eg group vs individual, or short term vs long term)
● by distribution channel
● by subsidiaries, if appropriate
in order to compare their relative contribution to the company’s profitability.
1.4 New business
It is also normal to perform the above quantification for the new business written, giving
what is called “value of new business”. This involves taking the new business written
in (typically) the last year and generating appropriate model points. These are then
modelled not as at “now” (they are by now existing business) but as if at “point of sale”
– meaning before incurring any initial expenses and before receiving the first premium.
Doing this allows the company to check that it has been writing new business at target
profitability. Splits by product, product class, distribution channel and subsidiary will
also be useful here. This will give a very useful indication as to the current profitability
of existing products.
Question 19.2
What will the “value of new business” tell you that the “value of existing portfolio” will
not?
In addition to assessing the profitability of existing business in the “embedded value”

fashion described above, a healthcare insurance company would normally study such
profitability by regularly profit testing the existing product range on the current pricing
basis. This will show if any products need to be re-priced due to altered financial,
demographic or expense circumstances.

2 Multiple-state modelling in other applications

The practical use of multi-state models in the pricing of health and care
insurance products was considered in Chapter 15 of this Course.
We also described various other techniques that may be used for the same purpose, the
choice of technique often being tailored to the modelling of specific types of health
insurance claims (ie using different claim models for income protection, critical illness,
long-term care insurance, and so on).
Similar tools will apply for reserving (and other) purposes, though the
assumptions underpinning the parameters will need to be adjusted in
accordance with the purposes for which the estimates are calculated. For
example, the assumptions used in calculating the reserves for statutory
reporting might be different from those used in assessing the liabilities which
are transferred on the sale of a company. Thus the assumptions used to
determine, for example, the transition intensities will vary according to the
overall purpose of the analysis.
This Core Reading is therefore making a comment about the different assumptions that
may be necessary for different modelling purposes: we discuss this subject fully in the
next chapter on assumptions (Chapter 20).

3 Sensitivities
The results from the models used in this and in previous chapters depend on the
choice of model points and the values assigned to the parameters in the model.
So this applies equally to:

● pricing models
● models used to determine reserves, capital requirements, and return on capital
● models used to assess the profitability of existing business
● multi-state modelling
● asset-liability modelling – see also the Investments chapter (Chapter 22).
3.1 Sensitivity to choice of model point
If an adequate set of model points has been chosen, it should not be necessary
to test for the effect of model-point error. However, situations may arise where a
less than ideal number of model points have to be used, in which case the effect
of a different choice should be assessed.
This refers to the sensitivity of the model to model point selection. Normally the model
will be based on a large number of model points, enough to eliminate any significant
model-point error. Often, if a large number of runs are required to test thoroughly the
various parameter sensitivities, then the model might be recreated with a much smaller
number of model points. In this case the sensitivity to model-point error is more likely
to be an issue.
3.2 Sensitivity to parameters
The effect of mis-estimation of the parameter values can be investigated by

carrying out a sensitivity analysis. This involves assessing the effect on the
output of the model of varying each of the parameter values. When doing this
any correlation between different parameters should be allowed for.
This mis-estimation refers to actual future experience being different from the parameter
assumptions. Since it will almost always be the case that the two are different,
sensitivity testing is very important in indicating the range within which we think the
“best estimate” (of our results) will probably lie. In other words, we are assessing the
range of possible outputs which might “reasonably” reflect the uncertainty associated
with the estimation of each parameter.

Allowing for correlation simply means testing under a scenario where two (or possibly
more) parameters are adjusted together, reflecting how they might move together in
reality. For instance, in a low future investment return scenario you would reduce the
expense inflation assumption correspondingly. Sensitivity testing in which several
parameters are changed in a consistent way is called “scenario testing”.
An important aspect of sensitivity testing is that it allows you to compare the relative
financial impact of the uncertainty that is associated with each parameter estimate. This
is of vital importance both in pricing and product design. For example, if a particular
parameter is highly uncertain, then you would try to design your product to be as
financially insensitive as possible to variations in that parameter. If that were to prove
impossible, then it may be appropriate to include higher margins for that assumption
than for other, less uncertain, assumptions.
3.3 Sensitivity testing when pricing
The results from the sensitivity analysis will help, in the case of a model used for
pricing, to assess what margins need to be incorporated into the parameter
values.
For instance, your income protection product has been priced on a yield assumption of
5% but the sensitivity tests indicate a loss if the investment return drops below 3%.
After consulting with an investment colleague, you attribute a probability of 0.1 to this
happening in the next ten years. You therefore decide to lower the investment return
assumption to 4%; sensitivity testing against this then shows reasonable results.
If the product profitability is overly sensitive to any factor, the results may indicate the
need to redefine the product or take some other measures. For instance, if it is too
sensitive to increasing withdrawal rates then a change in commission scales might be
considered; if too sensitive to morbidity then the reinsurance programme could be
revised.
Such sensitivity testing is also useful as a simple qualitative check that the model is
functioning correctly as far as the dependencies on those parameters are concerned. For
instance, increasing mortality rates should increase discounted future profits on most
healthcare products (unless there is a death benefit).

3.4 Sensitivity testing for business in force
In the case of models used to assess return on capital and profitability of

existing business, the results from the sensitivity analysis will enable the
actuary to quantify the effect of departures from the chosen parameter values
when presenting the results of the model to the company.
Question 19.3
What parameters would the actuary normally want to test in this way?
3.5 Alternative ways of allowing for risk
The statistical risk associated with the parameter values was allowed for in
Section 2.1 of Chapter 12 via the risk element of the risk discount rate. An
alternative to this would be to use a predetermined discount rate and then
assess the effect on the results of the models of statistical risk.
We can interpret “pre-determined” here as meaning arbitrarily set by the shareholders –

probably in relation to the return on risk-free assets rather than some absolute figure.
Example
Suppose that the shareholders demand a risk-free return of 4%. A suitable risk premium
(determined according to the principles described in Section 2.1 of Chapter 12) is 6%,
giving a risk discount rate of 10%. We can then profit test our product using best
estimate assumptions, discounting the projected profits at 10% pa for comparison with
the chosen profit criteria, in order to calculate the appropriate premium.
Alternatively, we could discount the profits in the model using the required risk-free
return of 4% pa. However, we must now allow for risk by using more pessimistic
assumptions for our parameter values, rather than the “central” best estimate parameters
we used before.
The worsening of the parameters should correspond to the degree of “badness” implied
by the additional 6% of the risk discount rate. For example, we might have decided that
using a 10% risk discount rate would produce a premium that would give the company a
probability of 0.95 that the actual return exceeds 4% pa. Then the “bad scenario”, with
which our worse parameters need to correspond, should be a scenario that we think will
occur with probability 0.05.

Where a probability distribution can be assigned to a parameter, it may be

possible to derive analytically the variance of the profit or return on capital.
More generally, a sensitivity analysis, as described above, can be carried out.
Whichever of these two is used, they will again help in assessing margins or in
quantifying the effect of departures from the chosen parameter values when
presenting the results of the model to the company.
The variance of the profit could also be assessed by using a stochastic model for the
distribution of the parameter, and then assessing the variance of the profit or return on
capital using Monte Carlo simulation.
The main problem with this is the difficulty (and subjectivity) involved in assigning a
probability distribution to the value of any parameter, and hence in estimating the
parameter risk associated with any particular case. A sensitivity analysis is a pragmatic,
transparent and informative way of getting a handle on the parameter risk, without the
difficulty (and perhaps spurious accuracy) of deciding upon some arbitrary probability
distribution to represent the uncertainty.
Choosing between stochastic and deterministic approaches
We first discussed this in Chapter 13 (Models), but we ought now to be able to refine
the circumstances in which stochastic or deterministic models should be chosen. So:
(1) Is a stochastic approach desirable or necessary (eg in order to cost guarantees)?

[If yes, go to (2); otherwise use deterministic (because it’s easier).]
(2) Is the future probability distribution of the variable(s) concerned predictable with
a good degree of confidence (eg have you a good idea of what the first two or
three moments of the probability distribution are)? [If yes, use a stochastic
model; otherwise use deterministic sensitivity testing, perhaps supported by
using a stochastic model to identify risky future scenarios.]
To answer this question, you will need to consider such things as:
– what are the past data like?
– does the experience correspond to the behaviour of our stochastic model
(ie does our model fit the data well)?
– what factors are likely to affect the variable in the future: are these (and
their effects) predictable with any confidence?

Question 19.4
The profit from an income protection product has been shown to be very sensitive to
withdrawal rates, particularly at early durations of the policy when the asset share is
often negative.
State whether you would use a stochastic or deterministic model for withdrawal rates if
you were trying to assess the future risks to the company from this cause, giving brief
reasons.
Finally, let’s not forget that a stochastic model can be invaluable:

● when you are trying to assess the impact of guarantees
● when the variable of interest does have a reasonably stable and predictable
probability distribution (eg investment returns in a developed economy under
stable economic and political conditions)
● for indicating the effect of year-on-year volatility (random fluctuations) on risk
● for identifying potentially high risk future scenarios (eg by tracing the sequence
of events that have led to your worst simulated outcomes).

Chapter 19 Summary
The actuary advising a life company will require models to assist with:
● product pricing
● assessing return on capital
● assessing capital requirements
● assessing the profitability of existing business (including the present value of
future profits on the existing portfolio)
● any other work involving financial projections.
Embedded value
The future profits projected from the existing business model can be discounted at an
appropriate risk discount rate to give the expected present value of future profits. This
plus the shareholders’ share of the net assets forms the embedded value of the company.
Sensitivity testing
Results from the model will need to be looked at in conjunction with sensitivity tests to
show the vulnerability of the results to unexpected future experience.
Outcomes will be analysed for sensitivity to variations in:

● model point assumptions (if applicable)
● parameter values.
Sensitivity testing, on a deterministic basis, can be used to help determine the margins
that may be necessary in a basis.
Such margins in each parameter assumption can be a way of allowing for risk in a
pricing model, as an alternative to risk margins in the risk discount rate.
Sensitivity analysis can help to determine the variance of profit, or of the return on
capital, for any business being modelled.
Alternatively stochastic simulation techniques can be used to assess profit variance.

Choosing between stochastic or deterministic approaches
Stochastic modelling should be used:

● when we are costing guarantees
● only when the variable can be reliably modelled by a well defined probability
distribution
● to incorporate the effect of year-on-year volatility of any given variable
● for identifying potentially high risk future scenarios.
In other situations stochastic modelling creates the risk of spurious accuracy (modelling
error), and deterministic sensitivity testing would usually be preferred.

Solution 19.1
(a) Long-term contracts
The present value of future profits (PVFP) for a model point that represents existing
business should be positive. There are two ways of looking at this.
First, retrospectively. At inception the PVFP should be zero or positive, otherwise the
company is knowingly writing unprofitable business. Immediately after inception
significant acquisition and management expenses will be incurred, and so the PVFP
immediately after having paid for these should be strongly positive. It will then
gradually reduce to zero at maturity. So it is always positive.
The second way of looking at the question is prospectively, with reference to reserves.
The PVFP for any existing business at time t will kick off with the business fully
reserved for at time t, with reserves that will satisfy the supervisory reserving basis.
These reserves should therefore be on a prudent basis, ie calculated making prudent
assumptions about future experience.
If the expected future experience in the embedded value basis is equal to these prudent
assumptions then the PVFP will be equal to zero. However, the embedded value basis
should be realistically chosen, and so we should expect positive profit flows in the
remaining years as the experience assumed in the embedded value basis is better than
that assumed in the prudent reserving basis. The PVFP is the discounted value of these
future positive profit flows, and so will therefore be positive.
The above argument assumes no huge changes in the embedded value basis or the actual
experience since the contract was priced. If the gap between discount rate and
investment yield is suddenly increased by several percentage points, the PVFP could
easily become negative.
(b) Short-term contracts
These are effectively recurring single-premium contracts, that are annually renewable
(like PMI and group health insurances).
Considering first the unexpired period of the current year of cover, the argument is
identical to that in (a) above. The unexpired premium and outstanding claim reserves
should all be prudently large, and these combined with any future premiums still due
should exceed the expected cost of claims and expenses arising, leading to an expected
profit.

In addition we need to think about future years of cover resulting from the renewal of
these in-force policies into future years. Future renewals should yield profit, on the
basis that any material deterioration in claims or expense experience should be covered
by future compensating premium increases.
So all future profits from in-force business should be positive.
Solution 19.2
The crucial thing here is that “the value of new business” tells you if the business that
you are actually writing is meeting target profitability given the actual acquisition
expenses, initial administration expenses and contribution to fixed overheads. Thus it is
quite conceivable, and sometimes happens, that an existing portfolio shows impressive
profitability once in-force but that writing it on current terms is unprofitable.
Solution 19.3
The parameters you would normally want to sensitivity test would include:
● claim incidence rates, claim recovery rates, rates of transfer between claim states
etc (as appropriate)
● mortality rates
● lapse and non-renewal rates
● average claim size (for PMI)
● future expense levels
● future expense inflation
● future benefit and claims inflation
● investment yield
● volumes and mix of new business
● taxation basis.

Solution 19.4
The problem with predicting withdrawal rates is that they are heavily influenced by
economic and commercial factors. For example, withdrawal rates can be influenced by:
● economic conditions, especially those affecting employment
● media publicity
● comparison with competitors
● selling practices.
Significant events (eg economic recession) occurring in the past lead to distortions in
the past experience data, whilst future occurrences of such events are almost impossible
to predict. It is therefore difficult or impossible to devise a probability distribution for
future withdrawal rates with any degree of confidence, which makes a stochastic
approach doubtful.
The best approach would probably be a deterministic model for withdrawal rates, testing
the effect of a whole range of possible outcomes (particularly at early policy durations).




using the course.

Chapter 20
Assumptions (4)
Syllabus objectives
– morbidity
– mortality
– lapses
– claim amount
– expenses
– taxes
(This chapter considers the above items for purposes other than pricing.)
0 Introduction
In this chapter we cover the topic of setting assumptions for purposes other than pricing.
Much (but not all) of what has been said in Chapters 10-12 about assumption setting for
pricing is also relevant in other contexts, but you must be aware of the differences.
In this chapter we discuss how to go about setting assumptions for a reserving basis and
for the purpose of assessing the profitability of existing business. Areas for consistency,
in addition to those discussed in Chapter 12, are also considered.
If you have not read Chapters 10-12 recently, we suggest you read again the
introduction to Chapter 10 before reading on, just to remind you of what setting
assumptions is all about.
At the end of this chapter we also have a (mostly) revision section on modelling and
setting assumptions.

1 Valuing insurance contracts for the purpose of

determining reserves
Reserving is covered in detail in Chapter 21. It is sufficient here to understand that a
company must carry out a valuation to demonstrate solvency to the regulatory
authorities and to use in preparing its published financial results. It may also perform
an “internal” valuation, which will serve to give a more realistic idea of the exact
position of the company than does the supervisory valuation.
The starting point for reserving assumptions will be the expected future
experience. The principles involved in deriving these assumptions will be
equivalent to those used in deriving assumptions for pricing purposes –
assuming that premiums are costed on a best-estimate basis. It is then
necessary to apply margins to these expected values so that the probability that
the resulting reserves will prove to be inadequate is below an acceptably low
figure. What is acceptably low will depend upon the reason for valuing the
contracts and any relevant legislation.
The immediate question in building a suitable basis for determining reserves is the
purpose of the valuation. If the valuation is for internal management use then the
actuary has a free hand in making his or her assumptions. Assumptions will normally
be best estimate, or best estimate with a very small margin against parameter error. The
actuary may also construct other sets of assumptions for sensitivity testing.
Published valuations tend to be for two distinct purposes:

● for reporting company results (such as would be of interest to shareholders), and
● for supervisory purposes.
Company reporting will require a true and fair approach, consistent with the relevant
accounting principles. This will usually imply more conservative assumptions than best
estimate: a market-value consistent basis is a possible approach here. (This is not
required knowledge for this subject, but is covered further in Subject SA1.)
If the valuation is for supervisory purposes (ie demonstration of solvency) then there
will almost certainly be some severe constraints on the assumption decisions. These
constraints might be:
● specific, eg the valuation interest rate must equal the premium basis interest rate,
or
● more general, eg you do the valuation as you wish, subject to the final result not
being lower than it would have been under a prescribed regulatory basis.

The important thing is that, where the actuary is acting freely, any decision must be
prudent.
This adequacy needs to be assessed in the context of the assets being held by
the insurer to meet its liabilities. This will affect the margins relating to the
investment, and maybe inflation, assumptions.
This brings us to an important difference in setting assumptions for a reserving basis as

opposed to a pricing basis: the policies are already in force, hence we have existing
assets, and an existing portfolio of liabilities, which both provide important information
for the purpose of setting assumptions.
The existing assets give us additional information, which we can (and indeed must) use
when deciding on the investment assumption for the reserving basis. A reserve is, by
definition, the amount of (the company’s) assets that the company holds in order to
ensure that it can meet the future payments under its policies as they fall due. Assuming
we don’t need to make any future investment, the yield we can obtain on these assets
would define the highest rate of interest we could use for valuing the liabilities, and still
have enough money to pay for them when they fell due. However, the yields obtainable
over the remaining lifetime of the existing assets might still be very uncertain, (which
would be the case, for example, if the assets were equities). This will, of course, lead to
a need for margins in the investment assumption to allow for future adverse experience,
whatever other sources of uncertainty there may be.
The above would apply to any portfolio of assets and liabilities for which little or no
future investment were necessary. Single premium or paid-up contracts would, in
theory, usually fall into this category. The valuation rates of interest for these types of
policy would therefore be closely linked to the current yields obtainable on the existing
assets, depending on the extent of matching achieved between the assets and liabilities.
The less closely the assets and liabilities are matched, the greater the need will be to sell
and / or buy assets in the future, which creates an investment risk due to future changes
to market yields and asset values.
For other types of long-term contract, which may involve significant future investment
of future positive cashflows, the valuation rate of interest must take account of this.
This will affect both the best estimate of the future investment return, and also the
appropriate margin to allow for its uncertainty. The principles involved here are now
the same as in pricing, but you should bear in mind that there will tend to be some
reduction in the investment risk due to having existing assets.
The investment assumption is less critical for short-term contracts, for which we will be
more concerned with reserving appropriately for future claim incidence rates and, if
relevant, the claim amounts that may be paid under the existing policies.

In some territories, legislation or accounting rules may permit the discounting of

reserves of short-term insurance contracts. This would allow for the investment income
expected to be earned on the reserves until the claims are actually paid. However, for
short-term health insurance contracts, most claims are settled relatively quickly, so the
effect of discounting would be small.
For the demographic and claim amount assumptions we have the additional information
that we know who the policyholders are! For long-term policies in particular we will
therefore have very good information about the class of lives involved, and the
investigation of the historical experience of this class of business is likely to give a very
good indication of the future experience, provided that the volume of data is credible.
Hence the parameter uncertainty for the demographic assumptions should be lower for
reserving than in pricing.
The expense assumptions for the reserving basis should also be easier to assess. This is
partly because there are no future initial expenses to be incurred, and partly because
there is much less uncertainty over the volume and mix of the (existing) business in the
future. Nevertheless, the share of the fixed expenses to be covered by the existing
business will be affected by how many new policies the company issues in the future, so
the expense assumptions are still subject to considerable uncertainty.
The above paragraphs have explained why the uncertainty associated with a number of
key reserving assumptions should not be greater than that of the equivalent assumptions
when used in pricing. However, once we have established the probability distributions
for the variables concerned, we should then use more prudent margins for our reserving
assumptions. This idea is further developed below.
The extent of the margins could be assessed:
● analytically, if the nature of the assumptions permits
If you have a good idea of the probability distribution (including its parameters)
of, for instance, the aggregate claim size distribution of your PMI claims, then
you can set your margins by reference to the variance and mean of this
distribution. For example, you could set the value of your mean aggregate claim
size assumption that you expect to be exceeded (eg) only 25 times out of 1,000
by the actual aggregate claim size (ie we are choosing the 97.5th percentile of the
distribution). In doing this you would wish to incorporate into your distribution
an allowance for parameter uncertainty as well as random fluctuations, as we
described before.

Let’s consider the difference between this and the equivalent situation when
pricing. The probability distribution of our parameters could well have
somewhat higher variance (ie greater uncertainty) in a pricing situation.
However, because pricing is usually less prudent than reserving, for competitive
reasons, we would probably take a lower percentile of this distribution, such as
the 90th, to establish the appropriate margin.
● using simulation with appropriate stochastic models
This is similar to the above but involves a numerical, rather than analytic,
approach. For instance, decide on the probability distribution (including its
parameters) which best describes aggregate claims. You can then generate (say)
10,000 simulated values for the aggregate claim amount using a model of your
in-force business, and take the 9,750th highest value. This will be the aggregate
claim size that you think will be exceeded just 2.5% of the time, so use this as
your assumed mean aggregate claim size. Again, both parameter and random
uncertainty should be included in the stochastic model.
● using sensitivity analysis.
Question 20.1
How would the sensitivity analysis approach work?
Alternatively the extent of the margins may again be laid down in legislation.
The actuary will base any assumptions for this purpose on analysis of the
experience of the business in force. This will entail calculating exposures and
incidence both by numbers and amounts. The availability of a good statistical
database is thus crucial.
The approaches described in Chapter 10 (and similarly in Chapter 28) are therefore
relevant for this purpose.

2 Valuing insurance contracts for the purpose of

determining the profitability of existing business
The principles involved here are the same as those that apply to deriving
assumptions for pricing purposes using a cashflow model. However, this does
not necessarily mean that the values for the parameters will be the same, in
respect of a particular contract, for both purposes. In particular, the allowances
made for risk may be different.
This section of Core Reading refers to the choice of a suitable basis to use in
quantifying the present value of future profits of existing business (eg for embedded
value purposes).
The factors to consider will be as described previously in the pricing context. However
the actuary will normally be aiming for best estimates for all parameters.
Question 20.2
When might you try to be more prudent than using best estimates?
In addition the time frame will be slightly different. For pricing work, you often want
assumptions that will be valid as from any start point over a non-trivial period of time
(the next year? the next three years?), to allow you to sit back and sell the product
without having to reprice every month. For embedded value work you can apply the
most appropriate values as you see them from the start point of “now”.
Regarding the allowances made for risk, the risk discount rate will probably be lower
than in the pricing basis.
Question 20.3
Why is this?

3 Consistency
As before (Chapter 12) any consideration of a basis must be carried out with a view to
consistency.
3.1 Consistency in setting a valuation basis
Previous basis
The start point in selecting a valuation basis will be the basis used for the previous
valuation. Any deviation from that must be justifiable. Changing the basis for a
supervisory valuation can have a significant impact on the published financial results of
the company. A weakening of the basis may require justification to the regulatory
authorities that it has not been done just to accelerate the distribution of profits to
shareholders or to improve the reported solvency position. A strengthening of the basis
may require justification to the fiscal authorities that it has not been done to delay
profits and hence delay the payment of concomitant tax.
Underlying these points we can see an important conflict of interest that the company
has to manage when setting its reserving basis. To reserve over-strongly delays the
emergence of surplus or profit, which will reduce the returns obtained by the providers
of capital. To reserve too weakly, whilst it will accelerate profits and increase returns,
will weaken the company’s financial security and would increase its insolvency risk.
Finding the right balance between these will partly hinge on educating the capital
providers to believe that their interests are best served by a solvent company (ie that
financial security is just as much a part of shareholder value as is the size of the current
dividend stream).
Question 20.4
Suggest a risk to the company’s financial security that can be brought about by
strengthening the reserving basis.

Assets v liabilities
The basis for valuing liabilities must be consistent with that for valuing assets. For
example, if assets are valued at market value then the investment return assumption of
the liability valuation basis must reflect the current market yields for those assets, and
the yields expected from future investment (where applicable).
Note that changes in market conditions do not necessarily lead to changes in the
valuation basis. For example, if assets are valued at book value (the price for which an
asset was bought) then the liability valuation needs to be consistent with this. This
would make the valuation interest rate much less affected by current market
movements, especially if the assets and liabilities were well matched.
We discuss this topic of consistency between assets and liabilities much more fully,
when we talk about supervisory reserving in Chapter 21, so don’t worry if this does not
make complete sense to you at this stage of your studies.
Pricing basis
The pricing basis will have allowed for the cost of setting up supervisory reserves, in
the pricing models used. These reserves will have been based on some assumed
reserving basis. The price determined from this process will then have allowed for the
cost of capital, assuming that the actual reserves for the contract would indeed be set
according to the reserving assumptions in the pricing model. If the actual reserves are,
for example, based on more onerous (ie conservative) assumptions than allowed for in
the pricing model, then the cost of capital will be higher than that assumed and the
policy will be less profitable than expected. There will also be more capital strain than
expected. Hence, it is essential that the assumed reserves in the pricing basis are
consistent with company’s actual reserving basis for the contract.
The tensions caused within the company through the choice of reserving basis are
apparent here.
Question 20.5
Assuming the pricing basis is consistent with the reserving basis, in the way described
above, what further problems do you envisage for a company that decides to strengthen
its reserving basis?

Supervisory valuation v internal valuation
Although not needing to be close, the internal valuation basis should be considered in
relation to the supervisory valuation basis.
3.2 Consistency in setting an embedded value basis
Previous basis
The start point in deciding on a suitable basis will be the basis used for the previous
embedded value calculation. Any differences will immediately cause some movement
in the embedded value. Thus any such change must be justifiable, especially if the
embedded value is being used to report externally on a company’s real worth.
Assets v liabilities
The same comments as for the valuation issue apply here.
Pricing basis
As already mentioned, the embedded value basis might be more “best estimate” than is
the pricing basis. However, the two should be looked at side by side. Any differences
will immediately lead to embedded value movements on writing new business different
from those implied in the pricing basis.

4 Health and care modelling complexities

The Core Reading in this section gives a list of some of the key modelling issues that
relate to each of the main healthcare insurance products. While these are mainly
concerned with modelling, some also relate to setting assumptions, which is why we
have put them here, at the end of the final assumptions chapter.
Some of the issues to be considered in the modelling of the various aspects of

health and care products at different stages of the actuarial control cycle are
listed below.
We have set this list out (mostly) in a question format. We suggest you attempt every
question under each product heading before checking with the solutions. Some of the
issues should be very familiar to you from the course so far, while others may be more
novel. Don’t worry if some of the questions seem “obvious” – you can get lots of
marks in exams by stating obvious things (and you can lose lots by not stating them,
too!).
The student will need to be aware of the relevance of each point to the product
being modelled – but will not have to expand in detail, unless this is done
elsewhere in the course.
4.1 Private medical insurance
● distributions of amount (indemnity often without ceiling)
This is to do with establishing the probability distribution of the claim amounts payable
under PMI policies.
Question 20.6
Explain why this is mainly relevant to PMI policies, and name one other healthcare
insurance product where this might also be an issue.
● distribution of frequency (difficulty in defining discrete claim)
Here the difficulty is in estimating the claim frequency, ie the claim incidence rates.
Question 20.7
Why is this a problem?

● frequency parameters dependent on duration from policy inception, age,

sex, time of year, occupation etc
Question 20.8
Why do we take variables such as these into account in modelling work?
Question 20.9
What is the relevance of the duration from policy inception for PMI policies?
● distribution of amount dependent on hospital capacity, medical science

progress, insurer/provider deals, inflation
Question 20.10
State briefly how each of the above factors is likely to influence the claim amount.
● other influences – macro-economy, flavour of government, state of market

competition
Question 20.11
State briefly how each of the above factors is likely to influence PMI business.
● absence of insurance statistics
This is the absence of any substantial pooled industry claim (and other) data, in many
territories.
Question 20.12
What is the importance of this?

● NCD multi-states (where applicable)
Question 20.13
Describe briefly what an NCD system is and its purpose, and explain the term
“multi-states” when used in this context.
● problems with family covers where individuals on risk may not be known
Question 20.14
Why are the individuals on risk not necessarily known for “family covers”, and why is
this a problem?
● problems with group arrangements similarly where individuals (especially

spouses and children) can only be estimated
Question 20.15
Explain this point.
● impact of IPT (or other sales tax) on future growth
Question 20.16
“This is talking about the effect of insipid persistent toxins on the future growth of
cereal crops.”
Correct this statement.
● pricing model needs to incorporate the reclaim of initial costs over several
renewals
Question 20.17
Describe how this would be done.

● modelling chain and speed of settlement
PMI claims often consist of a whole series of separate payments (eg an operation
followed by a series of follow-up physiotherapy sessions) all of which would incur
separate treatment costs and hence separate claim payments. This “chain” of claim
events should be considered when estimating the total claim costs arising from a given
claim event. It will, of course, differ by the type of condition being treated.
Question 20.18
The Core Reading also talks about the “speed” of claim settlement. What is the
significance of this for modelling PMI claims?
● impact of initial reserves vs eventual out-turn
This relates to the reserves set up when a claim starts, and which at any subsequent time
is designed to cover the remaining (future) costs under the current claim in payment.
They are normally called “outstanding claims reserves”.
Question 20.19
What do we mean by “eventual out-turn”, and what is its significance?
In theory, allowance for the prudent valuation of these outstanding claims should be
made when pricing, at least for any business for which the duration of claim payments
is reasonably long (or long tail).
Question 20.20
Why?
However, by “long tail” we mean claims that run for a significant time period, at least a
year, and it is rare for PMI claims to go on for anything like as long as this. (This is
covered in more detail in Chapter 21.)

● reserve case-estimates vs statistical estimation
You will also meet these ideas properly in the chapter on reserves. They are just
different ways of assessing the outstanding claims reserves, mentioned above. A
“case-estimate” is where the outstanding claims reserve is individually assessed by
considering the circumstances of the particular claim. A statistical estimate is based on
the experience of similar claims that have occurred in the past – ie on past data. For
PMI, which has mainly small claims (relative to other types of short-term business), the
vast majority will be based on statistical estimates.
Note this (and the previous two) points are relevant mainly to the modelling of reserves,
and it is unlikely that they would taken into account in the pricing model.
4.2 Long-term care insurance
● distribution of claim frequency – little experience
So we have little data on which to base our estimates of future transition rates – this is a
major difficulty with this line of business in many territories.
● distribution of claim amount (where funding for care) – cap on weekly/

monthly benefit, but otherwise little control
Question 20.21
What does “funding for care” mean, and what is its relevance here?
Question 20.22
How does this issue compare with the equivalent issue for PMI, as described in the
solution to Question 20.6?
Question 20.23
For which type of business – LTCI or PMI – would total claim costs be more of a
modelling issue, and why?

● portfolio projection: demand very dependent on political commitment
Question 20.24
For what kind of modelling is this important, and in what way does political
commitment affect LTCI business?
● no insurance statistics
Question 20.25
Which statistics are we referring to here, do you think?
● costs (where funding for care) economy dependent – inflation, capacity
Question 20.26
Why is this relevant?
● progress in medical science will play its role
Question 20.27
In what way does this affect modelling?
● inflation of care costs
Question 20.28
What kind(s) of inflation index (or indices) would you look at when considering the
assumption you would use for the inflation of care costs?

4.3 Income protection
● basic structure is a multi-state movement hierarchy
Question 20.29
So, briefly, what does this imply for modelling?
● need to model transition intensities
Question 20.30
The best approach to parameter estimation, from data, is by estimating transition

intensities. But what do you do with them once estimated – ie how do you use them for
modelling?
● published insurance parameters for incidence have poor credibility
Here we are considering the results from standard tables (eg claim inception rates) that
may have been produced based on pooled industry data.
In many territories we can only rely on them to a limited extent for practical purposes.
(This is, for example, the case in the UK where the industry-based standard IP tables are
used with much more caution than, say, the standard mortality tables based on life
insurance data.)
Question 20.31
What implication has this for modelling, pricing and product design?

● there is a need for accurate estimates of recoveries (eg by duration of

claim or by type of disability)
Question 20.32
Explain the importance of each of the following points, taken from the above Core
Reading:
● need for accurate estimates
● by duration of claim
● by type of disability.
● possible need to separate out second and subsequent incidences
Question 20.33
Why do we (possibly) need to do this?
● guaranteed and reviewable
The Core Reading is not saying that all IP policies are guaranteed and reviewable! It is
saying is that there are issues, depending on the extent of the guarantees and the extent
to which premiums and/or charges are reviewable.
Question 20.34
What are these issues in relation to modelling, and how do they relate to each other?
● economic morale can be a significant influence
Question 20.35
Explain how this can be so, for IP business.
● government provision of welfare has some impact
Question 20.36
How?

● tax may have some influence
This could refer to a number of possible things:

– a tax on premiums, which would discourage sales
– tax relief on premiums, which would encourage sales
– the way that the insurance company is taxed, which could make the
product more or less expensive (to the company and to the policyholder)
compared with other types of business
– the tax rates involved may change over time.
● worldwide statistics are plentiful, especially US, but how relevant?
Question 20.37
An overriding difficulty with all industry data for IP business, however plentiful, is its
relevance. Why is this such a persistent problem?
● sales are difficult to model
(Well, aren’t they always?)
Question 20.38
Why is the Core Reading singling IP out for this point?
4.4 Critical illness
● Theoretically up to forty different distributions → future trends; though

practically only cancers and heart attack will provide enough data.
Question 20.39
Where does the Core Reading get forty different distributions from?
By “→ future trends” we mean that we might have to establish the trends in experience
for each of these forty-odd groups separately, for the purpose of estimating future
experience. As the Core Reading says, the data are not adequate to do this reliably for
each group separately except for the most important causes.

● Separate approach for the disease-based and treatment-based?
You will recall that critical illness policies cover some specific treatments as well as
diseases.
Examples
Treatment-based triggers that are commonly used in UK CI policies include:

● Coronary heart by-pass surgery (ie the undergoing of open heart surgery to
correct the blocking of coronary arteries)
● Major organ transplant (eg heart, liver, lung, pancreas or bone marrow)
● Heart valve replacement or repair.
It may therefore be useful to model their claim frequency distributions (ie the expected
future claim experience) separately from each other.
Question 20.40
Why?
● Advancement in medical science will impact

– (a) cures
– (b) earlier diagnosis
– (c) simpler operations (more readily available).
Question 20.41
Briefly, how do each of the above affect the assumptions for CI claims?
● Different impact (of medical advances) on new and existing business.
Question 20.42
Using point (c) in the above Core Reading as an example, explain why medical
advances should affect new (ie future) business differently from business that is already
in force.

● Statistics provide help with historic incidence.
All we are saying here is that CI insurance has been around long enough for a useful
body of past experience to have been built up, for the purpose of estimating future rates.
● Different approaches needed for guaranteed and reviewable products.
See the similar point under IP above, and especially Question 20.34.
4.5 Other issues
The following three issues are highlighted as being of current importance for the health
and care insurance industry generally:
● role of genetics
● trends in anti-selection
● quality of underwriting.
Question 20.43
Explain how these three issues relate to each other.
4.6 Modelling uses – a summary
All we show in this section is a summary of the main uses of modelling that we have
discussed (mostly) in preceding chapters. This list could form a starting point to your
revision programme: can you describe the modelling procedures involved for each
application? (Don’t panic if you can’t, at least not yet!)
● costing and reserving for options
● model office – new business projections, embedded values, solvency,
takeovers
● reserves – statutory and management accounting
● pricing – profit, premium.
You will learn more about modelling for reserving purposes in the chapter on reserves
(Chapter 21).

5 End of Part 3
Review
review the key areas of Part 3, or maybe re-read the summaries at the end of Chapters
16 to 20.
Assignments


Chapter 20 Summary
Setting a reserving basis
The basis will depend on the purpose of the valuation: whether it is for publication (for
supervisory reporting purposes or otherwise), or for internal management use.
The basis should reflect:

● expected future experience
● margins to ensure adequacy of reserves
● legislation/regulation (for supervisory reserves)
● the need for consistency.
The assumed investment return should reflect the expected yield from the actual
investments held, and the expected returns from future investment, as appropriate to the
situation.
The demographic assumptions should take particular account of the historical

experience of the actual class of lives involved.
In general, margins can be determined analytically, stochastically through simulations,

or by sensitivity analysis.
The margins to apply to the investment return assumptions should reflect the volatility
of the actual investments held to meet the liabilities, and the extent of future investment
needed.
Setting the basis for testing profitability of in-force business
The same principles as for a pricing basis will be applied. However, the bases will not
necessarily be the same, especially as regards allowances for risk (eg the risk discount
rate will be lower).
Health and care modelling complexities
There are a number of specific considerations to be made in modelling, and setting

assumptions for, the various aspects of each type of health and care product.


Solution 20.1
Sensitivity testing tells you how the reserve value would change when we change the
assumptions. So we need to identify which changes (eg increase or decrease) in
parameter values cause our reserves to go up the most. (Note that it is not always clear
cut as to whether increases or decreases in parameter values will increase reserves. For
example, increasing or decreasing lapse rates can cause future losses depending on the
duration of the policy, the amount of any discontinuance benefit paid, and so on.)
Then we (arbitrarily) decide on some possible degree of adversity as it would affect the
parameter in question. For example, if looking at the issue of investment return: our
current return on assets is 5.5% and we are expecting 5% over the next 20 years with a
maximum foreseeable downside of minus 1%. You therefore take 4% as the valuation
interest rate.
Solution 20.2
Try to be more prudent than best estimates if:

● You really have very little idea of the best estimate, due to very limited
experience (eg withdrawal rates for a new class of contract which you have
written for less than one year). You will need to deliberately err towards
prudence to ensure that you have not been “optimistically wrong”.
● You want a prudent embedded value. This might be the case if your embedded
value results are going to be published. (This is similar to the argument about
including margins for reserve values, as we discussed in Section 1.)
Solution 20.3
Part of the uncertainty that contributes to the risk margin (risk premium) in the pricing
basis is due to the uncertainty of future volume of sales and the mix of business. This
uncertainty has been removed if we are considering already existing business.
Solution 20.4
The increase in capital strain per policy issued means that the company is more likely to
become insolvent on the supervisory basis. This assumes that volume of business and
capital provision remain unaltered.

If this were a significant threat, then the company would either have to reduce sales or
increase capital provision (either of which would have the effect of reducing future
returns on capital). Turning customers away would also send out very negative
messages to the market, and may deter intermediaries from recommending the company
to customers in the future.
Solution 20.5
Increased capital strain will increase the cost of capital, so the premiums/charges will
have to be higher to maintain the return on capital. This will make a price-sensitive
product less competitive in the market, leading to a (potentially devastating) marketing
risk (inadequate sales).
Solution 20.6
PMI policies often provide indemnity benefits, paying for the actual cost of treatment
incurred. So the actuary has to estimate both the expected size of the claims that will
occur, and also the variance of the claims (to ascertain appropriate margins for risk). A
probability distribution of claim size therefore needs to be assumed for this purpose.
(Note that we are talking here about the total amount of money paid following a given
claim incidence event – so this can obviously consist of several separate payments to
cover a series of treatments.)
Claim size distributions are unnecessary for the purpose of predicting claim amounts for
policies that have fixed nominal (or index-linked) benefits, so this is why it is relevant
for PMI business in particular.
Long-term care insurance sometimes has indemnity benefits, (or part indemnity, where
there would be a contractual ceiling on the amount paid).
Solution 20.7
The Core Reading is suggesting that the difficulty lies in deciding on the distinction
between, say, one claim consisting of a number of separate payments, or a number of
claims each consisting of one payment.
The important thing here is therefore to establish a definition of a claim, which you use
consistently for estimating (and modelling) claim frequency and the claim amounts that
arise from each claim.

Solution 20.8
Claim incidence experience data will need to be subdivided, and analysed, according to
these factors. This will enable us to model future incidence rates more accurately.
Some of the factors may also be used as rating factors – ie where the company charges
different premiums for the different risk groups. Age, sex and occupation would be
examples.
Solution 20.9
Generally, people who keep their policies in force longer are more likely to claim than
others, and/or have a greater expectation of claiming in the future. The main reason for
this is that claims for pre-existing medical conditions are normally excluded (through
medical underwriting or a moratorium clause) but as the policy continues in force,
claims for new medical conditions will arise (which will be covered).
The duration also has implications for renewal rates, as renewal rates tend to increase
the longer the policy has been in force.
Solution 20.10
Hospital capacity
Reduced capacity will increase treatment costs as supply falls, and hence claim amounts
will increase.
Medical science progress
This can lead to new treatments that may be expensive (increasing costs), or be much
more effective (reducing costs).
Insurer/provider deals
These are arrangements between insurers and hospitals (etc) to provide specified
treatments for policyholders at agreed costs. They will reduce the level of cost of
claims, and also reduce the claim cost uncertainty and hence reduce the variance of the
claim costs.
Inflation
Costs of treatment will increase with inflation, so increasing claim costs.

Solution 20.11
Macro-economy
Affects the affordability of PMI policies. People in financial difficulties are more likely
to rely on the State for their healthcare needs.
Some PMI policies can experience higher claim costs near the onset of a downturn in
the economy – eg members of group schemes may be tempted to get treatment for
medical conditions while still covered by their group policy, which would be forfeited if
they were to lose their jobs.
Flavour of government
Government policies can significantly affect public take up of PMI, firstly by making
the State healthcare provision more or less attractive, and secondly through the
provision (or otherwise) of direct incentives to take out insurance, such as a favourable
tax treatment on PMI premiums.
State of market competition
The more competitive the market the lower the premiums tend to be. This also affects
the benefits that are to be found under products from different companies. The PMI
market tends to be competitive on both counts. This also leads to product
differentiation – with no two companies providing exactly the same benefits so that it is
harder to compare them and hence enabling each company to charge higher premiums.
Solution 20.12
Companies new to the market will find it hard to estimate future claim experience
reliably, so they will have a large parameter risk.
It is harder to establish industry-wide trends in experience.
Companies will be less able to corroborate their own experience with the industry as a
whole, so more margins will be needed in pricing and reserving assumptions (similar to
first point).
Companies will find it harder to identify when their own experience may be differing
widely from its competitors, so leading to increased risks of under- (or over-) charging.

Solution 20.13
NCD stands for “No Claims Discount”. Policyholders who achieve a certain number of
consecutive years without claiming are charged lower premiums. A claim (or several
claims) will result in the NCD being dropped for the next year.
There may be several NCD “states” – eg higher discount rates applied for policyholders
who have longer durations free of claim. (These are the “multi-states” being referred to
in the Core Reading.)
NCD operates like an excess. By imposing a penalty on claim (loss of discount

following a claim), people are discouraged from making small claims, thereby
improving the insurance company’s efficiency.
Solution 20.14
A policy with family cover will provide medical treatment costs for all members of a
family unit, for which a single “family rate” of premium might be charged, and which
might involve a range of possible numbers of children.
The problem is that the claim cost will vary according to the number of children in the
family. For a new line of business, estimates will have to be made about the average
number of children per family and the likely effect this will have on claim costs. For an
existing product, the past data can be used to estimate future experience; here, however,
there can still be a problem if family sizes (per insured family policy) are changing over
time.
Solution 20.15
The persons on risk under a group policy are changing as employees leave and new
ones join. The premium is calculated on the basis of an assumed (or historical) mix of
employees; while this means the premium paid will not exactly match the risks covered
over a year, this can be adjusted for in retrospect when the information becomes known,
so this is not a major issue.
On the other hand, where cover is provided for family members of employees, then the
same problem as in Question 20.14 arises.

Solution 20.16
It’s actually talking about the effect of “insurance premium taxation” on future sales of
PMI business, and its overall impact on the “growth” in total volume of business (new
and renewed) each year. Premium tax essentially produces higher premiums for the
policyholder, and will discourage people from taking out the insurance, dampening
future growth prospects.
Note that IPT is the specific name given to the premium tax charged on short-term
insurance business in the UK. Details of country-specific taxation are not required in
the Subject ST1 exam, but will be covered in Subject SA1.
Solution 20.17
We will need to make assumptions (from past experience) for the rate of renewal in
each year following the first issue of a contract. The excess initial expenses and
commission (over the renewal levels) can then be spread over the number of years for
which the policy is expected to be in force, based on these assumptions. The same
premium is then charged for new business and renewals, each covering part of the
excess initial expenses. The renewal assumptions would be conservative (low), to
reduce the risk that the company suffers from unexpectedly high lapse rates and is then
unable to recoup the initial expenses fully.
Solution 20.18
The settlement of claims – ie deciding whether a claim is valid and how much should be
paid out – is usually achieved very quickly for PMI. The delay (ie from the date that
treatment is carried out to the date the claim is paid) should be allowed for in modelling,
but as significant delays are relatively rare for PMI (compared to other kinds of short-
term business) it is therefore not a critical modelling issue.
Solution 20.19
The eventual out-turn is the actual total costs of benefits paid out under a claim.
Although there is little delay in starting claim payments, the chain (sequence) of claim
payments is uncertain both in amount and especially duration. The reserve for the
outstanding claim payments is therefore only an estimate, and so can differ markedly
from the eventual total claim cost arising from this claim. Having said that, reserve
estimates would be updated regularly in the light of the claim’s subsequent
development. But the reserve initially set up at the start of the claim may differ
markedly from the eventual out-turn.

Solution 20.20
Capital will be tied up in the reserves for as long as they are held. This will reduce the
return on capital, increasing the cost of capital and thereby leading to an increase in the
premium that should be charged.
Solution 20.21
This means that the policy will pay out the actual costs incurred by the policyholder in
obtaining the care they need (such as the actual nursing-home fees payable). The policy
therefore pays indemnity benefits but would be subject to a maximum limit in order to
control costs. Nevertheless, we then have essentially the same situation as we had for
PMI in Question 20.6, where we have to establish an appropriate probability
distribution for claim size that we can use for modelling the expected claim size and its
variance. In practice, for LTCI this would mean estimating a probability distribution for
the periodic (eg annual or monthly) claim payment, while other parameters (such as the
probabilities of transition in and out of future benefit states) would be used to quantify
the cost of the duration of claims paid at each level.
Solution 20.22
Under LTCI we are only requiring the claim amount distribution in order to estimate the
periodic (rather than the total) claim amount. The cap should also make the claim
amounts (per period) easier to estimate, unless the cap is unrealistically high (unlikely).
Companies could well model on the basis that the maximum amount of periodic claim
benefit would be payable, so doing away with the explicit need to model the claim
amount distribution at all. So the issue of estimating the claim amount may not be as
difficult as for PMI, where there may be no maximum payment and we will be using the
claim amount distribution to model the total claim amounts, over a series of payments.
Solution 20.23
LTCI – because the claim frequency (governed by the transition rates between benefit
states) is so uncertain, and the potential claim cost much larger (because of the much
longer duration of most LTCI claims compared with PMI claims).

Solution 20.24
A portfolio projection is just another name for a projection made using a full model
office. So in this kind of modelling we are looking specifically at a projection of
business volumes, including future new business.
The government can strongly influence future take-up (and persistency) of LTCI
policies by its influence on what alternatives (to such private funding) are provided by
the state. Significant factors here include the level of state benefits available for LTC
and the rules governing the amount of personal wealth a person may retain and still
remain eligible for state LTC funding.
So new business (volume and mix) of business assumptions will be strongly influenced
by the expected future political environment.
Solution 20.25
Industry experience: there is very little pooled industry data for LTCI. This is all part of
the same problem identified at the start of this subsection – the data are very thin on the
ground.
Solution 20.26
So, we have benefits that are essentially indemnity based (that’s what’s implied by
“funding for care”), and these costs (nursing home fees, etc) will have a strong
inflation-linked element. In addition to this, they will be affected in real terms by other
economic factors, particularly supply of and demand for long-term care provision. (The
most likely scenario is that the demand for care increases more rapidly than supply –
which may stay static or even fall – thereby causing LTC costs to increase by more than
“average” inflation.)
The relevance from a modelling point of view is that the costs, being related to
economic factors, are hard to predict with confidence. Making appropriate assumptions
for benefit inflation is essential, and this must take account of the likely effect of the
change in capacity of care provision. The uncertainty involved also indicates that large
margins for risk should be included, where appropriate for the purpose of the model.

Solution 20.27
This can influence assumptions for the following:

● transition rates between states: for example improved treatments may allow
people to stay independent for longer, reducing claim incidence rates and the
rates at which existing claimants transfer to higher benefit levels (reducing claim
costs)
● mortality rates: particularly for the highest benefit levels, where improvements
in medical science can prolong life and hence increase the period for which care
is needed (increasing claim costs)
● periodic claim costs: medical advancements can alter the costs of medical care
(drugs, mobility aids, etc), which might change overall claim costs either way,
assuming the individual pays for these (eg through the nursing home fees
charged) or are covered under the policy (eg cost of buying mobility aids).
Solution 20.28
The closest index would be an index of long-term care costs (eg a residential and
nursing home fees index) if one is available.
Failing that, because long-term care is a people industry, an index of national earnings
would be suitable. Some of the costs are more to do with prices (eg food) so a national
prices index might also be relevant. A mixture of the two, probably weighted in favour
of the earnings index, would probably be used. Additional inflationary factors,
particular to long-term care costs, must also be considered (as discussed in Solution
20.26).
Solution 20.29
It implies we need to use a multiple-state approach for modelling the business,

especially the claim costs. As a second choice, we could use an approximation to this
approach, ie the claim inception/disability annuity method.
Solution 20.30
We have to convert them into transition probabilities first, then use these to construct
projected numbers (or proportions) in each state at future ages (assuming we are using a
multiple-state methodology). Alternatively, the transition rates (and derived transition
probabilities) can be used to calculate claim inception rates and disability annuity values
(if the inception and disability annuity method was being used).

Solution 20.31
It means we can’t rely on the standard tables too much. It is therefore essential to get
other sources of data for estimating our parameters. Reinsurers are often a useful
source; population statistics can help; ideally we use our own data if we have enough.
If our estimated parameters are based on universally insufficient data, then steps to
control the parameter uncertainty must be taken. This could include, for example:
● assuming large margins for risk
● only issuing products with reviewable premiums or charges
● ensuring the product is well protected by reinsurance.
Solution 20.32
Need for accurate estimates …
This means that the modelling result (price, reserve value, whatever) is sensitive to the
choice of recovery rate assumption, so it is important to get the parameter right.
… by duration of claim …
Recovery rates reduce as the duration of the claim increases. In order to produce
accurate estimates, it is therefore necessary to use recovery rate parameters that vary
according to claim duration.
… by type of disability
Recovery rates also differ dramatically according to the cause of the disability of
sickness underlying the claim. So, again, in order to produce accurate estimates of
recovery rates we need to have separate recovery rates for the different major causes of
disability.
Solution 20.33
We might need to do this because individuals who have had periods off work through
sickness in the past are more likely to claim again in the future, compared with those
that have never claimed.

Solution 20.34
Guarantees make a product riskier. The guarantees have to be allowed for fully in the
model, and it is important to identify how they affect the sensitivities of profit to
variations in future experience. These sensitivities must then be covered by including
suitable risk margins in the assumptions, unless other measures are to be taken to reduce
risk.
Reviewable charges and/or premiums effectively reduce the guarantees under a product,
which should reduce sensitivity and the need for such high risk margins. If the review
is subject to no restriction (eg there is no maximum extent to which rates can be
increased) then the modelling could be confined to making projections until the next
review date only, as future years can be considered to “pay for themselves”.
Realistically, there will always be limitations on the effectiveness of future reviews,
through the influence of competitive pressures and the impact of anti-selective lapses
following any rate rise. The modelling (and especially the assumptions made) has to
take these limitations into account.
These issues are common to other types of (long-term) health insurances, not just to IP.
Solution 20.35
A downturn in the economy will generally discourage people from working. This is
true, for example, for the self-employed who may find it more attractive to keep a
sickness claim going for as long as possible rather than go back to trying to make
money from working in unfavourable economic conditions.
Another example is for group IP, where the employer would prefer the insurer to keep
paying sickness benefits, rather than pay an employee for doing possibly unprofitable
work.
Both of these are examples of moral hazard.
Solution 20.36
This is mainly in the area of state sickness benefits for people off work through
sickness. A high level of benefit will mean there will be less demand for IP policies.
High state benefits also mean that there is a greater risk of policyholders receiving more
income while sick than if they returned to work, reducing their incentive to return to
work.

On the other hand, if IP claims are reduced by the amount of State benefit provided at
the time of claim inception, and this is not communicated properly to policyholders,
they may become disenchanted with their policies so harming the insurer’s reputation.
Solution 20.37
The problem is that pooled industry data are always going to be very heterogeneous for
this type of business. The heterogeneity arises from:
● different target markets and sales distribution methods, so that companies cover
different classes of lives that have different claim experience
● companies employ different underwriting strategies, both at initial sale and at the
claim stage, which will affect the claim experience
● different policy wordings and policy conditions, which can make the claim
experience differ markedly between companies – for example, there can be a
wide variation in deferred periods and definitions of disability available.
All these points make it very unlikely for the pooled data to reflect the experience of
any single company with any reliability.
Solution 20.38
It is implying that sales (future volume and mix) must be particularly difficult to predict
for IP business. There are a number of possible reasons for this:
(1) Sales are dependent on both economic and political factors, whose impact is
always very difficult to predict.
(2) Most markets are quite significantly under-insured (lots of people with
inadequate cover or not covered at all), which means that there is plenty of
potential for getting the sales assumption wrong.
(3) These are protection products, and so will be subject to quite keen competition,
especially if trying to sell to a reluctant public. Changes in the competitive
position can dramatically affect sales, especially if sold through brokers.
(4) There is the potential for mis-handling claims, which could have important (and
unpredictable) repercussions on company reputation, which can affect future
sales volumes considerably.

Solution 20.39
In theory every different cause of critical illness claim is subject to its own probability
distribution (of claim frequency). Coupled additionally with variations by sex and
smoker status, the number of different distributions quickly mounts up.
Solution 20.40
Future claims from treatments may well be subject to very different future trends from
claims caused by a disease, such as cancer. For example, medical developments may
reduce the number of diseases reaching critical levels (thus reducing certain disease-
type claims) but make certain treatments more available (thus increasing certain
treatment-based claims). It would be useful to allow for these separate trends explicitly
in the model.
Solution 20.41
(a) Cures
Increasing the cure rate will not necessarily improve claim experience. Claim
experience is normally dependent on diagnosis rate, and curing a diagnosed disease will
simply increase the proportion of so-called “windfall” payments. However, if medical
science improves prevention, then claim rates will be reduced.
(b) Earlier diagnosis
This will cause claim incidence rates to increase. (More on this in Chapter 24.)
(c) Simpler operations
If operations become more readily available, this may increase the incidence of
treatment-based claims.
Solution 20.42
Benefits and premiums can be changed on new policies to allow for the effects of
medical advances – for example, conditions that become curable could be removed
from cover (and maybe new conditions added instead). However, this not possible for
existing policies, unless they are reviewable, in which case any changes in cover
(particularly if they are seen as a reduction in benefits) will be difficult to impose.

Solution 20.43
Anti-selection is one of the biggest risks in the management of healthcare insurance, as

people who consider themselves to be of high risk are most likely to apply to take out
policies.
Underwriting is the company’s chief tool in combating the problems from

anti-selection: identifying the high risk lives from risk-related information provided by
each applicant and charging appropriate premiums (or other variations in terms) which
should mean that the company should (at least) cover its expected claim costs.
The “role of genetics” causes the problem. Genetic tests now exist (and/or are being
developed) that enable individuals to find out more about their possible pre-dispositions
to certain diseases. There is much ethical and political debate about the use that can or
should be made of such personal information (way beyond the scope of this subject),
but in some countries (eg the UK) at least some of this information does not have to be
supplied to insurers when underwriting. Potentially, this opens the way for increased
anti-selection, though its extent remains to be seen, as the claims experience resulting
from this practice is still young.
You do not need to know any detail of the genetic-testing issues for Subject ST1.

ST1-21: Reserving Page 1
Chapter 21
Reserving
Syllabus objectives
(l) Understand the purposes for and methodology by which valuation and reserving
are performed:
− the role of statistical and individual case estimates
− the uses of deterministic and stochastic processes
− purpose of calculation
● supervisory (solvency, prudent, prospective)
● experience review (realistic retrospective pricing and conditions)
● management information (realistic, prospective)
● embedded values (various)
● fair valuation (realistic).
(m) Understand the purposes and practices of supervisory reporting:
− principles of setting statutory reserves
− difference in assumptions from pricing
− sensitivity analysis
− strength of basis
− valuation of assets and consistency
− solvency margins and solvency assessment.

Page 2 ST1-21: Reserving
0 Introduction
This chapter explains why and how health insurers calculate reserves. If you have
already studied Subject CA1, then you will have already met the main methods and
reasons for calculating reserves. This chapter expands on that material and applies it
more specifically to the reserves of health insurers.
Even if you have not seen Subject CA1, the material in this Chapter should still make
sense based on your studies of the CT subjects.
To place a value on the liabilities we must use a reserving basis. There are many
possible approaches we could use 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. This chapter is a study of these factors and how they
are applied in different practical situations.
Changing the reserving basis does not affect the true financial position of the company,
but it usually changes its disclosed result. Whilst using a different valuation basis has
no direct effect on the real situation, 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.

1 The role of statistical and case estimates

The two primary methods used to calculate the reserves for health and care products are
statistical estimates and case estimates. The method used will depend heavily on the
characteristics of the product for which we are calculating reserves, and the purpose of
the calculation.
1.1 Long-term insurances
In almost all forms of long-term insurance, the benefit payable is known once a
claim is filed. The insurer will make a reserve for claims that have been notified
but not yet settled, using the amounts in the policy document, upgraded where
appropriate, by relevant inflationary indices or other increments. Where benefits
are paid as an income (income protection or long-term care, 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.
The insurer may also wish to hold a reserve for claims incurred but not reported
(IBNR claims). These will arise in circumstances where the policyholder learns,
some years after the disability itself, that his/her insurance policy provided
protection against such an event and then lodges a claim. Such late notification
is becoming increasingly common in critical illness insurance.
Question 21.1
Why do you think that this late notification is becoming increasingly common?
The bulk of long-term insurance provisions encompass 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 probability of a claim normally increases as the policyholder’s age increases.
1.2 Short-term insurances
Private medical insurance is essentially an indemnity cover, ie the amount

payable on claim is determined by the costs incurred by the claimant and thus is
not known for sure 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 (see below).
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.
1.3 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. The
following factors will be taken into account:
• procedure type − this will indicate the cost of the procedure itself and the
likely in-patient duration for accommodation costs
• hospital (medical centre) to be used
• name of surgeon, consultant or other medical principal
• policy coverage (full indemnity, excess, limits, recuperation benefit etc)
• age, sex and past claims history of claimant may have some bearing
• current levels of medical inflation.
Question 21.2
Why might the past claims history of the claimant have any bearing on the ultimate cost
of the current claim?
Case estimates cannot be used to produce estimates for claims that have not been
reported (whether incurred or not). For example, if case estimates are used for the main
reserving process then reserves for claims incurred but not yet reported must be
estimated separately using other methods.
Question 21.3
Suggest other disadvantages of using case estimates. What are the advantages?

1.4 Statistical estimates
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 “en masse” in relatively homogeneous
cohorts, based on historical trends and patterns, adjusting for known or
anticipated future changes. The portfolio might be split by contract type, by
distribution type or by geographical region and a statistical distribution fitted to
the past experience to estimate the claims incurred from the earned premium;
premium 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 adjusting for trends in incidence and in cost.
You will have been introduced to most of the terminology and statistical methods used,
in either Subject CT6. For example, the basic chain ladder technique is an example of
such a statistical method. However, detailed knowledge should not be needed for this
subject.
This above model can incorporate the provisions for IBNR (claims incurred but
not reported), if it has been established appropriately, ie IBNR claims included
separately in the historic compilation.
In other words, the statistical model we use to calculate the reserves for reported claims
may automatically include the calculation of our IBNR reserves, as long as the data we
have used is appropriate.
This will normally be a minor issue for PMI, as IBNR will be small.

2 Types of reserve
This section lists the types of reserve that a healthcare insurer might hold. They are
neither mutually exclusive nor exhaustive. The basis used to calculate the reserves will
depend predominantly on the reason for the calculation.
2.1 Long-term insurance
• Prospective premium reserves – the discounted value of future cashflows.
This is the reserve held to meet all future cashflows, allowing for future
premium income, benefit outgo and expense outgo. In Subject CT5 you will
have seen this as:
expected present value   EPV of future  EPV of future 

 + − 
(EPV) of future claims  expenses   premiums 
It is held for instances when the future outgo is more than the future income.
• Claims reserves – the discounted value of claims in payment including

claims that have arisen but have not yet been settled.
This will include reserves for:

– claims that have been notified to the insurer but which have not yet been
fully settled, eg IP claims currently in payment
– claims that have arisen but have not yet been notified to the insurer, ie the
IBNR claims as described in Section 1.1.
• Option reserves – additional costs which need to be set aside for the
eventuality that a particular option “comes into the money” − becomes
more valuable in its exercise than in its discard.
Some policies have options that for some policies may or may not be exercised.
For example, there may be guaranteed conversion options on Critical Illness
policies. This reserve is held in order to fund the value of those guarantees.
• In a group context, the concepts of unearned premium reserve, unexpired

risk reserve and incurred but not reported reserve will apply as defined in
Section 2.2 below.
These concepts will be explained in the next section.

• In some territories there may be a regulatory requirement hold an explicit

investment mismatching reserve. This is to allow for the extent to which the
assets held do not match the liabilities. This is covered in more detail
Chapter 22 (Investments).
2.2 Short-term insurance
For the long-term contracts described above, the insurer is committed to honouring
claims for a specified (possibly large) number of future years, which is why the
company has to reserve (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 contractually committed to honour claims that may occur
during this period, and must therefore cover these liabilities prudently.
We will consider this unexpired risk in two different ways:
(a) A retrospective approach: how much of the premiums that were charged should
we be holding in respect of the unexpired risk? This will give us the:
• Unearned premium reserve (UPR) – the balance of premiums

received in respect of periods of insurance not yet expired.
(b) A prospective approach: how much is needed now to cover the expected claims
and expenses from the unexpired risk? This will give us the:
• Unexpired risk reserve (URR) – reserve in respect of the above

unexpired insurance premium where it is felt that the premium
basis is inadequate.
Question 21.4
“Insurers do not need to hold reserves for long-term insurance contracts relating to the
unexpired period of cover to the next policy anniversary. These reserves (called UPR
and URR) are only required for short-term policies.”
Comment on this statement.

Let’s look in a bit more detail at how the UPR and URR are calculated.
Calculation of UPR
We’ll start by looking at a single policy. Let’s suppose our aim is to calculate the UPR
as at 31/12/2006, the year end. To do this we need to determine what the premium is
supposed to cover, and when precisely the premium is earned.
The premium covers:

• claim payments, which are incurred in line with the incidence of risk (which
may not be uniform over the life of the policy)
• initial expenses, ie commission, documentation, other set-up costs, which are
incurred at the start of the policy’s life
• other expenses, which will mainly be related to claims, and will therefore be
incurred with the incidence of risk
• profit, which arguably should also be earned in line with the incidence of the
risk.
Therefore, apart from the initial expenses, all the elements of the premium are 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.
unearned
m% of risk (100-m)% of risk
31/12/06 31/12/07
The UPR for this policy could then be calculated as
(100 - m)% ¥ risk related premium
For the whole portfolio, the UPR is the sum of these amounts over all policies. Easy!

However, it’s not all that practical if the pattern of risk is complex or unknown. In
practice, policies do not come with little tags specifying what proportion of the risk has
elapsed by the year-end. It is normal to base the split on elapsed time, unless this is
clearly inappropriate because the risk is not uniformly spread over the year, for example
where the insurance is heavily weather related, eg there may be more pneumonia claims
in winter.
Calculation of URR
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.
The URR would typically be calculated by estimating the future loss ratio and applying
it to the proportion of premium unexpired.
Question 21.5
How would the future loss ratio be estimated?
We now look at the other reserves held by short-term healthcare insurers.
• Outstanding claims reserve – 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 payments
have already been made), but have yet to be settled fully.
• Incurred but not reported – reserve in respect of claims that have arisen
but which have yet to be notified to the insurer.
This is the IBNR, which we met earlier.
• Incurred but not enough reported – as above but where it is felt that not all
detail has yet been submitted and a provision needs to be established for
the remainder.
This reserve, often abbreviated to IBNER, and also often called Incurred But
Not Enough Reserved, is a reserve for outstanding reported claims. It is an
adjustment, either positive or negative, to the existing outstanding claims
reserve.

So, for example, say you are using case estimates to calculate the reserve for
claims already reported. From this investigation, you see that these have tended
to be under-estimated and so you decide that your reserves need to be increased,
by £X say.
The reserve for outstanding claims can be increased by £X, or you may show this
adjustment as a separate reserve, known as the IBNER reserve. The total reserve
will be the same in both cases. The important thing is to state exactly what you
mean in the exam.
Question 21.6
Why define IBNER separately from the outstanding claims reserve?
• Equalisation and catastrophe reserves – reserves where it is felt that the

current year is atypical and amounts will have to be held back for
abnormal events.
Equalisation reserves are amounts held back generally from profitable years. In
the less profitable or loss making years, amounts may be drawn from the reserve
to boost the results for that year. There may be legislation controlling the
amounts that can be passed to and taken from the reserves. The primary purpose
of equalisation reserves is to smooth profits (and dividends, if applicable).
Catastrophe reserves are funds held aside just in case a future catastrophe were
to happen.
The regulation of both equalisation reserves and catastrophe reserves varies from
country to country. They may or may not be allowable, and may or may not
receive favourable tax treatment.
• Claims in transit – reserve in respect of claims reported but not assessed,

or not recorded.
These are reserves held aside for claims that are “in the pipeline”.
• An investment mismatching reserve may also be required (as described for

long-term insurance above).
Note that all the above reserving considerations are also applicable to long-term
insurance, with the possible exception of the IBNER. For example, it will be necessary
to hold IBNR reserves for CI and IP portfolios.

3 Deterministic and stochastic processes

The actuary may utilise deterministic or stochastic models in order to estimate
potential future claims outgo and thus set current provisions. This will further
give indications of capital adequacy under specific or statistically-generated
scenarios.
For further detail see section 2.4 of Chapter 13.

4 Calculating reserves
4.1 The purpose of calculating reserves
The reasons for calculating the technical reserves of a health and care insurer
include the following:
• To determine the liabilities to be shown in the insurer’s published
accounts.
• If separate accounts have to be prepared for the purpose of supervision of
solvency, to determine the liabilities to be shown in those accounts.
• To determine the liabilities to be shown in internal management accounts
of the insurer.
• 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.
For example, if you are setting premium rates at the end of 2005, based on the
claims experience in the years 2003–2005, then some of the claims will not have
been settled, or even reported, and so an estimate will be required of the final
claim amount.
• To value the insurer for purchase or sale.
Question 21.7
How will the choice of assumptions to be used differ between the suggested purposes
for estimating liabilities? Give brief reasons.
We are now going to look at the considerations to be made when determining reserves
for each of these reasons.

4.2 The published accounts
The assumptions to be made in determining the liabilities to be shown in an

insurer’s published accounts should have regard to the legislation and
accounting principles governing the preparation of those accounts in the
territory concerned. Matters to be considered include:
• whether the accounts are to be prepared on a going concern basis
• whether the accounts are required to show a true and fair view
• whether reserves are required to be assessed as best estimates or on
some other basis, and precisely how the terms used are to be interpreted.
4.3 The solvency accounts
If separate accounts are required as part of the process of supervision of

solvency, the rules governing the preparation of those separate accounts may or
may not be the same as those that apply to the published accounts. They may,
for example, be required to be prepared on a going concern basis or on a
break-up basis. Reference should be made to those rules and any guidance that
may have been issued as to their interpretation.
The accounts could also have to be prepared on a run-off basis. This means assuming
the company would continue to service in-force business but would cease to write any
new business. This contrasts with a break-up basis that assumes the company is wound
up and policies with unexpired periods of cover are cancelled (probably with a
proportion of the premium returned to the policyholder).
4.4 The internal management accounts
The principles to be followed in preparing internal management accounts are

matters to be discussed and agreed with the insurer. The aim is likely to be to
produce expected values of the future experience, based on realistic
assumptions.

The managers will want to see a realistic picture of the financial state of the company
that is not distorted by including margins in the assumptions. Internal management
accounts could be prepared for just about any purpose, for example to look at:
• profitability
• solvency
• claims and exposure
• expenses
• reinsurance performance.
Question 21.8
Suggest three other analyses managers are likely to require from time to time.
4.5 Setting future premiums
The assumptions to be made in analysing the experience for the purpose of a

pricing review are discussed in Section 6 below.
However, strictly speaking the assumptions are needed for the future experience, not the
past experience.
4.6 Sale or purchase
The starting point in valuing an insurance company for sale or purchase will be
to place a value on the existing business (embedded value), the liabilities for a
sale value being based on realistic assumptions without margins and those for a
purchase value being based on cautious assumptions that include margins. An
important element in the price is likely to be goodwill, corresponding to the
estimated profits expected from future business; such considerations go beyond
the scope of the course for this subject.

5 The principles of setting statutory or solvency reserves

The principles to be followed when setting reserves for statutory or solvency purposes
are based on guidance issued by a European body called the Groupe Consultatif des
Associations d’Actuaires des Pays des Communautés Européennes.
The principles are as follows:
1. The amount of the reserves should be such as to ensure that all liabilities
arising out of insurance contracts can be met by the insurance company.
2. The amount of the reserves should be calculated by a suitably prudent

valuation of all future liabilities for all existing policies, including:
• guaranteed benefits
• options available to the policyholder
This can often be problematic, due to the number of guess-like

assumptions you might need to make to value an option. For instance, if
valuing the worth of an option to extend critical illness insurances by up
to five years without any medical evidence, you would need to estimate
the proportion of policyholders who will exercise that option and the
extent to which their morbidity is below average.
• expenses, including commission
• taking credit for the premiums which are due to be paid under the
terms of each policy in the future.
This means that future premiums contractually due to be paid can be

taken as a form of asset. Credit cannot be taken for recurrent single
premium business, where the policyholders have the option of paying
future premiums but are not contractually obliged to do so.
3. A prudent valuation is not a "best estimate" valuation, ie neither too much

nor too little, but should include an appropriate margin for adverse
deviation of the relevant factors.

4. The valuation should take account of the nature, term and method of
valuation of the corresponding assets, depending on the type of policy.
Again, consistency between the valuation of assets and liabilities is being

emphasised.
The reference to term implies that if the assets and liabilities are badly matched
by term then some mismatch reserve would be called for. This is a reserve that
would cover any shortfall between assets and liabilities created by future
changes in investment conditions, the assets and liabilities having different
discounted mean terms.
5. The use of appropriate approximations or generalisations should be

allowed.
6. The rate of interest (where appropriate) used in the calculation of the

reserves should be chosen prudently, taking into account the currency in
which the policy is denominated, and having regard to the yields on the
corresponding existing assets and to the yield which it is expected will be
obtained on sums to be invested in the future.
7. The elements of the statistical basis, that is the demographic and

withdrawal assumptions, and the allowance for expenses used in the
calculation of the reserves should be chosen prudently, having regard to
the type of insurance, the territory of the persons insured, and the
administrative costs and commission expected to be incurred.
Question 21.9
For many types of contract, including those that pay surrender values, future
withdrawals are often ignored in the supervisory valuation basis. Explain how this
might be consistent with the above principle.
The various references to currency and territory are no more than common
sense. If you were the actuary to a health insurance company in Germany with a
portfolio of policies in Poland (with liabilities denominated in Zloti), it is
reasonable that the interest rate used to value those policies should reflect the
(Polish) assets underlying the reserves. Likewise, it is reasonable that the
demographic assumptions should reflect the policyholders in question and not
German policyholders.

8. If a valuation method defines in advance the amount of expenses to be

used in the valuation, the amount so defined should be not less than a
prudent estimate of the relevant future expenses.
This is a critical point and refers to the operation of the net premium valuation
method. In this method, future expenses are not valued explicitly. They are
assumed equal to (or less than) the difference between the real office premium
and the net premium used in the reserve calculation. Thus the actuary should
check that the company’s expected future expenses do not exceed this margin.
Question 21.10
What are the implications of this for single premium business valued using the net
premium method?
9. The method of calculation of the reserves from year to year should be

such as to recognise profit in an appropriate way over the duration of
each policy and should not be subject to discontinuities arising from
arbitrary changes to the valuation basis.
The Core Reading says that the method should not be subject to discontinuities
arising from arbitrary changes in the valuation basis. It is not implying that
discontinuities can always be avoided. Changed conditions may legitimately
require changes to valuation bases, giving rise to one-off changes in reserves.
The Core Reading is saying that, in calculating the reserves from one year to the
next, the actuary should avoid any arbitrary changes to the valuation basis with
the purpose of manipulating the resulting reserves.
10. Each insurance company should disclose the methods and bases used in
the valuation.

Some actuaries would prefer to strengthen some of these principles as follows:
• The allowance for expenses should allow for the possibility of the
company ceasing to write new business, if that would increase the
reserve.
So far in the above we have considered expenses assuming an ongoing business,

whether those expenses were valued implicitly or explicitly. Thus you could
argue that you are taking credit for future business, because the ongoing-
business scenario per-policy administration expenses are probably lower than
they would be in a closed-to-new-business scenario. In closing to new business,
total expenses will reduce (although there might be a big one-off cost initially,
due to redundancy payments etc). But the per-policy expenses will increase
because those expenses are being shouldered by a smaller body of policies.
(The background to these principles, knowledge of which is not needed for this
Subject, can be found in the following:
Report on the calculation of technical reserves for life insurance in the countries
of the European Communities, Groupe Consultatif - May 1990
Notes on technical provisions for life insurance, Groupe Consultatif - May 1990.)
The implementation of such principles within a country will depend on the

requirements of its insurance supervisory authority and possibly also
professional guidance from its actuarial association. Knowledge of how the
principles are implemented in practice in any particular country is not required
for this Subject, as they are covered in the Specialist Applications subjects.
Question 21.11
If a health insurance company were to hold larger reserves than the minimum required
by the supervisory authorities, the company would have fewer free assets and would
thereby compromise its investment freedom, its new business growth and its profit
distribution. Why should it ever choose to do this?

6 Statutory reserving vs pricing assumptions

In some countries it is standard practice to calculate premium rates using
prudent assumptions and then to use the same assumptions to calculate the
reserves for supervisory purposes.
This is a common approach in Continental Europe.
In other countries, it is standard practice to calculate premiums using

assumptions that broadly reflect expected future experience, with the risks to the
company being allowed for mainly through the risk discount rate. In this case, it
would not be appropriate for the same assumptions to be used both for pricing
and for reserving.
That is, if we used the same assumptions for reserving as we used in pricing, then the
reserves would not be prudent enough for supervisory purposes.
Question 21.12
In this situation why would it not be appropriate to use the same assumptions for
reserving as have been used for pricing, and allow for risk with an appropriate risk
discount rate?

7 Comparing the different types of basis

How do all the different bases used by a health insurance company relate to each other?
This is a question that is often asked by students, particularly in relation to the different
levels of prudence assumed. In this section we pull the various threads together.
7.1 Reserving basis
This depends upon the purpose for which the reserves are required. Typically a
company will calculate reserves for internal and for supervisory purposes.
The supervisory reserves are generally calculated on quite a prudent basis. However,
we can’t really generalise on the basis to choose for an “internal” valuation: it all
depends on the purpose. For example, we might be assessing the realistic value of the
company’s free assets, which would require best estimate assumptions, ie neither
optimistic nor conservative. But if we wanted to work out a conservative estimate of
the free assets, we would use more conservative assumptions for the reserve
calculations, and these could possibly be as prudent as the supervisory basis!
A reserving basis involves the discounting of projected future net outgo, so

“conservative” means high expenses, low investment return (discount rate), etc. Thus,
to be conservative, we don’t want to understate the future outgo.
7.2 Pricing basis
A pricing basis is often described as being “best estimate”, but this is unlikely to be
strictly true.
When we are using discounted cashflow methods, a pricing basis has two distinct
elements: the projection of future expected profits, and the discounting of those profits
at a risk discount rate. The assumptions used to project the profits, the risk discount rate
assumption, and the profit criterion all together define the pricing basis.
One methodology is to project profits on a best estimate basis; this is what is usually
implied when we say that a pricing basis is “best estimate”. But the choice of the risk
discount rate and profit criterion could lead to an overall price for the contract being
quite conservative. Margins for risk will be incorporated by using a high risk discount
rate and/or higher profit criterion. Prudence, here, will be to understate the value of
future profits, so discounting at a higher rate will achieve that.

Typically, in our pricing basis, we could:

• project future profits on a best estimate basis
• discount at a prudently high risk discount rate, and/or
• employ a prudently high profit criterion.
The overall level of prudence achieved will typically fall somewhere between best
estimate and supervisory levels.
So we might well have totally best estimate internal reserve calculations that are less
prudent than a pricing basis.
7.3 Prudence or conservatism?
We also have to distinguish between the ideas of “prudence” and “conservatism”, and
realise that they are not the same thing. A level of prudence implies a particular level of
risk, or (equivalently) confidence. For example, we might decide that a reserve is
sufficiently prudent if, by holding it, the company has a 99% probability of meeting its
liabilities without requiring future additional finance. So, when a company sets its
supervisory reserves, or its prices, it will have a level of risk in mind that it considers as
acceptable.
If the company is valuing contracts that include guarantees, such as non-reviewable

conventional critical illness contracts, then its reserving basis will need to be quite
conservative (ie there will need to be a big margin relative to best estimate), in order for
the company to achieve its required level of prudence. But if the contract were to have
premiums reviewable every five years, for example, the reserving assumptions would
not need to be so conservative in order to achieve the same level of risk for the
company. This is because the company can increase premiums in future if experience
gets worse, so it does not need to hold so much in reserve. Therefore, we can achieve
the same degree of prudence, using different degrees of conservatism (for different
contracts) in our bases.

7.4 Expected future profits on existing business and embedded

value bases
Working out the expected future profitability of existing business is actually part of the
embedded value calculation, because:
(Embedded value) = (expected present value of future profits on existing business)

+ (shareholders’ share of the free assets)
The basis used will depend on what we want: do we want a conservative (low), realistic
or optimistic assessment of the embedded value? The considerations here are identical
to those in pricing: conservative means understate future profits, and/or use a high risk
discount rate so as to understate the present value of those future profits.

8 Sensitivity analysis
It is clear from the earlier sections that the assumptions used for statutory
reserving need to be prudent estimates of future experience. That is they will be
the expected values plus margins for adverse future experience. Sensitivity
analysis can be used to determine these margins.
Sensitivity analysis could also be used to assess the need and extent of any
global reserves that may need to be set up to cover potential future adverse
experience.
Such global contingency reserves might be required to protect the company from such
things as:
• selective exercise of policyholder options
• a mismatch between the assets and the liabilities
• excessive death or sickness claims from AIDS
• asset crash.
Supervisors may require that the actuary includes stochastic modelling within
the process of establishing reserves, such that these provisions can be deemed
to meet future outgo to a certain level of statistical certainty. The basis for this
stochastic modelling of the portfolio may be prescribed in local regulations.

9 Solvency requirements
This section discusses the need for solvency capital. This is, in effect, the concept of a
required solvency margin (or capital requirement) that you have already come across
earlier in the course.
It is usual for insurance supervisors to require that an insurer maintains at least

a specified level of solvency capital. This solvency capital can be seen as
providing an additional level of protection to policyholders.
Question 21.13
Suggest two broad areas of risk where such solvency capital protects policyholders.
Thus, 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.
Practice on the relative balance between the two components varies between
countries. In some countries, for example Canada, reserves are set up on a
relatively weak basis, ie with relatively small margins from the expected values,
but there is a requirement for a substantial level of solvency capital determined
using risk-based capital techniques.
(Knowledge of risk-based capital techniques is not needed for this subject,

however further reading on these can be found in Asset shares and their use in
the financial management of a with-profits fund, Needleman PD and Roff TA, –
BAJ (1995) 1: 603-688.)
The aim of risk-based capital is to set aside an extra amount of capital where the amount
is appropriate to the extent of the risks involved.
In other countries, for example throughout the EU, reserves are set up on a
relatively strong basis, ie with relatively large margins, but with a relatively small
solvency capital requirement which is not closely related to the risks borne by
the company …
… although there is some relationship!

The difference in approaches can also be illustrated by comparing life insurance

and general insurance business within the UK …
… where we have the following situation (ignoring reinsurance):
Life insurance business:

• Reserves: Very prudent basis
• Solvency capital requirement: 4% of reserves (plus 0.3% of sum-at-risk)
General insurance business:

• Reserves: Undiscounted slightly prudent basis
• Solvency capital requirement: 16 to 18% of written premiums (but
modified if recent claims experience has
exceeded 70% of premiums)
So we have strong reserves and a small solvency capital requirement for life (long-term)
business, not-so-strong reserves but a stronger solvency capital requirement for general
(short-term) business.
As healthcare insurance may include both long-term and short-term insurances, the
healthcare insurance companies have to conform to two different sets of rules (in the
UK, at least).

10 Best estimate reserves

Under different circumstances, the actuary will be called upon to provide “best
estimates” of the likely future claims outgo. This method will generally be used
when management wishes to have a best estimate of the company’s financial
performance. This might arise in circumstances where the insurer is to be sold
or where directors wish to reward key staff for their specific contributions to the
overall growth of the company.
Here assumptions will be produced which are stripped of margins. The basis
derived will be closer to that used for new business pricing, though without the
effect of underwriting.
Question 21.14
What effect would underwriting have on a pricing basis?
All items will be included explicitly (expenses, withdrawals, investment return).
There would be no elimination of negative values.
When setting reserves on a policy-by-policy basis, the calculated reserves on some

policies might be negative, eg if the expected future premiums are more than sufficient
to cover expected future claims and expenses. If elimination of negative values applies,
then these negative reserves would be set to zero.
Question 21.15
Why would there be no elimination of negative values when setting best estimate
reserves?
A cashflow method would estimate, possibly case-by-case or possibly with some

grouping, the amounts that need to be in hand now to meet future claims
(including options), expense and tax outgo against the expected premium and
investment revenue inflow.
In other words, the cashflow method projects future income and outgo, and the present
value of any shortfall would be the reserves needed to be held now.

11 Fair value reserves

The issues surrounding the calculation of reserves under fair value accounting
principles will emerge gradually during the coming years. It is understood that
they will be closer to realistic estimates as outlined in Section 10 above. It is
however not intended that these be examined in the current series of
examinations of this subject.
This is a European initiative within the accounting discipline of insurance firms (life
insurance, general insurance, health insurance, etc). The basic idea is that accounting
rules and regulations will change at some stage over the next few years, so that accounts
reflect more realistically the true underlying financial position of each company.
However, you do not need to be aware of this for the ST1 exam.


Chapter 21 Summary
Calculation of reserves
Statistical methods and case estimates are used to calculate reserves. The method used
will depend primarily on the characteristics of the product and the purpose of the
calculation.
Types of reserve
Long-term insurance:
• prospective premium reserve
• claims reserves (including IBNR)
• option reserve
• for group contracts, UPR, URR and IBNR, as defined below.
Short-term insurance:
• unearned premium reserve (UPR)
• unexpired risk reserve (URR)
• outstanding claims reserve
• incurred but not reported claims reserve (IBNR)
• incurred but not enough reported claims reserve (IBNER)
• equalisation and catastrophe reserve
• claims in transit reserve.
Investment mismatching reserves may also need to be held.
Reasons for calculating reserves
• to determine liabilities for published accounts

• to determine liabilities for solvency accounts
• to determine liabilities for internal management accounts
• to assist in premium rating
• to value the insurer for purchase or sale

Assumptions
Assumptions to use will depend on:

• legislation and accounting principles
• whether to have a going concern basis, break-up basis or run-off basis
• whether the purpose requires a true and fair view
• the basis to be used, eg best estimate or otherwise
• the purpose of the calculation.
The principles of setting statutory or solvency reserves
• the reserves should cover all liabilities arising from all contracts
• the reserves should be calculated prudently, allowing for all relevant liabilities
• the reserves should take credit for future premiums if these are contractually due
to be paid
• the valuation should be prudent, not best estimate, and so the basis should
contain margins
• the valuation of the liabilities should be consistent with the asset valuation
• appropriate approximations or generalisations may be allowed
• the interest rate used for calculating the reserves should be chosen prudently,
taking into account the currencies, yields and reinvestment yields on the assets
• the demographic, withdrawal and expense assumptions used should all be
prudent but the expenses can be on an ongoing business basis
• if the valuation method itself defines the amount of expenses assumed (eg the
net premium method) then the amount implied must be no less than a prudent
estimate of the relevant expenses
• the valuation calculations conducted over time should not suffer discontinuities
arising from arbitrary changes to the basis
• the valuation method used should recognise the emergence of profit
appropriately over the policies’ lifetimes
• valuation bases and methods should be disclosed

Statutory reserving vs pricing assumptions
It is common in some countries to price prudently and then to define the reserving basis
as the pricing basis. In other countries, premiums are calculated using a realistic basis,
with risks to the company being allowed for through the risk discount rate assumption.
Sensitivity analysis
Sensitivity analysis may be useful in determining appropriate margins in respect of

possible adverse future experience, and in calculating global contingency reserves.
Stochastic modelling may be obligatory for supervisory reserve calculations.
Solvency capital requirements
Insurance supervisory authorities normally require that insurance companies establish a

certain amount of solvency capital. This is to protect policyholders from
under-reserving liabilities, and from asset values falling. Statutory reserving needs to
be considered in conjunction with the solvency capital requirements, and vice versa.
The relationship between reserves and solvency capital requirements varies between
different countries. Normally it will be one of two cases:
• strong reserving, with a small solvency capital
• weak reserving, with a large solvency capital
where “weak reserving” means a basis close to best estimate.


Solution 21.1
Although we cannot be precisely sure of the reason, the most likely explanation seems
to be that policyholders don’t actually realise that they have cover for certain conditions
(the number of allowable conditions having increased dramatically over the years) until
well after the event. Eventually, perhaps as a result of a conversation with their broker,
they realise they were covered and so claim in retrospect. The increasing frequency of
this would then reflect increasing involvement of intermediaries in their clients’ affairs.
Another reason for late notification is that policyholders may not realise that they have
the symptoms of a condition that would lead to a claim, until some time after those
symptoms have actually appeared. As more conditions are being picked up by
improved medical screening, it is possible that more cases of this kind are now being
identified than in the past.
Solution 21.2
An investigation of past claims may give information about the ultimate claim cost of
the current claim. For example, during the claim verification stage of a prior claim, it
may have been discovered that the policyholder was extremely susceptible to
post-operative stress disorders, which would be very likely to occur in any future
operations, thereby increasing the cost of medical treatment.
Solution 21.3
Disadvantages
The estimate relies on the skill and judgement of individuals. Different individuals may
produce quite different results.
Assessors may be naturally conservative or optimistic in their assessment.
If the estimate is used for negotiation with claimants, there may be a tendency for the
estimate to be biased to the lower end.
Case estimates are extremely difficult to check.
In some classes there may be thousands of outstanding claims. It will take many
person-hours in total to estimate each claim amount individually, making the method
very expensive, perhaps unnecessarily so (for example if the claims were reasonably
stable then cheaper statistical methods might be more appropriate).

Assessors may not use consistent rates of inflation (although it may be easy to avoid this
problem). Also it will be hard to produce estimates on a range of possible bases.
In some circumstances, estimates of the outstanding claims reserves will need to be

made by outsiders who do not have access to all the data on individual claims. In these
circumstances, individual case estimates are not possible.
Advantages
It is the only approach that can make use of all the known data on outstanding claims.
There are many qualitative factors that will influence the amount of a claim. An
experienced and skilled assessor will be able to weigh up all these factors when
estimating the amount of the claim.
Case by case methods may still be applicable when statistical models are not reliable.
Solution 21.4
This statement is false. When we calculate a long-term policy reserve on a particular

valuation date, we calculate the expected present value of all future claims (and other
outgo), net of future premium receipts, occurring at any time after the valuation date.
This includes the period between the valuation date and the next policy anniversary,
whether that should be of 1 or 364 days duration. The UPR and URR are effectively
subsumed in the prospective policy value calculations used for valuing liabilities over
longer terms than just the current year.
Solution 21.5
Using a typical actuarial technique − that of analysing past loss ratio experience, and
projecting it forward, making allowance for trends, changes in mix of business, etc.
Solution 21.6
Reasons for defining IBNER separately include:

• it may give more information to management, in order that they can make
better-informed decisions
• there may be different trends in IBNER reserves, which are best modelled
separately
• IBNER may receive different tax treatment from other reserves.

Solution 21.7
Published accounts: prudent side of best estimate to ensure stability and consistency
from year to year.
Supervision of solvency: the most prudent in order to protect policyholders.
Internal management accounts: best estimate to give a realistic view of the financial
condition of the company.
Rating process: probably best estimate but may be slightly cautious if there is a lot of
uncertainty, in order to avoid premiums that are too low.
Purchase or sale: close to best estimate, but preferably on the optimistic side if you are
selling and on the cautious side if you are buying.
Solution 21.8
• movement analyses (eg number of new policies, lapses etc.)

• investment performance
• results split by source of business.
Solution 21.9
The biggest risk to solvency from withdrawals is that there is a panic and everyone
decides to withdraw at once. The company needs to hold enough money at all times to
cover the amount of all surrender values that would then be payable. The prudent basis
for the supervisory reserves means that, in the majority of cases, the reserves are
substantially higher than the surrender value on each policy. If this doesn’t happen
automatically (for example, near the start of a policy where the surrender value may be
artificially increased for marketing reasons) then supervisory reserves can be set subject
to a minimum of any surrender value payable.
So, if all policies surrender at once, the company will have more than sufficient reserves
to pay them, and would actually expect to make a (supervisory basis) profit should this
happen.

The same thing will normally happen when a policy surrenders in the future. If a
surrender occurs t years from now, a profit will be made equal to the excess of the
supervisory reserve at time t over the surrender value paid at that time. So this normally
means that the current supervisory reserve allowing for future surrenders will be less
than one that assumes no future surrenders. So, it is generally prudent to assume no
surrenders in the supervisory valuation.
The exception is where there may be guaranteed surrender values. If these are higher
than the projected supervisory reserves at the times of surrender, then future surrenders
will cause supervisory losses and a larger reserve will be required now to cover them.
In this case we would value policies on the assumption that all of them surrender at the
worst possible time from the company’s point of view.
Solution 21.10
No different than for single premium business valued under the “gross premium”
method. It is theoretically possible to calculate a net premium for single premium
business. However, in valuing single premium business liabilities there is no future
premium income so such a net premium would be irrelevant. Given that there will not
be the implicit expense allowance of “office premiums less net premiums”, an explicit
expense assumption will be required. Alternatively, an implicit allowance could be
made by reducing the interest rate.
Solution 21.11
Health insurance companies need to hold reserves that are sufficiently prudent to cover
their liabilities. If the actuary judges that these reserves should be higher than the
minimum that regulation requires, then this is what should be held (ie greater than the
minimum).
The actuary has a professional responsibility to the company’s policyholders and

supervisors to make sure that, in his or her judgement, the reserves are sufficiently
prudent for the company to be able to honour its contractual obligations. Stability of the
statutory solvency position is also important. Considerations of investment freedom,
marketing plans and profits have to take second place to the security of policyholders’
money.
Of course, the actuary might judge the sufficiently prudent level of reserves to be lower
than the supervisory minimum, in some circumstances. In that case it’s just tough
bananas – you have to hold the minimum!

When you think about it, you can see that some of the ideas of the control cycle can help
you to answer this question. The problem under consideration is “how much should the
company hold as reserves?”. Some constraints on the solution arise from the business
environment, eg from regulation. Other constraints arise from a consideration of the
risks involved. The risks (of holding inadequate reserves) include:
• the company may distribute too much money as “profit” and thereby be left
short of money to pay contractual benefits in the future
• the company, thinking it has more free assets than it really has, may pursue
more risky strategies in other areas, for example in selling greater volumes of
new business or following a more risky investment strategy, which in turn could
have serious consequences for future solvency.
On top of all this comes the professional responsibility to ensure that policyholders’
interests are fully reflected in the decisions reached.
These considerations indicate that regulation is only one factor in the determination of
supervisory reserves, and that other factors may well lead to higher reserves being held
than any statutory minimum.
Solution 21.12
For a reserving basis, the discount rate has to be the investment return assumption,
because a reserve is an assessment of the amount of assets needed to meet future
liabilities, and as such is dependent on the return that those assets will earn in the future.
The risk discount rate is related to the return that the shareholders require on their
capital, it has nothing to do with the return that the company can earn on its assets, and
hence is irrelevant to a calculation of the reserves.
Solution 21.13
It will protect policyholders against:

• the reserves being underestimated (ie adverse future experience relative to the
reserving basis assumptions), and
• a drop in asset values (including individual asset defaults).

Solution 21.14
Normally, we would expect underwriting to improve the experience for the company,
and so produce a more optimistic basis. For instance, underwriting a critical illness
contract should result in lower critical illness rates in the future experience than if the
contracts had not been underwritten.
Solution 21.15
Eliminating negative reserve values is prudent, and we have said that management
wants the reserves to be calculated on a best-estimate basis.

ST1-22: Investment Page 1
Chapter 22
Investment
Syllabus objective
(n) Describe the principles of investment underpinning health and care insurance:
− cashflow and liquidity
− matching and immunisation
− fund manager assessment
− asset valuation
− effect on product development and pricing
− customers’ PRE.
0 Introduction
In this chapter we consider how a health and care insurance company should invest its
assets. The investment strategy followed by the insurer can be of considerable
importance to its commercial success, financial results and security.
However, it is important to realise that most health products are protection products and
therefore have low reserves. For these products, investment returns will be far less
important.
Question 22.1
Name one healthcare product where investment returns are of considerable importance.
Investment returns can be important because they can lead to cheaper and hence more
competitive premiums.

Page 2 ST1-22: Investment
High returns on assets will also help to provide good financial results. Here the assets
fall into two categories – those where all or most of the return goes to policyholders
(ie unit-linked business), and those where the shareholders profit directly from high
returns (ie without-profits business and the shareholders’ own free assets). Even where
most investment return goes to policyholders, the insurer will still want to maximise
returns for the shareholders as well as for the policyholders.
Finally, the choice of investment strategy will affect the security that the insurer is able
to offer to policyholders. Most obviously, we wish to ensure that guaranteed benefits
will be met, but also that the returns will meet policyholders’ expectations.
Expressing all of the above in the most simple terms, the insurer will want high returns
that are not volatile. However, these two objectives conflict: investments offering
higher returns normally show relatively volatile returns. We shall see below how the
insurer will attempt to balance returns and security, given the nature of its liabilities.
Before starting to consider the selection of the most appropriate investment strategy for
a health and care company, it will be useful to revisit briefly the characteristics of the
major asset types. This should be familiar from earlier subjects.

1 Asset characteristics
We can consider asset types according to the following characteristics:
• return
• security (and volatility of market value)
• marketability
• expense
• term
• currency.
Additional points to consider would include any supervisory constraints on the insurer
in holding that asset, and any problems caused by the minimum size of the investment.
Government fixed-interest stock
This refers to loan stock issued and guaranteed by governments.
It offers a nominal return. It is normally issued with a coupon yield similar to market
yields, although some countries also offer zero-coupon stock where the running yield is
zero and all of the return comes through the high redemption value. The return on this
asset is not variable if held to redemption. (Although it is variable if not held to
redemption – this is an extremely important point when it comes to consideration of
matching issues.)
It is normally considered the most secure asset type, other than cash. Although the
market value of such stock 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.
Government floating-rate stock
This differs from the fixed-interest stock in that the coupon payments will be defined
with reference to some index or value – such as local price inflation.
The amounts and variety of floating rate stock issued by a government are often smaller
than the amount of fixed rate, which can render the floating rate stock slightly less
marketable.

Corporate fixed-interest stock
This refers to loan stock issued and guaranteed by private companies.
Question 22.2
Describe the properties of corporate fixed interest stock.
Equities
Equity investment offers an income (the dividend) which would be expected to increase
in real terms. The market value of the share should also increase in real terms from the
purchase date. However, the running yields on equities are correspondingly low.
There are risks attached to the income and capital value. The underlying company itself
might go bankrupt, or just perform very badly. In addition, the market value of the share
will be volatile. This volatility can be a problem even when holding the asset for
long-term income (because you might need to use its market value to help demonstrate
solvency), and obviously can be a problem if sold, as you might sell it for much less
than you hoped.
In many markets equities are generally highly marketable. In other markets equity
investment may not really be an option because of the size and reliability of the local
market; in this case an insurer might consider overseas investment in more mature stock
exchanges.
Property
Question 22.3
Describe the investment characteristics of direct property.
Cash
By cash we normally mean 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 obviously very
liquid, and dealing costs are almost non-existent. One problem, in addition to the
relatively low return, is the discounted mean term of zero: this is equivalent to saying
that the future return is unknown (it will depend on market conditions). As we shall see
later, this is a big problem for an insurer with long-term liabilities.

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 so as to maximise the overall

return on the assets, where overall return includes both income and
capital gains; and,
(c) the extent to which (a) may be departed from in order to meet (b) will
depend, inter alia, on the extent of the company's free assets.
These principles can be expressed also as:
• the company should invest so as to maximise the overall return on the

assets, subject to the risk therein being within the financial resources
available to it.
This states the fundamental approach towards balancing risk and return. The aim is to
maximise return subject to an acceptable level of risk. The level of risk will depend on
the financial resources of the company – ie its free assets. We consider below how
holding more free assets enables an insurance company to pursue a riskier strategy.

3 Asset-liability matching requirements
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 receipts, or proceeds, arising from the assets. If
it is possible to buy assets whose proceeds are identical to the outgo of money being
paid out on the liabilities, as they occur, then the assets and liabilities would be perfectly
matched and there would be no investment risk.
Perfect matching is a theoretical concept that is usually neither achievable, nor

desirable.
Question 22.4
Why isn’t perfect matching usually desirable?
Question 22.5
Under what circumstances would perfect matching be desirable?
Whatever the situation for the insurance company, the degree of matching between
assets and liabilities is of critical importance for its effect on the company’s actual
investment risk. We therefore need to consider in detail the nature, term and currency of
the liabilities and how these will affect the selection of suitable assets. In this section,
we make the simplifying assumption that this is the only aim of the company’s
investment strategy.
The liability outgo consists of:
benefit payments
+ expense outgo
– premium income.
In practice the actual liability outgo in any year, or month, depends on the
monetary value of each of the constituents and the probability of it being
received or paid out. Consideration will be given first to the monetary level of
the amounts. The effect of the probabilities will be considered later.

The asset / liability modelling described later in the chapter will incorporate any
probabilistic effects. Here it is sufficient to bear in mind that, in considering any
particular contract, we can estimate the likely future outgo in respect of uncertain
elements such as morbidity claims, surrenders and expenses. Future premium income is
also an area of uncertainty. However, for a large portfolio of policies and given a
reasonable amount of past experience, there should be little problem in deriving
reasonably accurate estimates of future net cash flows.
Nature
Following on from the above breakdown of liabilities, we can consider separately the
nature of benefit payments, expense outgo and premium income.
The benefit payments can be subdivided into four types:
• Guaranteed in money terms – this consists of benefit payments where the

amount payable is specified in the insurance contract in money terms.
• Guaranteed in terms of an index of prices or similar – this consists of

benefits whose amount is directly linked to such an index.
• Indemnity – this indicates policies such as private medical insurance

where the amount paid in respect of the policyholder is dependent on the
costs incurred in receiving treatment covered by the policy.
• Investment-linked – this will consist of the benefits whose amounts are

directly determined by the value of the investments underlying the
contracts.
Expense payments tend to increase. The rate of increase is not strictly

comparable to the rate of change in a price index, but for investment purposes it
is adequate to treat it as being so. Hence they can be included with benefit
payments guaranteed in terms of an index of prices or similar.
The point about expense inflation is that it will be unique to a particular company,
depending largely on the increases in salaries and other related costs that occur for that
company. Here we are treating expense inflation as if it is 100% correlated with
increases in an “index of prices or similar” (salaries in this case). The difference to the
company’s investment decisions caused by this assumption should be negligible.
Premium payments are usually fixed in monetary terms and hence can be
thought of as negative benefit payments guaranteed in money terms. The
existence of contracts where the policyholder can choose the amount of
premium to pay each year does not invalidate this.

Question 22.6
Explain the last sentence.
As a result of the above the liability outgo may be split into four categories:
• guaranteed in money terms
• guaranteed in terms of a prices index or similar
• indemnity
• investment-linked.
Term
In thinking about term in an investment context – whether discussing assets or liabilities

– we normally use the concept of “discounted mean term” (or “discounted mean
duration”) rather than the actual nominal term. The discounted mean term of an asset or
liability is defined as the weighted sum of the terms of the payments, where the weight
attributed to each term is the present value of the payment at that term.
The discounted mean term of a liability is useful in considering an appropriate

investment strategy. If we have a liability with a certain discounted mean term, then
choosing an asset with an identical discounted mean term will give us an investment
that will move in value with the liability in the event of interest rate movements
(provided certain other conditions hold – see below). We are therefore protected against
the risk of such interest rate fluctuations. This is the concept of immunisation that we
discuss further below.
Question 22.7
Valuing at an interest rate of 9%, estimate the discounted mean terms of the following:
(a) a new ten year bond with an annual in-arrears coupon of 6%
(b) an equity whose dividends increase at 3% annually
(c) cash
(d) a ten-year single premium critical illness contract (immediately after sale),
assuming a constant claim incidence rate of c = 0.0015 pa for policyholders
surviving to the end of each year, and a constant death rate of q = 0.001 pa.

Currency
Liabilities denominated in a particular currency should be matched by assets in

the same currency, so as to reduce any currency risk.
An alternative way of matching is to invest in overseas assets and then to hedge the
currency risk by use of appropriate currency options.
Question 22.8
Why might a company want to invest overseas?
3.2 Effects of the nature of liabilities
We now consider in further detail the investment implications of the four liability types
defined above:
• guaranteed in money terms
• guaranteed in terms of an index
• indemnity
• investment-linked.
Guaranteed in money terms
A company will ideally want to invest so as to ensure that it can meet the
guarantees. This means investing in assets which 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.
This form of liability applies to, for example, conventional critical illness policies. For
these, premiums and benefits are fixed. With large numbers of policies, the cash flows
from premiums and benefits (including expenses) will be statistically predictable. So
the company could try to invest in assets which have an equal and opposite cash flow.
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. A best match is all that can normally be
hoped for.

It will often be difficult to find assets that match the required liability cashflow. For
instance, there may not be any assets with a long enough term. Or, with a block of
recently written business, premium income may exceed benefits and claims for some
years, giving a net inflow in such years. No asset type can match that (without straying
into a derivatives quagmire), and so the company will have to invest these surplus
premiums at unknown future rates.
The best match that the company finds may still be a poor match for some patterns of
outgo. Often, the proceeds from assets will exceed the net liability outgo. The excess
will have to be reinvested at unknown rates, making strict matching impossible. This
problem can be overcome by the use of zero-coupon bonds, but they might not exist in
the market being considered.
The technique of immunisation, covered in Subjects CT2, CA1 and ST5, may be
used for this purpose, however that technique is subject to theoretical and
practical problems. A technically superior, though more complicated, approach
to assessing what a best match may be will be given in Section 4 below.
Immunisation is an alternative (really a second best) to exact matching. The aim is the
same as that of matching: ie to protect the investor from changes in future interest rates.
You should recall that we will have a position of immunisation if:
1) the present values of the liability outgo and the asset proceeds are equal
2) the discounted mean terms of the liability outgo and the asset proceeds are equal
3) the spread about the mean term of the value of the asset proceeds is greater than
the spread of the value of the liability outgo.
In such an immunised position – of which there would normally be many different

possibilities, for any given set of liabilities – the company would be protected against
assets not covering liabilities in the event of interest rates moving, provided the
movement were not too large.
Question 22.9
What are the various problems and limitations of this approach?
Given these various limitations, immunisation is really only of relevance for guaranteed
liabilities. Even then, the approach described later in the chapter will normally be
preferable.

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.
Question 22.10
How good a match for liabilities linked to a price index would equities be?
Indemnity
The insurer will monitor the likely costs arising from the various treatments
which are covered by these medical insurance contracts. Normally, private
medical insurance and its offshoots are short-tail business with little scope for
significant investment return.
This is because it is hoped that, at least approximately, the premium income from all
policies should be sufficient to pay for the claims of the unfortunate few, and to cover
the company’s expenses. Therefore the reserves under PMI policies will be very small,
and so investment income on them is negligible.
However, assets will still be required, so normally a mixture of cash and securities such
as short-term fixed-interest bonds would be suitable.
However, occasionally, an insurer will need to establish reserves where it is

aware of future treatment which 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
retail price inflation) prior to final settlement.
Hence 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.
Question 22.11
Which assets are likely to be suitable in these circumstances?

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 index. Clearly the company could avoid any investment
matching problems by investing in the same assets as used to determine the
benefits.
The most common example of this liability is a unit-linked product. In some markets
the insurer might be required to invest so as to match the underlying assets exactly.
Even if not legally obligatory, it is normal practice to do so and there would have to be
very strong reasons not to do so. One such reason would be if the company thought that
it could profit from such a deliberate mismatch (eg the units are defined in terms of
asset A, the company thinks that asset B will perform better over the next 6 months so
the assets invested by the company to meet the unit liabilities are switched from A to B).
We shall see below how such a position might be allowed by a sufficient level of free
assets.
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 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 of that return.
So suppose that 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 there are free assets they can be used as a cushion to
reduce the probability of becoming insolvent.

Example
Suppose Abingdon Healthcare Company has guaranteed fixed liabilities worth £100
now and it needs to choose some appropriate investment strategy. In order to increase
returns (moving away from a matching strategy) it would like to invest 50% in equities
and the remaining 50% in government bonds.
To simplify the situation even further, suppose the value of equities might fluctuate by
+ / - 10% in the course of any year, and that accounting regulations allow government
bonds to be valued at book value if they are to be held to maturity (ie we can ignore
downward market fluctuations on government bonds). There is no minimum required
solvency capital.
What investment strategy would be possible if Abingdon Healthcare possessed no free

assets? If it were to invest in £50 of equities, as it would like to, and £50 of bonds, then
it would be likely that at some point those equities fall in value to £45 and the total asset
portfolio would then be worth £95, making the company insolvent. In fact, with no free
assets, the company cannot make any equity investment.
What would be possible if the company had £7.50 of free assets? These free assets
would enable the company to withstand a drop in the value of the policyholders’ assets
of £7.50 (if the free assets themselves do not drop in value – otherwise we would need
to allow for that movement). Thus the company could invest in up to £75 of equities.
So the company can invest the policyholders’ fund 50% in equities as originally hoped
for.
The techniques discussed below can be used to determine how much of the free
assets are needed as a cushion so as to reduce the probability of insolvency to
an acceptable level.
Clearly this use of the free assets is most appropriate in regard to the assets
backing the guaranteed benefits.
So, the greater the free assets the greater the freedom in choosing investments for
guaranteed liabilities, ie the greater the variability of return which the company can
accept on the backing assets.
Also one could argue that it is a reasonable use of the free assets to mismatch
investment-linked benefits if by so doing the company can expect to achieve a
higher return. Note though that if this is done any return achieved above that on
the “matched” assets will not accrue to the unit-linked policyholders but to the
owners of the business.

Question 22.12
In the event of the return on the chosen assets being lower than that of the determining
the unit price, who bears the loss?
A final point to note in this section is the consideration as to the appropriate matching
strategy for the free assets themselves. In effect they do back liabilities: they form part
of the capital of the company, so there is an obligation to provide a return to the
providers of that capital. Hence one would expect investment in high yielding assets to
help meet this obligation.
3.4 Regulatory framework
The regulatory framework within a country may limit what a company would like
to do in terms of investment. There may be restrictions on:
• the types of assets that an insurance company can invest in
• the amount of any particular type of asset that can be taken into account
for the purpose of demonstrating solvency
• the extent to which mismatching is allowed at all.
For example, in some countries there is a requirement to hold minimum proportions of

total assets in certain types of investment, such as government stock or bank deposits.
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.
An alternative is to allow largely unrestricted investment, but to permit only a certain

percentage of some asset classes to count when demonstrating supervisory solvency.
For example, equities might only be allowed to count for 25% of assets in
demonstrating solvency. So a company with, say, 40m in equities and 60m in gilts
would only be able to show assets of 80m in its supervisory balance sheet.
Another approach adopted in some countries focuses on preventing over-concentrations

in individual assets (eg the shares of one particular company), rather than in particular
asset classes. 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.

The regulatory environment can also affect the choice of assets through their
relationship with the investment assumptions used to value the liabilities. A
particular asset distribution may allow a company writing long-term health
insurance products to use a higher investment assumption and thereby reduce
the value of the liabilities and increase the free assets. Typically, however, such
distributions will not enable the company to maximise the expected investment
return.
For example, in the UK, the rate of interest that can be used to value the liabilities is
higher if the backing assets are government stock than if they are equities.
Finally there may be a regulatory requirement to allow for mismatching. This

could involve the possible setting up of an investment mismatching reserve.
The more a company decides to invest in riskier assets with a higher expected
return, the higher could be any such resulting reserve. This would increase the
value of the liabilities and reduce the available free assets.
A careful distinction needs to be made here between the risk of cashflow mismatching,
and the risk from short-term shocks in investment conditions.
The risk from cashflow mismatching is that, over time, the income from the asset
proceeds falls short of the outgo needed to meet the liabilities, due to such things as
having to buy assets in the future at lower than expected yields, or having to sell assets
(to meet outgo) at depressed market values. These events would result from a
mismatching of assets and liabilities by nature, term or currency, and its effect would
only unfold over time as the actual cashflows took place. In order to assess the true
mismatching risk of a company, a cashflow projection model would be used.
The risk from short term asset shocks relates to whether the company would continue to
be able to meet its supervisory reserving requirements if market investment conditions
were to change suddenly. Examples might be a change in fixed interest yields or a fall
in the capital values of equities or property. To identify this risk, the company would
have to analyse its supervisory solvency position under different assumptions of current
investment conditions. This is also referred to as resilience testing.
To cover either of these risks an insurer may have to set up additional reserves.
Another regulatory constraint that might be important is the method required to value
the assets. For instance, in countries where assets are valued at book value, there is a
disincentive to invest in equities because gains can only be seen when the assets are
sold, and there will be times when the company might not want to sell.

The most significant regulatory requirement could be regarded as the need to stay
solvent! Although this might seem so obvious it is not worth mentioning, there are a
couple of interesting ramifications.
First, in setting an investment strategy as described below, the company will use some
arbitrary “acceptable probability of insolvency” – for instance 1%. Although this might
seem prudently low, it is saying that the company will face with equanimity the idea of
becoming insolvent once every century, say. This reflects not the company’s playing
Russian roulette, but a tacit assumption that, in the event of very severe market
movements, the regulatory solvency capital requirements might be temporarily
weakened to prevent all insurance companies in the country going out of business. In
other words, in deciding on an acceptable probability of insolvency, it is important that,
as well as seeming low in absolute terms, the level is not in excess of that generally
adopted in the insurance industry of the country concerned.
Hence the insolvency risk is as much to do with timing, and with industry correlations,
as with absolute probabilities of ruin. For example, a company will be less concerned if,
because of exceptional economic conditions, it has breached its solvency capital
requirements along with the vast majority of the rest of the industry. It would not be in
the public (nor therefore the government’s) best interest to wind up a large part of the
industry. Some saving measures would probably be found for all concerned. However,
if one company were to become insolvent on its own, especially if there were no
extreme global circumstances to justify the event, then the government would probably
have little hesitation in closing the company down. Hence, if it could be achieved, the
company should be very keen to make the probability of individual ruin (that is, with the
industry remaining solvent) infinitely small.
Secondly, the solvency regulations are likely to require that the insurance company
demonstrate some form of solvency capital in addition to the supervisory reserves.
What are the investment implications of this? At its simplest, such a capital
requirement can be seen as a necessary strengthening of reserves. For instance, instead
of needing to hold assets to cover a reserve of $100,000 in respect of some portfolio of
business, the company must hold assets to cover a reserve of $100,000 and a solvency
capital requirement of $5,000. Viewed in this way, it is clear that assets in respect of the
statutory capital requirement should be invested in the same way as the assets
underlying the supervisory reserves for that business.
Although this is a theoretically prudent approach, and commonly used, some companies
might in some situations view the solvency capital requirement as intrinsically different
from the related supervisory reserves, and adopt a different investment strategy. This
would often be the case with investment-linked business, where the assets in respect of
the solvency capital requirement might be invested in government bonds rather than
invested in the specific assets underlying the investment link.

4 Developing an appropriate investment strategy

We now consider how an insurance company would use asset and liability modelling
techniques to assess the viability of any investment strategy. The logical starting point
is to identify the strategy that forms the most appropriate match for the liabilities. This
will represent a “minimum risk” strategy for the company. We then need to consider
what divergences from the base will lead to greatest expected rewards to shareholders
and policyholders, as appropriate, while maintaining risk control commensurate with the
company’s resources, particularly its available capital.
4.1 Using a model office to determine an investment strategy
Using a model of the business in force, a model investment portfolio can be built
up based on the company’s proposed investment strategy and incorporating an
appropriate proportion of the free assets.
Question 22.13
Why incorporate just a proportion of the free assets?
What is appropriate here will be determined to some extent from the results of
the investigations below.
The liabilities and the assets would then be projected forward on assumptions
that represent expected future experience, although the company will want also
to consider the effect of variations from these.
In fact one of the most important considerations will be how the proposed investment
strategy fares in the light of significant market movements downwards.
For the assets, stochastic investment models can be incorporated in order to

project future investment income and changes in capital values. Inflation rate
models can also be used to project future expenses on the liabilities side.
As always in modelling work, great care will be required that the parameters are
consistent – for the assets we will need consistency between inflation, interest rates and
market (capital) values, and these should be consistent with the valuation interest rates
used in the liability model. By “consistent” here we mean that the relationships
between the different variables should be suitably realistic.
The projected liabilities and assets can then be valued at the end of each year of
the projection on the company’s supervisory basis.

This implies that the company wants to test solvency at the end of each year. With
modern computational power there should be no reason not to test this solvency
continuously throughout the projection period, to ensure that the company is always
solvent.
The item of interest will be the excess of the value of the assets over the value of
the liabilities. This will need to be sufficient to cover comfortably the level of
solvency capital required by the company, which will probably itself depend on
the investment strategy being investigated. What is “comfortable” will depend
on any regulatory requirements, the nature of the business, and the level of
cover provided by other companies.
An example of “comfortable” cover could be having a solvency capital equal to twice

the minimum. But exactly how much cover is “comfy” will depend on whether the
regulatory authorities, perhaps “unofficially”, expect companies to achieve a certain
level of cover, on the riskiness of the business in question and on what is normal in the
market.
The market norm is also a factor because brokers may examine the amount of cover that
insurers show in their published returns, perhaps via articles in the specialist financial
press, and use it as their main measure of a company’s financial strength.
Using a stochastic investment model and simulation techniques, the above can
be extended to produce a statistical distribution of the amounts available each
year to cover the level of solvency capital required. From this, the probability of
potential future insolvency can be estimated given a particular investment
strategy.
The simulations might involve several hundreds or thousands of randomly generated

“sample paths”, each one representing the future solvency positions resulting from one
set of randomly-generated investment returns.
For example, a collection of sample paths might look those shown in Figure 1. The
ratio of assets to liabilities at the date of projection is 1.2.
As you can see, one of the paths clearly goes insolvent (assets less than liabilities).
Others may denote insolvency, depending on the extent of any required amount of
minimum solvency margin under the supervisory regime in question.

Fig 1: Example sample paths
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
0.5
0.4
Time (in years)
Another possible set of sample paths is shown in Figure 2.
Fig 2: More example sample paths
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
0.5
0.4
Time (in years)
In Figure 2 all of the sample paths go insolvent at some point. Highly worrying!
For valuing the liabilities the company’s current basis will most likely be chosen,
but it could incorporate into the simulation exercise dynamic assumptions
which take into account the simulated investment conditions.

If the valuation basis is in any way contingent on the assets underlying the reserves, the
return on those assets, or even just the expected reinvestment yields in the market, then
the reserves in the model for year y should be calculated on a basis that reflects the
simulated asset situation in year y. Keeping the valuation basis constant could give very
misleading results. In essence, we are back to the fundamental concept of consistency.
Finally, and very importantly, we need to identify some measure of success (ie of
profitability) that we can use to compare investment strategies. Some aggregate
measure of the company’s earned profit over a future time horizon would ideally be
required. (An example for a proprietary company is given at the end of this
sub-section.)
However, in general, the method of increasing the insurer’s expected profitability is the
opposite of the process of reducing its risk: by deliberately mismatching its assets and
liabilities to take advantage of opportunities that are expected to give rise to increased
profit. Note the important link here with the liabilities: choosing assets that produce the
highest expected returns does not necessarily produce the highest expected profit,
because profit is a function of how the liabilities, as well as the assets, behave. Hence a
more rewarding strategy is, by definition, a more risky one, because it implies less
matching. This is precisely why you need to look at the overall profit emerging from an
asset-liability model as a basis for determining an optimal investment strategy.
Summarising the model office approach:

1) allocate a certain amount of free assets to support the assets underlying the
reserves
2) perform asset-liability model projections of the company’s future assets (arising
from the starting assets defined above), and compare these total assets against
the reserves
3) check that the excess of these assets over the liabilities exceeds any statutory
solvency capital requirement (or possibly, exceeds some comfy multiple of that
requirement) for the entire projection period for most (eg 99%) of the model runs
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
6) identify which of the possible strategies, having equal insolvency risk, produces
the highest profitability.
Question 22.14
Identify three potential weaknesses in this particular approach.

What decisions need to be made here? In essence there are three elements which can be
varied:
• the riskiness of the investment strategy
• the level of the free assets
• the probability of insolvency.
The basic approach that has been described above is to take the level of free assets,
decide on some acceptable risk of insolvency (eg 1%), and then determine the most
risky, and hence rewarding, investment strategy compatible with those criteria.
A minor variant of this is to take only a proportion of the free assets and determine the
most rewarding investment strategy feasible.
Question 22.15
How would we make an investment strategy riskier?
However, the simulations could also be used to determine the level of free assets
the company needs in order to support a particular investment strategy and
keep the probability of insolvency below an acceptably low figure.
An alternative, which corresponds to what a company might do in reviewing its current

strategy, is to take that investment strategy in conjunction with its actual free assets and
to estimate the probability of insolvency. This is the essence of dynamic solvency
testing.
For a proprietary company, the process can be extended further and the effect of
the investment strategy on future shareholder earnings can be considered. In
particular, an investment strategy can be determined that maximises
shareholder income whilst keeping the risk of insolvency sufficiently low,
bearing in mind the available level of free assets.
In the case of a proprietary company we can measure profitability directly in terms of

the value of the distributions of profits made to the shareholders, ie as transfers from the
projected income statements (profit and loss accounts). This can therefore be used as a
means of comparing the merits of different possible investment strategies in conjunction
with the appropriate risk measure.

4.2 Fund manager assessment
Given that “The company should invest so as to maximise the overall return on
the assets, subject to the risk therein being within the financial resources
available to it” as stated in Section 2 above, it is important the actuary or other
analyst should monitor the results of the fund manager. The results of the fund
manager should be assessed against the targets originally set for overall return,
against the riskiness of the strategy undertaken and against the performance of
other fund managers with similar investment briefs. Where possible, the
assessment would be over several such periods to avoid luck or otherwise in a
single random swing.
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 more difficult access to performance data.
4.3 How liquid do the assets need to be?
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 funds.
For example, if the insurer has closed to new business and is merely managing the
run-off of the existing business, the claims experience will become more volatile as the
number of remaining independent claims dwindles. In this case, immediate cashflow
could become a problem and so a source of ready cash is advisable (or at least assets
that can be realised at short notice, with minimal risk).
In the face of widely fluctuating claims, we might in theory be able to reduce the
resulting high liquidity requirement by having appropriate reinsurance in place.
Even with reinsurance protection, the insurer will still be left with the obligation
to pay the gross claims perhaps far in advance of making recoveries from
reinsurers. Note that this may introduce tension with the matching
requirements.
Question 22.16
Explain the last sentence of Core Reading.

4.4 Effect on product development and pricing
The extent of a 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 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.
We mentioned this at the start of this chapter. A healthy investment return, particularly
on longer-term contracts, can be used by an insurance company to keep premium rates
down, or to make the benefits more attractive for the same price, if competitive forces
demand it.
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.
The method of valuation of assets will depend on the purpose of the exercise
and the market’s perception of fair value. For PMI business, there would be little
alternative but to value assets at their market price (this would normally be cash
or near-cash assets in any case).
For long-term liabilities, there are two possibilities. The first is to discount the
likely returns on these assets including eventual disposal, on a basis consistent
with the valuation of liabilities. The second is to use market values as an
objective readily-understood methodology. The latter method became the norm
in many territories in the persisting bear markets at the beginning of the 21st
century, or maybe they took the prudent route in selecting the method of the two
above which provided the lower result.

Example
A health insurer, with predominantly long-term liabilities, holds a portfolio of equities.

The current market value of the portfolio is £100m, and the portfolio has recently been
yielding an overall dividend of 10%pa.
What value would you place on this portfolio?
The answer depends firstly on why you want to value it. For example, for supervisory
purposes, a prudent approach would be appropriate. But how prudent?
• Should you ignore current expected future capital growth?
• Should you ignore the dividend?
• Should you allow for the possibility of the capital value falling?
There is of course no definitive answer.
One method is simply to use a discounted cashflow method, by discounting both the
value of expected future dividends and the expected future sale values, at a rate of
interest consistent with that used for the valuation of the liabilities.
A second is simply to use £100m as the asset value, on the understanding that this value
already reflects, in theory at least, expected future asset proceeds.
4.6 Policyholders’ reasonable expectations
It is unlikely with health and care products that the policyholders have any
expectation 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 underperformance in this
area would necessitate a price increase at a policy review. This would almost
certainly raise questions of a PRE nature.
In other words, policyholders of fixed benefit but reviewable premium products, such as
critical illness, would not appreciate a rise in premium level purely as a result of
under-performance of the company’s investments. In their eyes, they may view the
under-performance as “not their problem”.
The major exception to this would be investment-linked products where the benefit
(and/or future premium levels) depends on the future investment performance.

5 End of Part 4
Review
the key areas of Part 4, or maybe re-read the summaries at the end of Chapters 21 and
22.
Assignments


Chapter 22 Summary
The investment strategy of a health and care insurer is of importance to its commercial
success, financial performance and security. The scale of importance depends on the
product and in particular on the size of the reserves.
The company should invest so as to maximise the overall return on the assets, subject to
an acceptable level of risk.
Assets should be selected to match the nature, term and currency of the liabilities, where
by term we mean discounted mean term.
The nature of the liability outgo can be considered as one of the following:
• liability guaranteed in money terms
• liability guaranteed in terms of some non-investment index
• indemnity liability
• investment-linked liability.
Assets would normally be selected to match these four components as follows:
Liabilities guaranteed in money terms
Immunisation theory can be used to build up a suitable portfolio of government bonds,

but there are a number of problems and limitations with this approach. Normally an
appropriate balance between risk and return would be chosen after dynamic asset /
liability modelling, in order to allow for free assets.
Liabilities guaranteed in terms of some non-investment index
The ideal is to invest in some asset based on the same index; failing that, use the most
similar asset available.
Indemnity liabilities
Short-term assets are appropriate for most of these liabilities. There may be some
longer term liabilities that could be matched by real long-term assets.
Investment-linked liabilities
It is normal to invest in the assets underlying the investment link concerned.

Overall strategy
In deciding on the investment strategy, the company will need to consider any
supervisory or regulatory constraints.
The overall principle is to invest away from a matched position, to the maximum extent
possible, consistent with the desired level of risk, in order to maximise returns.
The company will perform asset / liability modelling, to test the proposed investment
strategies, which could be used alternatively to investigate:
• the level of riskiness of investment strategy that can be supported,
• the level of free assets required to support any strategy, or
• the resulting probability of insolvency,
noting the interdependence between these three aspects.
The insurance company should keep a close eye on the performance of its fund
managers.
It may need to keep a supply of ready funds, to allow for the volatility of its day-to-day
cashflows, particularly if modelling reveals that outcomes are very sensitive to
experience.
There are various approaches to valuing assets. Two possibilities are a market value
approach and a discounted cashflow approach. The purpose of the valuation will have
an influence on the method used.
Health and care policyholders usually do not expect poor investment returns to influence
the premium reviews under reviewable contracts, unless maybe if the policies are
unit-linked.

Solution 22.1
Pre-funded long term care, ie where reserves will be high.
Solution 22.2
Corporate fixed interest stock should offer an expected return slightly better than
government stock of equal term to reflect default risk and lower marketability. That
return will not be volatile. Running yields will normally be similar to prevailing interest
rates for the term concerned.
Security could be a significant problem, especially if the issuing company has a low
credit rating. The value of the stock may fluctuate with the markets, but this will not be
too important if the investor is prepared to hold the stock to redemption.
Marketability of such stock is often poor, and dealing costs high.
The terms available are normally similar to those found for government stock.
Solution 22.3
Property is normally associated with a relatively high return. The income, in the form of
rent, gives a low running yield but should eventually increase in real terms.
Property investment is normally seen as secure, although the actual income stream may
suffer occasional interruptions. The market value can vary significantly, many property
markets suffering from some form of cycle.
It is a very illiquid investment, with significant dealing expenses. Expenses are incurred
even in just administering (ie holding) the asset.
It is a very long-term investment – as with equities, it can be thought of as a perpetuity.

Unlike equities the option of buying with the intention of selling in the short term is not
practical due to the impact of dealing costs.
Direct property investment can only be made in large chunks – so a small insurer may
have problems with diversification.
Each property is unique, and so valuation can be difficult.

Solution 22.4
It eliminates all possibility of making investment profit.
Solution 22.5
Perfect or nearly perfect matching is desirable if the company has very low free assets
such that, without matching, the probability of ruin would be unacceptably high.
Solution 22.6
The idea of defining liability as the value of future benefit payments less the value of
future premium payments should need no explanation! For normal long-term regular
premium policies, a large guaranteed benefit is procured at outset, financed by the
contractual obligation to pay a certain amount of premium in the future.
The right approach is less clear in the case of recurrent single premium products, where
the policyholder can choose at any time when and how much premium to pay. Valuing
future premiums in this instance will be impossible. This is not a problem because, for
such policies, there is no sum insured to be financed by future premiums (each year’s
premium pays for that year’s cover and nothing more). So in effect, for such contracts
the value of the liability corresponds purely to what has been bought by premiums paid
to date, and the value of future premiums and the benefit that they buy can be taken as
zero.
However, if the policy involves some guarantee whereby the policyholder can pay future
premiums under some advantageous terms, it would be more prudent to assume a
certain level of future premium payment, deducting the value of the associated
purchased liability.

Solution 22.7
The discounted mean terms are:
(a) Ten year bond: 7.5 years
This is calculated using

{ }
0.06 ¥ 1 v + 2 v 2 + 3 v3 + ... + 10 v10 + 10 v10
,
0.06 ¥ a10| + v10
with v calculated at 9%.
(b) Equity: valuing as a perpetuity, the discounted mean term will be 1/d. In this
case d will correspond to an interest rate of approximately 9% – 3%, so that
d = 0.06 1.06 = 0.0566 . So the answer is 18 years.
(c) Cash: Zero
(d) Single premium contract : 4.8 years, calculated using:
{
c ¥ 1 pv + 2 (1 - c)( pv)2 + ... + 10 (1 - c)9 ( pv)10 }
(
c ¥ pv + (1 - c)( pv)2 + ... + (1 - c)9 ( pv)10 )
where p = 0.999 , although any broadly similar morbidity/mortality will give the
same answer.
Solution 22.8
A company would need to invest in an overseas market if some of its liabilities were
denominated in the currency of that market.
In addition, the company might want to invest overseas in order to increase

diversification, or to invest in assets not available locally, or because some country’s
assets seem to offer particularly good value compared with the home market.
As we shall see, such deliberate mismatching will only be feasible if the company is
able to allocate some free assets to cover the potential downside.

Solution 22.9
The problems and limitations of immunisation theory are:

(i) it immunises against profits as well as losses
(ii) it can be difficult to immunise against real liabilities
(iii) the theory only works with small interest rate fluctuations, though in practice it is
usually quite robust to large interest changes
(iv) the theory assumes that when interest rates change, the same change occurs at all
terms
(v) you would need to reanalyse the situation every day and change investments
accordingly
(vi) assets of the required term may not exist
(vii) the timing of asset proceeds might not be known, and that of liabilities can only
be estimated (for a health and care insurance policy).
Note that points (iii), (iv) and (v) do not apply to absolute matching (though the other
points do), and explains why immunisation is really “second best” compared with
absolute matching.
Solution 22.10
Equities are not a perfect match for this liability because their return is not guaranteed,
either in absolute or index-linked terms. However, the return does behave to some
extent in line with price inflation, and so they offer a reasonable match. This would be
contingent on diversification: any one equity stock is likely to offer a very inferior match
to an inflation index (quite apart from the exposure to asset default).
The suitability of the match is also a function of how long a time period is considered.
Hence over a short time period the match will be poor, due to the high volatility of the
return from equities over the short term, while over a longer period the match will be
much better, as the long-term return from equities tends to be less volatile.
Equities may be a better match for earnings-related indices than price-related indices.

Solution 22.11
Index-linked bonds may go some way to matching the liability, although we see that
claims costs may inflate at a greater speed than the index. If this is the case, then other
asset classes that traditionally give higher long-term real returns may be more suitable,
such as equities and property. However, the volatility of such assets needs to be borne
in mind.
Solution 22.12
The insurer will bear the loss, since the liabilities in respect of the unit-linked policies
will increase in line with the other higher-performing assets.
This is the reason why such mis-matching is not common: the risk of a sizeable loss is
too great, even if the free assets are sufficient to prevent the loss causing sudden
insolvency.
Solution 22.13
An insurance company may want to dedicate only a portion of free assets to support the
investment strategy of the policyholders’ fund. This is because the shareholders may
not want to use all of their assets as “security” for that fund: deliberately mis-matching
the policyholders’ fund to increase return, and using free assets as a cushion, means that
those free assets might disappear to pay for any loss arising from the mis-match. Quite
reasonably, the shareholders may not think that increasing the return on assets for the
benefit of policyholders justifies the risk of all of their free assets disappearing.
Another more prosaic reason is that some of the free assets might be inadmissible under
local statute as assets to cover reserves (or any statutory solvency capital requirement).

Solution 22.14
First and most obviously, there is 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.
Secondly, there is the issue of considering only a portion of free assets. Although the
owners of the free assets might justifiably 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. For instance, we can still have a constraint along the
lines of “we accept that 50% of free assets will disappear with a probability of 1%” but
model the entire asset portfolio, and interpret the results accordingly. This could give
more useful results.
Thirdly, we will need to be very careful if the statutory solvency capital requirement is
not constant. In fact it is commonly defined in many countries as a function of, amongst
other things, the reserves. In this case an approach that is less vulnerable to error would
be to include the solvency capital requirement in the asset-liability model to ensure that
it is modelled correctly.
In other words, a better approach might be for the model to be of the whole company but
possibly with some free assets earmarked “not for solvency demonstration”.
Solution 22.15
The following will make an investment strategy riskier (interpreting risk as “variability
of profit”):
• For assets backing some given liabilities:
– reduce the amount of matching by nature
– reduce the amount of matching by term
– reduce the amount of matching by currency.
• And looking at assets in isolation (ie assuming there are no associated
liabilities):
– increase duration.
• And in both cases:
– move from government stock to corporate stock
– move from AAA-rated corporate stock down to something lower
– for equity stock, move from an established company to a new company,
or from an established sector to a new sector.

Note that a company would never normally increase risk by reducing diversification.
This is because we are interested in varying sector risk, not specific risk (which should
always be minimised).
Also a company would never increase risk unless it also leads to increased expected
profitability.
Solution 22.16
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 in terms of term or underlying risk, the need
for ready cash may mean that shorter-term investments would be a better idea.




using the course.

ST1-23: Nature of risks (1) Page 1
Chapter 23
Nature of risks (1)
Syllabus objective
(g) Understand the nature of the risks facing the insurer:
− data – experience, insured experience, population data, overseas

data
− claim inception and termination rates
− claim cost information: by treatment, per diem, length of stay, medical
inflation
− investment performance
− expenses and inflation
− withdrawals
− mix of new business by nature and size of risk and by source
− volumes of new business
− guarantees and options
− competition
− management of insurer
− counterparties in distribution
− counterparties in provision of medical services
− counterparties in reinsurance
− regulation and fiscal developments
− customer service shortcomings/reputational risks
− internal audit failures/fraud
− physical risks including IT recovery
− aggregation and concentration of risk
− catastrophes
− non-disclosure – underwriting at outset versus underwriting at claim
stage
− earlier screening/diagnosis.

Page 2 ST1-23: Nature of risks (1)
0 Introduction
This chapter and the following two chapters look at the macro risks with which a
health and care insurance company might be faced. In this chapter and the next we
shall look at the possible sources of those risks. In the third of our three chapters on risk
we shall consider the problems that those risks can present to an insurer.
We have already spent some time discussing risks earlier in the course, in the context of
specific contracts. We identified those risks as “micro” risks, but they might equally
well be thought of as specific examples of some of the “macro” risks covered in this
chapter.
For example, uncertainty over future investment returns is a general risk for a health
insurer and so we shall be discussing it here. However, we have already seen that its
importance as a risk varies depending on the type of contract involved.
What we shall be doing in this chapter is looking in more detail at how and why our
assumptions about the future may turn out to be incorrect. Indeed, the general theme of
much of this chapter and the next considers that:
1 Actuaries are constantly involved in investigations that require them to make

assumptions about a wide range of future events. These investigations form the
basis of the company’s strategic decision-making (for example for pricing,
product design, investment strategy and reinsurance strategy).
2 For various reasons reality will turn out differently from assumed (ie from
expected). The extent to which these deviations may be more adverse than the
expected outcomes constitutes the insurer’s risk. Hence each assumption
represents a source of risk.
We shall also consider some risks that do not fit into this framework, for example the
effects of competition and the management of the company.
The identification of risks is an essential part of a health and care insurance company’s
control cycle. Any business will wish to identify threats to its financial well-being and
profit stream.
Having identified the risks, the company can put in place mechanisms to monitor them.
The company can also do a number of things to limit and control the risks that it faces.
In this part of the course we are still concentrating primarily on the sources of risk rather
than the control and monitoring. These other aspects of the control cycle will be
covered later.

1 Policy and other data
1.1 Policy data
A health insurance company will maintain a database of the policies it has on its books.
For each policy this will include items such as age at entry, date of entry, policy term,
date of diagnosis (where relevant) and many others, dependent on policy type.
The main actuarial reason for needing policy data is so that a regular valuation
of the liabilities can be carried out, usually, but not exclusively, for insurance
supervisory purposes. These data will be maintained by the insurance company
and the actuary carrying out a valuation will not, usually, have a direct control
over them. There is, therefore, a risk that the company will not maintain the
adequate, accurate and complete records required by the actuary and hence the
result of the valuation will not itself be accurate.
Question 23.1
How serious would this be?
A similar point relates to policy data required for any internal investigations
carried out by the actuary so as to give appropriate advice to the company.
Clearly, if the data are so inaccurate as to lead the actuary to give incorrect advice then
this is potentially very serious, both for the company and the actuary. It would
undermine the monitoring which is so important to the control cycle. Therefore the
actuary would normally carry out some checks on the quality of the data. It is
imperative that the actuary is at least aware of any data problems.
For some investigations a model of the whole or part of the business of the
company may be used. There will be a risk that this model does not adequately
represent that business.

There are two aspects to this risk:
● Firstly the data of the company might be inaccurate, inadequate or incomplete, as

above, so that any model of the business in force which has relied on these data
will be similarly affected. This is clearly a data risk.
● Secondly, where model points have been used to represent the business in force,
there is a risk that these will not represent the characteristics of the actual
portfolio well enough to produce valid results, leading to incorrect business
decisions being made. (See Chapter 13 for a full description of model points.)
This second kind of risk is therefore properly referred to as a model or modelling

risk. It is the risk that results from our model office being an over-simplification
of the real company in terms of the portfolio of policies currently in force, and as
a consequence behaving unrealistically. We return to the subject of model risk
in Section 2.
1.2 Other data
The most typical “other data” required by an actuary will be those needed to
determine actuarial assumptions such as disability incidence, survival periods
or mortality.
These other data may relate to the insurance company’s own experience or may come
from an external source such as insurance industry data, national statistics or an
overseas market.
It may be that the data internal to the company will not be adequate to provide
reliable indicators of future experience, because of inaccuracy and/or
insufficient volume. Even where adequate, data may prove to be inappropriate
because of differences between the population on which it was based and the
population for which it will be used. This is especially true where the actuary
uses population data, overseas data or even insured data where policy
conditions and underwriting/claims procedures may differ significantly from
those in the actuary’s company.
Internal data might be inadequate for various reasons, for example:

● there may be missing data
● the data may be inaccurate
● there may not be enough data for credibility.

Even if the data are of good quality, they may not be suitable as a basis for future
assumptions (unless they are significantly modified), because they may be based on an
inappropriate class of lives.
Question 23.2
A health insurer has written large volumes of long-term care insurance over many years.
It has performed a careful analysis of the average expense per policy of this business. It
is about to start writing critical illness insurance for the first time, and it plans to use the
per-policy expenses from its long-term care insurance as its expense assumption for the
critical illness insurance. Suggest reasons why this might not be appropriate.
Alternatively, any external data used may be inadequate or unreliable, and even
where it is reliable may prove to be inappropriate for the same reason as above.
This is because of differences between the population on which it was based and the
population for which it will be used.

2 Claim inception, mortality and recovery rates; average

claim amounts
2.1 Types of risk
In most of the investigations carried out by an actuary, assumptions will need to

be made regarding future mortality, incidence of critical illness and incidence of
sickness, as appropriate. There are three risks associated with these
assumptions:
● a “model” risk, that is the model, typically a probability distribution,

chosen to represent future mortality, etc, may not be appropriate;
● a “parameter” risk, that is the parameters used with the model may not
adequately reflect the future experience of the class of lives insured or to
be insured, even though the underlying model may be appropriate;
● a “random fluctuations” risk, that is the actual future experience may not
correspond with the model and parameters adopted, even though these
adequately reflect the class of lives insured or to be insured.
The first two risks always exist, as actuaries cannot predict the future, however
the extent of the risk will differ according to the reliability and applicability of
any existing data.
The main risk is that mortality or morbidity turns out to be more adverse than assumed
in the models we have used for decision-making. The three types of risk listed above
help us to understand the various ways in which the risk can arise. This in turn can help
us to devise suitable means of controlling the risk. In other words, understanding where
the risk has come from is half the battle.
2.2 Identifying the type of risk
There are no dogmatic rights or wrongs about how much of the risk associated with a
particular variable is due to model, parameter or random fluctuations risks. It all
depends on how you envisage the variable behaving, and how you model it.
It is usual to think of a variable which can take on different uncertain values as a random
variable, where the values depend on some kind of probability distribution. The values
that we project for the future values of this variable represent some kind of model for
the variable.

Many projections involve assuming that future values of a variable (eg investment
returns) are fixed and constant (eg 6% each year). This is an example of a deterministic
projection, or a projection using a deterministic model. You can have deterministic
models which involve different values in each projection year, for example where you
assume a life will experience mortality according to the rates in a particular standard
table: this is still deterministic because the values are set (and known) in advance.
The philosophy underlying a deterministic projection is (usually) that the projected

values are the means (or expected values) of the variable in each future year. If we have
made this assertion, then we can consider the likely risk of deviation of the variable
from these values by reference to the probability distribution of the variable.
Example
Assume that a group of 1,000 policyholders all aged 40 will suffer mortality of
q40 = 0.003 over the next year. How would we assess the risk of the actual number of
people dying being different from the 3 we would expect?
To do this, we need to specify our model more precisely. We could suppose that the
policyholders are identical and independent (a typical statistical assumption), and define
the probability of each dying as 0.003. If these assumptions are correct, then the
number of deaths will follow a Binomial probability distribution, with parameters of
1,000 and 0.003. This will enable us to quantify the random fluctuations risk of this
portfolio, because we can predict such things as the probability of more than 10 of the
1,000 lives dying during the year solely as a result of the natural, or random,
fluctuations inherent in the system.
But there are other, possibly more significant, reasons why we might get more deaths
than expected. Probably the most important is the parameter risk: for example, we
might have lives who are identical and independent but whose actual probability of
dying is 0.006. This will significantly increase the probability that more than 10 of the
people die, for example.
The uncertainty surrounding the parameter value of this model (ie of the probability of
dying, q40 ) can itself be thought of in terms of a probability distribution or, more
prosaically, as an expanding funnel of doubt. This can be thought of as an expanding
funnel because, if we were trying to predict the value of q40 in ten years’ time, rather
than next year, say, then we would consider a broader range of values of q40 to be
possible. In other words, the variance of the parameter q40 would increase the further
into the future you are trying to predict it.

The other main source of risk is the model risk. For example, if our lives were not
independent, then the variance of the number of deaths would increase. This is because
the Binomial model is valid only if the lives are independent with respect to their
mortality, and so the random fluctuations risk would actually be higher than we would
estimate using the Binomial model. Further error would arise if our population were
heterogeneous – in other words, the lives were not identical with respect to their
mortality.
Model and parameter risk
Parameter risk is essentially the risk that the parameters we are using in our underlying
model of the future are “wrong”. Sometimes the distinction between model and
parameter risk is rather blurred. For example, the mortality of people aged 40 might be
rising over time. So part of what we called “parameter error” in projecting mortality in
ten years’ time in the above example could be due to failing to allow for future changes
in mortality over time: that is, due to model risk, rather than parameter risk.
As the Core Reading says, the likelihood of our assumptions for the future being right
depends on the quality and relevance of the data available. In other words, poor or
irrelevant data will increase the parameter risk:
● At one extreme we could be dealing with a well-established type of contract,
with reasonably stable and predictable experience, and lots of relevant data on
which to base assumptions. This would be low risk.
● At the other extreme we might be dealing with a contract type which is
completely new to our market, and have to rely on a mixture of intelligent
guesswork and heavy adaptation of what little relevant data exist. This would be
high risk.
Question 23.3
Insurers in a number of countries developing long-term care contracts have made use of
experience from the United States, where the market is more established, from which
more precise parameter estimates can be calculated because of the greater volume of
data available.
Explain whether this practice is likely to lead to large or small parameter risk in the
countries concerned.

The possibility of new diseases or sudden advances in medical treatment can never be
ruled out. There will always be an expanding funnel of doubt, however good the
experience data may be.
Random fluctuations risk
The “random fluctuations” risk arises, partly because of the heterogeneity of the
lives insured or to be insured, and partly because the numbers exposed to risk are
unlikely to be large enough for the law of large numbers to apply.
The second idea here, that unpredictable fluctuations are larger in small samples, should
need little further explanation. But even in large samples there will be some random
fluctuation, and so there will always be random fluctuations risk.
We already touched on the first idea, concerning heterogeneity in the population, at the
end of our example about the 1,000 lives aged 40. We may model a large population of
policies by a single qx for a given sex at age x. This may disguise a great deal of
variation in the population which we would model better by splitting it down further, for
example into smokers and non-smokers.
In our example we referred to this as “model” risk. What the Core Reading is saying is
that any heterogeneity in the population will lead to a greater amount of apparent
random fluctuation about the mean than expected from the model. Arguably, then, we
might describe this element as “unexplained” rather than “random” fluctuation. It is
unexplained because of the inadequacies of our model. The important thing, though, is
that the risk of error undoubtedly exists, whatever view one takes of its nature. By
considering its nature, as we have done here, we can get much further towards
quantifying the fundamental risk: the extent to which actual experience will be worse
than we have assumed in our projection model.
Question 23.4
Discuss the extent to which sickness experience represents a risk on income protection
insurance for an insurance company operating in an established insurance market in a
country with a developed economy.

2.3 Other considerations for estimating average claim amounts
Under private medical insurance, a further element of risk lies in the estimation
of future average claim amounts for each of the various procedures covered by
the policy. In most markets, the requirement to predict is seldom for more than
a year ahead. Nonetheless, the fact that the insurer is generally “guaranteeing”
to cover whatever a third party (hospital or other health service provider) may
charge, introduces short-term uncertainty.
The average cost of claim will vary certainly as inflation increases costs year on
year. Additionally, however, claims costs will rise as different medical
procedures are performed to treat the same conditions (as medical science and
recommended protocols progress), as hospital capacity changes the likely stay
as in-patient for a given procedure, and as pricing agreements are negotiated
and re-negotiated with providers.
Do not underestimate this additional uncertainty for private medical insurance. For
example, in mid-2003, the rehabilitation period following hip replacement surgery was
typically a few weeks. Towards the end of 2003, however, advances in treatment meant
that patients could be treated effectively within a matter of days. The difference in cost
between a few days and a few weeks in-patient care amounts to thousands of pounds per
patient.

3 Investment performance
3.1 Future investment
In most of the investigations carried out by actuaries, assumptions, either on a

deterministic or stochastic basis, will need to be made as to the rate of return,
allowing for both income and capital appreciation, on amounts to be invested in
the future. Both “model” and “parameter” risks can, therefore, arise.
Traditionally, actuaries have made deterministic assumptions about future investment

returns. The effect of possible variations has been explored by sensitivity testing.
Stochastic modelling is now an alternative, under which the investment returns on asset
classes in any given period are modelled as the outcomes of random variables with
specified probability distributions. We gave an example of the use of such a model in
Chapter 22.
A key advantage of a stochastic approach is that it enables us to attempt to model the

inherent volatility (ie random fluctuations risk) in some asset classes, notably equities.
However, the measure of volatility is set deterministically, when we choose what value
to use for the variance of the relevant distribution. With stochastic modelling we have
to choose not just the mean returns but the whole probability distribution. Furthermore,
we may wish to specify relationships between the returns on different asset classes, or
limit the extent to which returns may vary from one year to the next.
In other words, when we make projections using a stochastic model, more aspects of the
probability distribution of the variable being modelled are included. Whatever
parameters are required for the projection (which might include one or more parameters
for each of the mean, variance, skewness, correlation with other variables, etc) then
there will be a parameter risk (or uncertainty) associated with each one.
As we have seen, “model” risk, in the most general sense, is the risk that the model is
inappropriate. No model can reflect perfectly the complexity of the real world. So
perhaps it is better to say that the model is not a sufficiently accurate representation of
reality to give reliable results.

Examples of errors in a stochastic investment model might be:

● the probability distribution for the random error term is inappropriate, for
example normal when it should have been log-normal
● the time-series relationships between outcomes at different times are not
specified appropriately.
When we use a deterministic approach we are essentially using just one parameter, the
expected value. The range of values we use in sensitivity testing says something about
our view of underlying variability, but we do not really model this explicitly.
The separate projection of income and capital gains is common. One reason for this is
that the tax treatment of the two may differ. However, for health insurance that has
relatively low investment content an average overall return assumption is likely to be
used, the error caused by the simplification being likely to have little financial effect.
Question 23.5
How might “amounts to be invested in the future”, as referred to in the Core Reading,
arise?
3.2 Existing assets
Some investigations will require assumptions, again either on a deterministic or

stochastic basis, as to the future income and capital appreciation in respect of all,
or parts of, the existing assets of the company. Again there can be “model” and
“parameter” risks.
This would be necessary when we are performing any projection that involves the
existing business of the company.
Investigations involving a comparison of the value of the liabilities with the value
of the assets will be subject also to a capital values risk in respect of the existing
assets being valued.
Investigations of this sort tend to be of a “snapshot” nature, at one point in time. The
risk is that an insurance company that appears solvent on one day could become
insolvent the following day after a change in asset values.
Question 23.6
Explain whether “change” should be “fall” in the last sentence.

3.3 Asset management
The passage of responsibility for the process or management of investments to

third parties introduces further risks.
However, it is hoped that the expertise that the third party would bring would make that
extra risk worthwhile. In any case, any sensible insurer would choose the investment
company carefully and monitor it closely.
3.4 Significance of investment performance
Investment performance may be of lesser significance when considering private

medical insurance because of its short tail from premium receipt to claim
settlement. For some long-term insurances, particularly funded long term care,
the investment assumptions and hence risks may be major considerations.
Question 23.7
In critical illness products too, there is a significant gap between premium receipt and
claim settlement (hopefully!). Is it fair then to say that investment performance is of
great significance for this product?

4 Expenses, including the effect of inflation

In most investigations carried out by actuaries, assumptions will need to be made
as to the future expenses to be incurred by the company. These will allow,
implicitly or explicitly, either on a deterministic or stochastic basis, for inflation.
There is therefore a “parameter” risk. In addition, there will be a “model” risk if
stochastic assumptions are being used.
When a stochastic approach to investment returns is used it is normal to model inflation

stochastically. In fact, the model may be “driven” by a stochastically generated inflation
rate, with investment returns linked in some way to the projected inflation. The
inflation of health and care insurance company expenses may not be the same as general
price inflation in the economy, but can be linked to it in the model.
As we commented above, you should not assume that a deterministic approach has less
risk simply because the model is not as explicit as under a stochastic approach.
The company will include, either explicitly or implicitly, in the premiums it charges
its policyholders, amounts designed to cover its expenses. These charges may be
augmented by others made, again either explicitly or implicitly, against the funds
built up by contracts.
On non-linked contracts the charges for expenses may be invisible to the policyholder,
as they are loaded within the quoted premium rate. Sometimes, a fixed policy fee to
cover some part of the expenses will be quoted explicitly.
On unit-linked contracts, as we saw earlier in the course, charges are explicit. They may
be deducted from premiums (eg by allocating less than 100% of the premiums to units)
or from the fund (eg through a regular policy fee paid for by unit cancellation).
It is not likely to be possible to design the charges, be they implicit or explicit, so that
they correspond exactly to the expenses of administering the product, and change in line
with any changes in expenses.
There is, therefore, a risk that the charges accruing to the company in a year will
not match the actual expenses of the company in that year.
A particularly important example of this is when heavy up-front expenses are recouped
gradually by charges made over the term of the policy. The insurance company may
then be vulnerable, for example, to the policy being withdrawn. Another problem exists
on policies of long duration, where higher-than-expected inflation may mean that the
original expense loadings prove to be inadequate.

Another important aspect of expense risk involves the influence of business volumes on
the company’s ability to cover its fixed expenses. We return to this subject in more
detail in the next chapter.
Risks become wider when third parties are involved and the ultimate expense
costs are difficult to estimate. For example, income protection insurers may use
third parties to manage their claims. This additional outgo might be deemed
part of the overall claim amount (and loaded as such) especially if costs vary
directly with the amount of benefit. Many such private medical insurance costs,
although not directly related to treatment of policyholders, are subsumed within
the benefit outgo amounts.

5 Withdrawals
In most investigations carried out by actuaries, assumptions will need to be made
as to the future withdrawals under the contracts issued by the company. There is
therefore a “parameter” risk and there may also be a “model” risk.
For example, we might have a model for withdrawals that links withdrawals to
stochastically generated investment returns (perhaps as a proxy for general economic
conditions). We might be mistaken in our view that withdrawals would be linked to
investment returns in this way. This would be an example of model risk.
Even if the structure of our model is correct we might get the parameters wrong, for
example by generally underestimating the level of withdrawals.
One can also imagine random fluctuations risk affecting withdrawals, especially within
small portfolios.
The parameters covered in Section 2 will be based on a model of the selective

effect of withdrawals. Departures from the latter may invalidate the former.
Question 23.8
Explain the last paragraph of Core Reading.
The parameters for future expenses, mentioned in Section 4, will be based on a

model of future withdrawals. Departures from the latter may invalidate the former.
Higher than expected withdrawals mean that fixed costs have to be spread over fewer
policies. This may produce higher per-policy expenses than the company had allowed
for in its pricing.
Also such departures may be a cause of the mismatch, mentioned in Section 4,

between the charges accruing to the company and its actual expenses.
Question 23.9
Explain the previous sentence.

Withdrawal rates will be closely monitored under private medical insurance

where often initial costs and maybe commissions are amortised over an
assumed average number of renewals.
This is because private medical insurance is a short-term contract, where the insurer
relies on a certain level of persistency (renewals) in order to recoup the high initial
acquisition costs. If renewals turn out to be lower than expected, there is a high chance
that the insurer will be unable to recoup all the costs.
The risks of lapse and re-entry are particularly acute in any market where
increasing statistical information and/or aggressive competition is driving the
new business price down. This has been a feature of many critical illness
environments, fed, in part, by an excess in capacity among reinsurers. This
state of affairs is no longer prevalent in the UK.
In summary, the key things about withdrawal risk are:
• the financial risk that the surrender value is higher than the asset share at the
time of withdrawal – often made worse by the mismatching of the initial
expenses and the charges made to recoup those expenses (note that this includes
the cases where there is no surrender value but the asset share is negative, as
commonly occurs with long-term health insurance at early policy durations)
• the risk to the mortality and/or morbidity experience due to the selective effect of
withdrawals
• the risk of increasing the per-policy fixed expenses due to the loss of business
volume from withdrawals.

6 The mix of new business
6.1 The mix by nature and size of contract
A significant unintended change in the mix of new business by nature or by size

of contract could lead to a significant change in the risk profile or capital needs
of the company that were not within the resources available to it.
A change in the mix by nature might involve, for example, a change in the mix by:
● class of business (eg the proportion of sickness business written)
● type of contract (eg critical illness versus long-term care)
● contract design (eg conventional versus unit-linked)
● premium frequency (single versus regular premium).
If the risks involved in the business or the capital required to write it vary by any of
these aspects, then the overall risks and capital needs of the company will change if the
mix changes.
If contracts are smaller on average than had been assumed, the income from charges and
premium loadings will be reduced, and this is unlikely to be matched entirely by a
reduction in expenses. This will occur especially on non-linked products, where most of
the charges are likely to be related to the premium size, while a larger proportion of the
expenses may be per policy and hence independent of size.
Question 23.10
Why don’t companies just charge a fixed fee for contracts, irrespective of their size, to
get round the problem of mix by size of contract?
A significant unintended change in the mix may be another cause of the

mismatch, mentioned in Section 4, between the charges accruing to the
company and its actual expenses.
A mismatch between charges and expenses might result from a change in the mix of
contracts by nature and size. For example, an insurance company may have to accept a
relatively low contribution to total overhead expenses from a particular type of contract.
This could arise if that contract were subject to greater competition, keeping premium
rates or charges low.

If the mix of business were to change so that more of this contract were sold and less of
other contracts carrying higher overhead loadings, the insurance company might not
receive a sufficient overall contribution to cover overheads.
6.2 The mix by source
The parameters adopted for the assumptions for claim inception, mortality and
recovery rates, average claim amounts and expenses will be based, where
appropriate, on an expected mix of new business by source. A change in the
mix by source may invalidate those parameters.
By “source” here we mean distribution channel. As we saw when we studied

distribution channels earlier in the course, the different populations reached by different
distribution channels can exhibit different experience for mortality and other claim
parameters.
It is also common for withdrawal experience to vary by distribution channel.
Question 23.11
Suggest two key factors related to distribution channel that may cause withdrawal
experience to vary between channels.
Expenses of distribution also vary by channel. For example, the amounts of the
salespeople’s remuneration may differ.
A health insurance company may wish to charge the same price for a product through all
its distribution channels, despite the different expected experience. It would therefore
have to use some sort of weighted average of the experience, dependent on the expected
mix by source. If the mix turned out differently then the company might make or lose
money, but the uncertainty creates a risk.
Conversely, if a health insurance company prices differently for the different

distribution channels, and can achieve the same level of profitability in the different
channels, then it is not exposed to this risk of changes in the mix by source.

7 The volume of new business

We shall see in this section that a health and care insurance company may experience
problems as a result of writing too much or too little business.
An insurance company will need to ensure that the capital and administrative
requirements of writing new business are within the resources available to it.
An inappropriate volume of new business could, therefore, lead to the available
resources becoming inadequate.
Question 23.12
Broadly speaking, what capital does an insurer have available for writing new business,
and why might writing unexpectedly large volumes of business cause a problem?
Question 23.13
Describe the risks, associated with administration, caused by:

(a) too much new business
(b) too little new business.
The parameters for future expenses, mentioned in Section 4, will be based on a

model of future new business. Departures from the latter may invalidate the
former.
The parameters for future expenses referred to in the Core Reading relate not only to
future new business but also to in-force business.
Question 23.14
Explain why the expense assumptions for in-force business may depend on a model of
future new business volumes.
As in any other industry, a significant fall in volumes of new business will damage an
insurer’s profitability, its level of efficiency and hence competitiveness, and perhaps
even its long-term viability.

Chapter 23 Summary
In most investigations, actuaries have to make assumptions about the future. Because
we cannot predict the future with certainty, there are risks attached to making these
assumptions.
These risks may often be usefully classified as follows.

Model risk: The risk that the underlying model is not adequate.
Parameter risk: The risk that the parameters assumed for the
underlying model are incorrect.
Random fluctuations risk: The risk of unpredictable fluctuations arising from
sample error – this is greater the smaller the sample.
The following are some of the risks faced by a health and care insurer:
Policy data
Inadequate, inaccurate or incomplete policy data could lead to incorrect results and
recommendations in actuarial investigations, including those performed for the
supervisory authorities.
Where a model office is used, this may not represent the in-force business accurately
enough.
Other data
Data used in the formulation of actuarial assumptions may be inadequate. Even where
they are adequate in themselves, they may not be applicable to the purpose for which the
actuary requires them.
Claim inception, mortality and recovery rates, average claim amounts
The future parameters can never be predicted with certainty, because of, for example,
new diseases and advances in medical treatment. However, where there are good
quality and relevant data this reduces the risk of errors in parameter estimation.
A random fluctuations risk also exists.

Investment performance
Investment return assumptions may be needed for the existing assets or future
investment (and probably both). The importance of the assumption depends in part on
the delay between premium receipt and claim payment, and importantly on the size of
the reserves.
Investment return might be modelled deterministically or stochastically. In either case

there are model, parameter and random fluctuations risks.
In a stochastic approach the random fluctuations are modelled explicitly. In a

deterministic approach this risk can be explored through sensitivity testing.
There is also a “capital values risk” in any investigation comparing existing assets with
liabilities.
Expenses
There is a risk of higher than expected expenses. The risk may be greater if third parties
are involved.
Contributions to expenses from premiums and charges may be significantly mismatched

with the actual expenses incurred, over time.
Higher than expected inflation of expenses leads to an expense risk. This can have
model, parameter, and random components.
Withdrawals
The unpredictability of withdrawals makes it a risk. Early withdrawals usually represent

a particular risk of loss, because of the failure to recoup initial expenses, and asset
shares can be very low or negative as a result.
If withdrawal experience is different from expected it may invalidate assumptions about

the effects of selective withdrawals on mortality, critical illness or sickness experience.
Expense assumptions may also be invalidated due to the effect of withdrawals on the
volume of business in force.

The mix of business by nature and size of contract
The unpredictability of the mix of new business by nature and size of contract is a risk
for the insurer.
Unexpected variation in nature or size may change the risk profile of the company,
which may lead to an overstretching of the company’s capital and other resources
available to cover the risk.
Coverage of per-policy expenses is particularly vulnerable to a reduction in the average

size of policies issued.
The mix of business by source
Different distribution channels involve different sales methods and reach different
populations. As a result, the demographic and expense experience of the various
channels is likely to differ. Variation from the insurer’s assumed mix by source could
therefore invalidate the insurer’s demographic and expense assumptions.
The volume of business
Insurers may experience difficulties as a result of:

● too much business, so that its capital resources or administrative capacity are
exceeded, or
● too little business, so that it fails to cover its overhead expenses.


Solution 23.1
Potentially, this could be EXTREMELY serious. Clearly this depends on the size and
nature of the error. In the extreme, an insurance company might declare itself to be
solvent when it was insolvent, or vice-versa.
Less serious errors could still lead to incorrect decisions, for example through
underestimating the capital available to fund new business.
Solution 23.2
Don’t worry if your answer did not include much of the detail here, especially if you are
studying this subject for the first time. The analysis of experience and its use for future
assumptions is an important part of the control cycle, and something we shall be
studying in more depth nearer the end of the course.
The expenses of the critical illness insurances are likely to be different from those of the
long-term care insurances, for a number of reasons:
● different extent of underwriting on the two types of policy would lead to
different initial expenses
● the simpler nature of the contract may reduce ongoing expenses
● the mix of business by distribution channel may differ
● commission payable for the contracts might be different.
We must allow for inflation that has occurred since the time period that has been
analysed …
… and for some future inflation, if the premium rates are to be used unchanged for some
time.
Per-policy expenses will also be affected by relative business volumes.
The insurance company’s expenses may have changed over time and may be expected to
change in the future for any number of reasons, for example greater efficiency.

Solution 23.3
There will be high parameter risk, because, although data may be credible, they have
little relevance. The reasons include:
● different health of the population due to different environment, lifestyles,
behaviour, etc
● different policy wordings causing claim experience to be different, even if health
were similar
● different psyche regarding propensity to claim, different levels of home care
support by relatives, etc.
So the data would need adjusting before they could be used, to allow for the differences.
These adjustments might be at best intuitive guesswork, and so there is a high risk of the
parameter estimates being incorrect.
Solution 23.4
The sickness experience is the most important element in the basis and so is a
significant risk. On the other hand, in an established market there is likely to be good
data on which to base assumptions. Also, population sickness has been reasonably
stable, or at least subject to steady trends, in developed countries. So there should be
low model and parameter risk.
Even so, the possibility of a new disease represents a risk that is difficult to quantify.
The risk to a particular insurance company will also depend on the portfolio size. The
bigger the portfolio, the bigger the potential loss. On the other hand, a larger portfolio
should reduce random fluctuations risk.
Solution 23.5
Possibilities are:
• reinvestment of proceeds from the assets
• future premiums on existing business
• future premiums on new business.

Solution 23.6
No, or at least, not in theory. A fall or a rise could lead to insolvency if liabilities are
valued at market rates. If assets were invested with a shorter discounted mean term than
the liabilities, then on a fall in interest rates the value of the liabilities would rise by
more than the value of the assets would.
Another way of looking at this is that if interest rates fall then the proceeds from the
assets, which on average are available earlier than required, can no longer be reinvested
at the rates needed to meet the liabilities.
On the other hand, for this to be an issue in practice, the asset value change would need
to make a significant difference to the valuation rate of interest used by the actuary to
value the liabilities. Given that the actuary should have included margins to cover such
an eventuality (ie by valuing at a prudently low rate of interest), the effect of the market
value change on the supervisory reserves should be significantly dampened.
Solution 23.7
Usually, no. For critical illness policies where the probability of a claim is relatively
low, the reserves held for such policies will also be low. When reserves are low,
investment income is relatively unimportant because there are few funds to invest.
However, it is worth noting that some critical illness policies (for instance, those in
South Africa) offer benefits payable on a multitude of conditions, making an eventual
claim on the policy a likely outcome. In this case, reserves will be significant and thus
investment returns become important.
Even where policy conditions (and hence claims) are more restricted, reserves can be
quite large for policies with long guaranteed terms.
Solution 23.8
Selective withdrawals on healthcare insurance contracts are a risk because they leave
behind a “sub-standard” group of insured people. Insurers know this and so can allow
for the expected effect in pricing.
However, the risk of more selective withdrawals than expected is still there. If this
happened then it would lead to worse experience for morbidity etc than had been
assumed.

Solution 23.9
If a company is recouping initial expenses gradually over the term of a contract then
there is a mismatch in the timing of income and outgo. The amount of charges to recoup
the initial expenses will have been set, when the contract was priced, on the basis of
assumed rates of future withdrawal. Higher than expected withdrawals would then
make the future income from these charges inadequate to repay the initial expenses.
It may be possible to counter this at some durations, and for some products, by giving
the policyholder a surrender value low enough for the insurance company to recoup its
expenses, and perhaps even make its required profit.
Solution 23.10
Well, they might do!
One significant problem is that a fixed fee can make smaller policies seem too
expensive and uncompetitive. Even though small contracts will probably be less
profitable than large ones, insurance companies are still interested in writing smaller
contracts in order to get some contribution to cover fixed expenses (as long as all the
variable costs are at least met).
A possible solution is to charge a fixed fee that covers part of the expenses, while still
accepting some cross-subsidy from large contracts to small ones.
Solution 23.11
The level of financial sophistication of the customer.
The degree of pressure of the sale, which may be affected by who initiated the sale.
These were the two key factors given by the Core Reading in the chapter on distribution
channels.

Solution 23.12
Broadly speaking, its capital is the excess of its assets over its supervisory liabilities and
over any required solvency capital.
Writing new business uses up this capital, largely because of prudent statutory reserving,
solvency capital requirements and high initial expenses. If the company writes too
much business then it might have to impose limits on further new business.
In the extreme, it could make itself insolvent in the regulators’ eyes.
Solution 23.13
Too much new business suggests over-stretched resources. Buying in extra capacity
may be difficult, expensive and inefficient (eg untrained staff, or existing staff working
overtime). Can lead to delays or mistakes (eg in underwriting), which can generate bad
public relations and marketing risk or other risks.
Too little new business suggests excess capacity: costs may not be covered by
premiums/charges and profit per policy will fall. This reflects the fact that some costs
are “fixed”, at least in the short term, to the extent that they will be incurred regardless
of business volume.
Solution 23.14
There are some expenses involved in running the business that are not directly related to
volumes nor obviously associated with either new business or in-force business. (An
example would be the Chief Executive’s salary.) The more business that comes onto
the books, the more policies there are over which we can spread such expenses, and so
the smaller the per-policy expense assumption can be.
This is another example of the effect of fixed costs that we introduced in the previous
question.




using the course.

Chapter 24
Nature of risks (2)
Syllabus objective

− data – experience, insured experience, population data, overseas data
inflation
− withdrawals
− competition
− catastrophes
stage
− earlier screening/diagnosis
0 Introduction
In this chapter we continue our study of the sources of risk to a health and care insurer.

1 Guarantees and options

In the case of both guarantees and options, the insurance company is offering
terms in advance of the happening of the event to which those terms relate. The
actuary will need to determine the cost to the company of doing this, using
parameters for the future experience in respect of the assumptions relevant to the
particular situation, combined with a model of how to calculate that cost. There
will then be risks associated with each of these (ie with the choice of parameters and
the choice of model).
The following question will help to illustrate these ideas.
Question 24.1
A health and care insurer offers a regular premium, unit-linked pre-funded long-term
care insurance policy, with the long-term care benefits being available from normal
retirement age. The insurer guarantees that the fund proceeds at retirement age from the
contract will not be less than premiums paid accumulated at 3% pa.
State precisely the additional risk that the insurance company faces as a result of giving
this guarantee.
In the above question, even if the guarantee appears fairly low, there must be some risk
that the insurance company will have to find some money to cover a shortfall in the
value of the unit fund. The expected cost (in a statistical sense) must be determined.
Could we use a deterministic model to do this? A deterministic model is a projection of

one possible outcome. If we project on the basis of best estimate unit growth rates, then
provided these comfortably exceed 3% pa, the guarantee will appear to have no cost.
But a best estimate (ie an expected value) of the cost of the guarantee must be positive,
unless the probability of a shortfall occurring at retirement age is zero.
We could use a range of possible deterministic scenarios, ranging from pessimistic to

optimistic, assign some probabilities to each outcome and take an expectation based on
this. This would be better, but would probably be highly subjective in terms of the
scenarios chosen and the probabilities assigned to them.
A better approach might be to use a stochastic model. The company would have to
choose a suitable stochastic model to model unit growth. Suitable parameters would
also have to be chosen, such as the mean and variance of the random element.

The model would be run using simulations. This could produce several thousand
possible values for the unit fund at retirement, and hence of the cost of the guarantee,
derived from the investment returns generated by the model. An estimate of the
expected value of the cost of the guarantee would then be an average of all the simulated
outcomes.
The estimate of the cost of the guarantee might then be used to work out the charge to
be levied for the guarantee on the policy. This can itself cause more problems! You can
end up going round in circles because the more you charge for the guarantee, the more
money is taken out of the unit fund, making the guarantee more onerous and increasing
its cost!
The results will only be valid if the model and the chosen parameters are appropriate.
Either might be inappropriate, in which case the company might charge too little or too
much.
It is also worth mentioning that the insurance company could greatly reduce the risk it
faces from the guarantee if it could protect itself with a suitable derivative.
Health and care events are often less easy to predict than their life insurance
counterparts and greater care has to be taken in the wording of options and
guarantees, the prices charged for them and the reserves held to provide for
their utilisation. The measurement of the risk will vary directly with the
relevance and volume of data used to assess its impact.
This extra uncertainty could be reflected in our models created above. For example,
extra prudence could be built into the parameters used.

2 Competition
The need to compete, in a free market, may lead the management of an insurance
company to take decisions which increase its risk profile beyond that which can
be supported by the available resources. Some of the decisions which it might
take are:
● reduce premium rates or charges under new business contracts
● offer additional guarantees and options under new business contracts
● increase the coverage under existing contracts, eg further critical
illnesses
● increase salaries or commissions in the respective distribution channels
● on existing business with reviewable charges, arrest the future growth of
charges.
The impact of the above decisions can then be compounded if greater volumes of
new business result.
Question 24.2
A health insurance company has decided to add a renewal option to its ten-year
without-profits critical illness contracts. It will charge for this option by increasing the
premium for the original contract to cover the expected cost of the option. Has the risk
for the company increased by giving this option?
It is of course not always the case that the example decisions given in the Core Reading
above will be inappropriate or will stretch an insurance company beyond its means.
Where this is the case, the actuary’s course of action will depend on local regulation and
professional guidance, and on the actuary’s professional conscience.

3 The management of the company

An actuary of a health and care insurance company will make recommendations
as to how it should operate so that its risk profile stays within the resources
available to it. However, management may not follow these recommendations:
● for competitive reasons as mentioned in the previous section
● for reasons of self-aggrandisement such as maximising new business
volumes or amount of funds under management
● so as to maximise shareholder earnings.
There is nothing in itself wrong with seeking to maximise shareholders’ (expected,

risk-adjusted) returns. However, the actuary may be in a particularly good position to
judge the financial risks involved in a particular course of action.
The actuary may also have a regulatory or professional responsibility to ensure that
inappropriate risks are not taken, particularly where the security and fair treatment of
policyholders are concerned.
There may in fact be a fundamental conflict between shareholders’ interests and those of
policyholders, because the two groups may have very different attitudes to the trade-off
between expected profit and risk of insolvency. For example, a without-profits
policyholder has nothing to gain from the insurance company pursuing high profits at
high risk, but a great deal to lose if the result is insolvency.

4 Counterparties under reinsurance arrangements

When an insurance company enters into a reinsurance agreement with either
another insurance company or a pure reinsurance company, it is relying on that
company to meet its obligations under the agreement. There is a risk that the
reinsuring company will not be able to do this.
We shall be discussing reinsurance more fully later in the course. Reinsurance is a

process by which part of the liability under a contract, and hence some of the risk, is
passed on to another insurer.
Such an insurer may specialise in reinsurance business and not write any business
directly to the public (a “pure reinsurance company”). Alternatively, the reinsuring
company may just be another insurance company (although this is rare for healthcare
insurance).
The usual contractual arrangement is that the full liability to the policyholder rests with
the company that sold the business in the first place (the “direct writer”). The
reinsurer’s liability is to the direct writer, not to the policyholder. If the reinsurer is
unable, perhaps because of financial difficulties, to pay its share of a reinsured claim,
then the direct writer faces a greater cost than expected.
The possibility of such a failure therefore represents a risk for the direct writer.

5 Other sources of risk
5.1 Counterparties in distribution
The risks here are that:
● A distributor may be in a position, knowingly or otherwise, to commit the

insurer to conditions which were not the original purpose of the contract.
For example, a broker might (if allowed), in the course of selling a long-term
care insurance contract, manually change the policy wording by making the
ADLs more lenient, in order to satisfy a demanding customer.
● A distributor, under circumstances where policyholder money

transactions are conveyed through the distributor, may not return
premiums received at the appropriate time, or may become bankrupt
before these are passed over. A similar problem may arise with claims.
For example, the broker might hold on to all premiums paid to him and only pass
these on to the insurer at the end of every quarter. These represent very
short-term assets to the insurer, but have the added complication of possible
default.
At the other end of the spectrum, a valid claim payment may be made by the
insurer to the broker, to be paid in due course to the policyholder. It is possible
that the broker becomes bankrupt before the claim payment is finally made, in
which case the insurer will probably still be liable.
● A distributor may, in dealing with clients on behalf of the insurer, bring

the insurer into disrepute.
For example, the broker might dispute a claim directly with the policyholder,
only for the policyholder to find out later from the insurer, after complaining
directly to it, that the claim was perfectly valid.
The nature of the practical and legal relationship between the insurer and the
distributor will dictate the extent of these risks and the means to mitigate or
resolve their impact.
For example, thorough training and established claim control procedures should
mitigate the example in the third risk above.
We will cover risk mitigation in more detail in Chapters 26 and 27.

5.2 Counterparties in provision of medical services
The area of health and care is a complex one and often third parties are involved
to manage aspects of the client relationship and control claims cost. Examples
of these are underwriting agencies, third party claims assessors and disability
counsellors. The extent to which these bodies can commit expenditure on
behalf of the insurer is a source of risk.
Under medical expenses covers and some long-term care insurances, the
benefit itself is provided by third parties on an indemnity basis. The risk of the
ultimate claims cost then lies, to at least some extent, in the hands of these third
party providers.
Question 24.3
What do you think could be done to mitigate the risk of using third parties for claim
handling?
5.3 Regulation and fiscal developments
Local law and supervisory requirements may often transcend the explicit
conditions specified in the policy. New legislation and regulation may apply to
policies already in force changing the nature of the contract between insurer and
policyholder. For example, certain exclusions may be deemed no longer
acceptable or the payout for certain conditions may be increased nationally by
court precedent. Taxes may be introduced to benefits or premiums which may
change the profitability or coverage of existing contracts.
Another example of a legal restriction is the prohibition of certain factors to be taken

into account when pricing policies. For example, in some countries, local legislation
prohibits the use of race as a factor to be used to determine critical illness insurance
premium rates.
Long-term care insurance is another type of health insurance that is likely to be the
target for legal developments. It is an unwritten rule (in most developed countries at
least) that “Society” should take care of the sick and elderly. So, often these contracts
are subject to unexpected and sudden mandatory changes, even for in-force policies.
There’s not a lot that can be done about this. The best plan is to keep an ear to the
ground to listen out for any possible developments, and build a certain level of prudence
into your assumptions just in case.

5.4 Customer service shortcomings/reputational risks
Where there is a high degree of consumer market awareness or culture of

consumer protection, the insurer runs a risk of losing both existing client base
and potential new business, when its service record is named and shamed. This
may arise formally and legally through the courts and regulators, but also less
formally through press comment and television exposure (consumer watchdog
programmes).
Again, the media generally like to concentrate on insurance “misdemeanours”,

especially where these occur against the sick or elderly. Therefore, health and care
insurers often have a moral obligation over and above their contractual policy
obligations, sometimes arising quite unexpectedly.
5.5 Internal audit failures/fraud
Any business operation is at risk from internal misdemeanour. Staff in positions

of trust may abuse that privilege. This may take the form of leaking of
confidential information or the embezzlement of funds. Watchful management
and appropriate internal audit procedures are vital.
Over the last few years in the UK (and these years are not exceptions) you will have
undoubtedly seen press articles about possible fraudulent internal corporate activity, not
only within health and care insurers but in any corporation.
5.6 Physical risks including IT recovery
An insurer runs a number of risks to the physical conduct of its business: fire,
flood, impact, loss of key staff. It is imperative to have business continuation
procedures in hand to manage the smooth flow of business in these
circumstances, with systems back-ups and alternative premises. Insurance
cover will be needed after the event, including business interruption cover, but
the intervening damage makes proper processes and drills essential.

5.7 Aggregation and concentration of risk
Part of an insurer’s assessment of portfolio risk will be the extent to which the
insurer is over-exposed to a particular risk or region as a result of specialisation
of product or concentration of distribution. Examples of this in health and care
might arise where a small sickness insurer was at risk of an outbreak of local
illness, or where an insurer had concentrated on providing group income
protection to a particular industry which was now associated with a particular
disease.
Risks are mitigated through more widespread marketing, through reinsurance

and through coinsurance with reciprocation.
Coinsurance with reciprocation is whereby risks are shared with another similar insurer
(or reinsurer), but one having risks of a complementary nature. For example, the “small
sickness insurer” above, at risk of an outbreak of local illness, could share its risks with
another (perhaps small) sickness insurer with a concentration of risks in another area of
the country. By sharing each other’s risks, diversification is achieved for both insurers.
You will meet more on reinsurance and coinsurance later in the course.
5.8 Catastrophes
A health and care insurer is at risk from a catastrophe, an event which gives rise
to the introduction of widespread illness (epidemic) or injury (war). By their very
nature, these are difficult to predict. Their resolution lies mainly in reinsurance
or possibly in more global expansion to spread the risks.
A catastrophe in health and care insurance is normally an event that gives rise to many
individual claims, all stemming from the same cause (such as an epidemic or war).
You would not normally get an individual immense loss. This fact will influence the
type of reinsurance that an insurer would buy.

5.9 Non-disclosure – underwriting at outset versus underwriting at

claim stage
We introduced underwriting in Chapter 6. It is covered in detail in Chapter 27.
Non-disclosure, the decision by the policyholder at the proposal stage not to

share all risk-related information with the insurer, is difficult to police and prove.
It makes the assessment of appropriate premiums more problematic.
The problem is possibly exacerbated if the insurer decides to accept all

policyholders initially on the basis of a declaration of health and then underwrite
more formally at the claim stage – the so-called moratorium approach. Here the
insurer will have greater difficulty in proving knowledge at the time of policy
application and in many territories, it is often a cause of press-outcry if claims
are refused at a time of medical need.
Question 24.4
So why go for the moratorium approach at all?
Resolution or mitigation lies in the following:

● better explanatory sales literature
● better sales intermediary processes
● better worded proposal forms
● more frequent resort to doctors’ reports at new business stage
● more checking of information provided
● thorough audits on sample cases
● closer dialogue between underwriting, sales and claims management.
The topic of access to information from genetic tests is very relevant here and
may be subject to local legislation and practice.
5.10 Earlier screening/diagnosis
A very specific risk arising in health insurance is that brought about by

advances in medical science. Earlier, it was noted that the cost of treatment for
particular illnesses might rise because new and more expensive treatments and
equipment are now in use. A further risk, of particular relevance to critical
illness insurance, is that of earlier diagnosis.

Typically, a critical illness policy will pay the sum insured when the policyholder
is unequivocally diagnosed as suffering from a particular disease. If medical
technology advances in the diagnostic area, insurers may find that they are
facing claims significantly earlier than was expected on the basis of the data on
which premiums were calculated. Indeed the earlier diagnosis may prompt
some claims which would not otherwise have been payable (because the
policyholder might have died prior to diagnosis, or lapsed, or a term policy
might have expired).
A term policy here means temporary, ie a term (temporary) critical illness insurance
policy.
The encouragement by medical professionals for members of the public to get

themselves screened or the launch of a national screening campaign for
particular illnesses, such as breast cancer, will accelerate this issue. PMI
insurers are also at risk of increased claims due to higher prevalence of
screening programmes.
On a similar tack of medical advances, the increasing availability of many

(formerly complex) treatments, such as coronary by-pass grafting, is another
risk area for critical illness insurance providers and PMI writers.
The main problem here is that for PMI, and for CI benefits based on surgical procedures
(eg coronary by-pass grafting), greater availability of treatment means that more of these
treatments are being claimed for under the policy, leading to a direct increase in claims.
A secondary problem, at least for the insurer, is that these treatments prolong the lives of
the sufferers, who will be more likely to need treatment later in life following the
treatment. This may be a problem for PMI and stand-alone CI.

6 Product specific risks and capital to meet them

The risks described below are the ones that are particularly important for each of the
main types of health and care insurance products.
6.1 Income protection risks
The main risk relates to the sickness transfer probabilities in the underlying
multiple-state model, ie the claim inception rates and the claim termination
rates. This risk increases with the relative leniency of the contract’s definition of
what constitutes incapacity.
You will have studied the general principles of multiple state models in an earlier
subject. For long-term sickness contracts, a possible model involves three states:
1. healthy (able to work)
2. sick (strictly, unable to work according to the policy definition, and receiving
benefit)
3. dead.
The possible transition probabilities are then:

1. healthy to sick (known as claim inception rates)
2. sick to healthy and sick to dead (known as claim termination rates)
3. healthy to dead.
Question 24.5
Explain how you might adjust the above model to include lapses.
Inception rates would have to be determined by age, and termination rates by age and
duration of claim. Further breakdowns would also be likely, such as by sex and
smoking habit, but these need not concern us here.
More complex models have been proposed, but the principles and problems remain the
same: the probabilities of transition between the states must be estimated in order to
decide what premium to charge, and the insurance company is at risk of getting these
estimates wrong.

This problem is not helped by the fact that “unfit to work” is a less well-defined concept
than “dead”. The less well defined the criteria are for making a claim, the more
uncertain will be the claim experience (and, therefore, the greater the risk).
Let’s consider what happens if the sickness criteria in the policy conditions are more
lenient: that is, where you don’t have to be quite so sick to claim under the contract.
This will lead to a greater range of incapacity being accepted as valid claims. This
broader definition of incapacity will cause two things: first it will increase the expected
cost of claims (because more people will qualify for benefit more often), and second it
will mean that the company will be able to estimate its expected sickness experience
with less certainty. It is the second of these that increases the risk, as the increase in
expected sickness rates can be allowed for by increasing the premium rates charged.
As we saw earlier, one source of risk arises from using inappropriate data when
estimating suitable assumptions to use in our actuarial models. One usually reliable
source of data is that of the industry experience. However, because policy conditions
vary so much between different companies, using the industry data from income
protection policies as a basis for obtaining future sickness rate assumptions is a lot more
difficult, and subject to much more uncertainty than, say, the equivalent life insurance
data for mortality.
Associated with this risk is a significant anti-selection risk in the case of

individual contracts and a minor such risk in the case of group contracts.
Question 24.6
Explain the nature of the anti-selection risk on individual IP contracts.
It is true that anti-selection risk is generally reduced on group IP contracts, because the
individuals involved have less active choice about taking out the contract. However,
there have been some costly examples of anti-selection on group IP schemes.

Example
A UK reinsurer reported a group IP scheme of which it was aware, which had been set
up to cover employees of a bus company in a British city. Within six months of the
scheme starting, more than fifty employees were claiming, when the expected number
would have been only one or two.
Essentially, the employer and the workforce had collaborated to use the sickness policy
as a redundancy scheme at the insurance company’s expense. All the claimants had
medical certificates, although it was suspected (but not proved) that “pressure” had been
brought to bear on the doctors involved. (It was a tough city.)
The insurance company had no option but to pay the claims.
There is also, in the case of individual contracts, a sickness risk from selective
withdrawals. (This has been described in the course a number of times already.)
There is also a very real risk under IP contracts of moral hazard – where, as a result of
having insurance, the insured behaves in such a way as to increase the insurer’s claim
costs (see Chapter 6).
Question 24.7
Explain how you think moral hazard is most likely to occur on a portfolio of IP policies.
State which transition probabilities will be affected by the moral hazard you have
described, and state how they will alter.
There are lesser risks associated with mortality, expenses and investment.
Question 24.8
Explain the nature of the mortality, expense and investment risks on IP contracts.
Also withdrawals will be a financial risk at times where the asset share of the
contract is negative.
This will generally happen early on in the life of a policy.

Capital requirements will depend on the relationship between the pricing and
supervisory reserving bases, in particular with regard to the sickness
assumptions, but are likely to be low relative to most other types of contract.
This will of course depend on the particular circumstances and the supervisory
regulations. One could argue that the need for prudent margins is greater for sickness
contracts than for life contracts, because of the greater difficulty in predicting sickness
experience. Of course, this may affect the pricing basis to some degree too.
Question 24.9
In addition to the difference between the pricing and the reserving bases, what factors
will affect the capital requirements of individual IP business, and how significant would
you expect each factor to be?
6.2 Critical illness risks
For both stand-alone and rider benefits, the main risk is in respect of the rates of
diagnosis of the critical illnesses specified in the contract.
A particular aspect of this is the relatively limited information available in most markets
with which to assess the likely rates of diagnosis. These contracts are very new to many
markets and relatively new to all. The limited data mean that estimates of historical
experience rates will be unreliable or even non-existent, and this will considerably
increase the risk from these contracts.
Question 24.10
Explain why unreliable estimates of historical critical illness experience rates will
increase the company’s risk.
The problem is made worse if different companies cover different illnesses under their
critical illness contracts. Any industry data could then be very heterogeneous, and so
misleading as a basis for any particular company.
Unexpected changes in future rates of diagnosis also constitute a risk.
Question 24.11
Explain the effect that medical advances might be expected to have on future critical
illness rates.

Associated with this will be a significant anti-selection risk for individual

contracts and a much-reduced one for group contracts. In addition, for
individual stand-alone contracts, there will be a risk from selective withdrawals.
Even as a rider benefit there will be some risk from selective withdrawals.
Insurance companies will of course seek to reduce the anti-selection risk. For example
they might use a “waiting period”. This is a period (eg six months) at the start of the
contract during which diagnosis of critical illness will not qualify for benefit. There will
also be medical underwriting.
Stand-alone contracts will give rise to an expense risk and a usually minimal
investment risk.
As would be expected from a protection policy, the reserves would be relatively small
so that the financial impact of investment risk would also usually be small.
A financial risk from withdrawals will also arise at times where the asset share is
negative.
The capital requirements of a stand-alone contract or the marginal requirements

of a rider benefit will be of the same order as for a long-term sickness (IP)
contract.
This is likely to be the case because expenses and commission for the contracts will be
of the same order and the supervisory requirements should be similar.
6.3 Private medical insurance risks
The main risk to the insurer is that the benefit payments are determined, in the
large, by individuals over whom the company has no control. An anaesthetist or
consultant has little control exercised upon him as to what he may charge for
services rendered. Indeed the original trigger for the claim may be effected by
the general practitioner who refers the patient for specialist advice. Claim
frequency is very much bound up in this process of referral.
In regions where the State offers an alternative (free) healthcare service, the
insurer is constantly under pressure to remind policyholders that the insurance
package is preferable to the “free alternative”. Failure to do this, especially in
times of economic malaise (and thus when premiums become unaffordable for
many), may result in loss of considerable business with a risk of inability to
cover expenses and ultimate insolvency.

However, it is interesting to note that most PMI insurers still give cash benefits for using
the alternative free healthcare service for some treatments, even though their insurance
would normally cover the cost of treatment. This keeps claims costs down, as the cash
benefit will be less than the cost of providing the treatment − and for many treatments
the policyholder may not care whether he or she received private or State treatment
(eg for emergency, but minor treatment, such as a minor fracture).
While most claims are modest in comparison with many commercial general
insurance risks, the private medical insurer is always at risk, where no policy
limits apply, of a single large claim (eg expensive treatment in the US) or a
single incident giving rise to an accumulation of claims (eg accident within
single insured workforce).
However, most PMI policies do specify policy limits for most types of claim.
Capital strain under PMI is not usually as severe as under many of its long-term
cousins such as income protection or critical illness.
This is because of its short-term nature. Reserves need only be held in respect of a
one-year time horizon, and so the possibility of something going horribly wrong is much
reduced (although of course the insurer would hope to keep the policy in force for much
longer than one year).
Significant new business cost can however arise in scenarios where an insurer
decides to invest in the recruitment of an existing sales team and either a
“golden hello” is payable or initial commission is promised which exceeds an
annual premium.
This new business cost would arise whatever the contract type. Hopefully, the insurer
will allow for this extra cost in its business model, to ensure that overall, profits will
ultimately meet required targets. Clearly the idea of enhanced commission is to
encourage sales and so it is hoped that the profit on the greater volumes of business
would pay (at least) for the extra commission.
6.4 Long-term care insurance risks
The main risk with such contracts relates to the transfer probabilities in the
underlying multiple-state model. Of these the most important will be the claim
inception probabilities and any transfer probabilities between claim states if
there are more than one. Associated with these, there will be a significant anti-
selection risk and a risk from selective withdrawals.

With long-term care contracts we may well assume that there is no equivalent of the
“sick to healthy” transition we saw for sickness contracts, although this cannot be ruled
out. However, there may be several claim states that the claimant may go through, with
different benefits payable in each. For example, there may be at least one level of home
care and at least one level of residential care.
A typical multiple state model might be the following:
States:
1. healthy
2. needing own-home care
3. needing residential home care
4. needing nursing home care
5. withdrawn
6. dead.
Transitions:
1. separate transitions from healthy to each of the other states
2. separate transitions from [2 to 3], [2 to 4], and [3 to 4]
3. separate transitions from each sick state (2, 3 and 4) to dead.
Features to note are that there should be the same number of sick states as there are
categories of benefit level, and that whilst there are transitions between all sick states
they are normally only in the one direction: that of deteriorating health and higher claim
cost. (This assumes that people normally only deteriorate with age. Reverse transitions
could be included between the sick states if this were felt to be appropriate to the lives
in question. Ignoring the reverse transitions is also the more prudent assumption.)
The problem of moral hazard would be unmanageable without the use of ADLs, which
were discussed earlier in the course.
In most markets there is currently a shortage of reliable data on which to base estimates
of transfer probabilities, because the contracts are relatively new. The contracts are
relatively well established in the United States, but US data may need significant
adjustment before it could be used in other countries.
Question 24.12
Explain why this would be the case.

There will be an investment risk as significant reserves may build up in advance

of a claim starting, and there will be an expense risk.
Question 24.13
Explain why the reserves could be quite large despite the fact that this is a pure
protection policy.
At times when the asset share is negative, there is a financial risk from
withdrawal. At other times, whether there is such a risk depends on how any
withdrawal benefit paid compares with the asset share. (You should be getting the
hang of this one by now.)
There could be a significant marketing risk with these contracts as the

policyholder may expect the benefits to be enough to cover the eventual costs of
care.
With most benefit definitions, the company would not be guaranteeing to cover the total
cost of care, and so would have to be careful to make this clear to the policyholder. If
the policyholder was led to an inappropriate expectation that all care costs would be
covered, then a failure to meet the expectation would do the company’s public image no
favours, and would almost certainly be bad for future sales of the contract.
Question 24.14
What is the problem with using a benefit definition of the “cost of care needed”?
The capital requirements could be comparable to those for endowment

assurance, or other types of investment contracts, but will depend on the nature
of the contract and in particular any guarantees that are given.
An endowment assurance is a contract of fixed term, that pays a benefit on maturity or

on earlier death. The benefits may be linked or non-linked, and may have guarantees.
The similarity to the endowment as regards capital requirements stems from the fact that
a long-term care contract has the same pattern of paying regular premiums in advance,
for a benefit which (when payable) will be paid from the point at which premiums stop.
It can perhaps be considered as even more similar to a whole life assurance (where the
benefit is paid on death whenever that might be), as there is no fixed latest time at which
the claim has to be paid. But unlike an endowment or a whole life assurance, the benefit
under a long-term care policy is not certainly paid, as policyholders can die without
needing any long-term care.

With guarantees come risks, and increased risk is likely to require increased prudence
and hence larger reserves. Some supervisory authorities may specifically require
additional reserves to be established to cover certain types of guarantee.

summaries together for revision purposes

Chapter 24 Summary
The following are some of the risks faced by a health and care insurer:
Guarantees and options
To calculate the cost of guarantees and options, an insurance company will use a model.
Model, parameter and random fluctuations risks therefore occur.
Competition
The need to compete may lead management to take unacceptable risks. This might
involve decisions to:
● reduce premium rates or charges under new business contracts
● offer additional guarantees and options under new business contracts
● increase the coverage under existing contracts
● increase salaries or commissions
● arrest the future growth of charges.
The management of the company
The company’s management may choose to ignore the actuary’s advice concerning what
the actuary views as unacceptable risk. Possible reasons for this are:
● to be competitive
● to increase the size of the business
● to maximise shareholder earnings.
Counterparties under reinsurance arrangements
If an insurer has reinsurance agreements with other insurers then it is at risk from the
possible failure of the reinsurers to cover their share of policy liabilities.
Counterparties in distribution
The risks are that a distributor may:

● commit the insurer to new conditions
● delay premium or claim payments or become bankrupt
● bring the insurer into disrepute.

Counterparties in provision of medical services
Some loss of claims cost control to third parties.
Regulation and fiscal developments
For example, tax, policy conditions, exclusions and premium rating.
Customer service shortcomings/reputational risks
Through media exposure, court cases and regulators.
Internal audit failures/fraud
For example, leaking of information or embezzlement of funds.
Physical risks including IT recovery
For example, fire, flood, impact, loss of key staff.
Aggregation and concentration of risk
For example, outbreaks of local illness.
Catastrophes
Such as epidemics and wars.
Non-disclosure
Makes premium rating more difficult. The extent of this risk depends in part on
whether a moratorium approach is used.
Earlier screening/diagnosis
Advances in medical science mean that claims for health insurance may increase. Also,
screening is encouraged, which may also increase claims frequency.

Product-specific risks:
IP
● claim inception and termination rates, including anti-selection
● selective and normal withdrawals
● to a lesser extent, mortality, expenses and investment
● capital requirements will normally be low.
CI
● diagnosis rates, including anti-selection
● expenses, and to a lesser extent, investment
● capital requirements will normally be low.
PMI
● third party control over claims
● single large claims and accumulations
● capital strain even lower than IP and CI, unless commission high.
Long-term care
● claim inception and transfer probabilities, including anti-selection
● investment and expenses
● marketing risk
● capital requirements could be extensive.


Solution 24.1
The risk is that the unit fund at retirement age, net of any charges, is less than the value
of premiums accumulated at 3% pa. The insurance company would then have to make
up any shortfall.
This effectively means that the unit fund must grow on average at a rate rather larger
than 3% pa in order to offset the charges on the funds. The company may not achieve
this rate. (One reason might be a temporary fall in the value of the assets backing the
unit fund just before maturity.)
If you said, “the risk is that investment returns are less than 3% pa”, then this is not
strictly correct, because of the policy charges.
Solution 24.2
Yes. Even though the company has charged for the expected cost of the option there are
still extra dimensions of uncertainty. The costing of the option will involve a model and
parameters that may turn out to be incorrect.
There may be unforeseen changes over the course of the ten years of the original
contract.
There may have been weaknesses in the original underwriting that are compounded by
allowing customers to take out further contracts.
The increased premium might be viewed negatively in the market, leading to lower sales
volumes.
Solution 24.3
First make sure that, as the insurer, you vet the possible candidates thoroughly before
entering into any agreement to use their services. Once you have decided on a provider,
make sure that the agreement itself is watertight, in terms of who is allowed to do what
under what conditions, etc. This may include fixing fees at a specified level, thereby
helping to control the insurer’s expenditure.
Once you have the agreement in place, make sure that you monitor the experience and
investigate anything unexpected early on. Regular spot checks and visits might help.

Solution 24.4
Basically, to sell more policies! Policyholders don’t like answering questions about
their health, and will be more attracted to companies who do not ask them (at least at the
proposal stage).
Another advantage is that the new business administration is simpler, and thus cheaper,
for most policies. For policies that never claim, this is a clear saving.
Solution 24.5
We would need an extra (absorbing) state: “lapsed”.
An extra transition would be needed from healthy to lapsed.
There would be no transition from sick to lapsed, as people who are sick would be
receiving benefits and would not (unless they were quite mad) decide to lapse.
Solution 24.6
Individuals who know they are ill and likely to claim in the very near future may seek
cover. There may also be a tendency for those who are currently in very good health to
think that they do not need this type of insurance, but the impact of this will be less
important.
Solution 24.7
IP policyholders who are receiving benefits have less of an incentive to return to work
than others in similar situations who are not covered by insurance. Those with
insurance might tend to delay their return to work more than those who are not covered.
The existence of the insurance alters the behaviour of the individual, resulting in a
financial cost to the insurer.
In this case, the transition rate from sick to healthy has been reduced by the effect of
moral hazard. It may also affect claim inception rates, in that uninsured persons will be
more likely to struggle on at work, even while ill, than those who can legitimately claim
benefits under their IP insurance policies.

Solution 24.8
Mortality: The main risk is that claimants live longer than expected, ie claim
termination probabilities are lower than expected. (A particular risk here
is where treatments for specific illnesses are successful in extending life
rather than curing the illness.)
There is also a risk from early deaths of non-claimants while the asset
share is negative.
Expenses: Higher than expected expenses would lead to reduced profits. Possible
causes include higher than expected inflation and poor business volumes,
leading to high per-policy expenses. (Note that these expense risks are
common to almost any policy you can think of.)
Investment: The investment returns on the assets backing the business may be lower
than assumed.
(Reserves on IP insurance can be quite high, but are not usually large enough for
investment profits / losses to be significant compared with those from the transition
probabilities. However, this depends on what level of investment return can be
achieved, which may sometimes be significant in some territories.)
The above comments are geared mainly towards non-linked contracts. On unit-linked
business the general theme of reduced risk for the insurance company would apply.
Solution 24.9
The design of the contract
Unit-linked designs could be made more capital efficient than non-linked designs. This
could be quite significant. For example, contracts with reviewable charges (or
reviewable premiums for conventional products) would be more capital efficient.
Premium frequency
Usually this is mostly an issue of single versus regular premium. As we have said,
individual contracts are usually regular premium, but this would be a significant factor if
single premium contracts were available.

Initial expenses
These could be significant, because of heavy underwriting. The additional complexity

of the contracts may also increase other acquisition costs. For example, it may be
necessary to pay higher commission to intermediaries.
Solvency capital requirement
This could be significant, because the greater unpredictability of sickness rates

compared with death rates increases the risk.
Solution 24.10
Unreliable estimates of historical critical illness rates will mean that the company’s
estimates of its future expected critical illness rates are equally unreliable. There is
therefore much uncertainty around the critical illness assumption (used, for example, in
pricing the contract), leading to a high risk that the actual experience could be
significantly worse than expected. This is parameter risk.
Solution 24.11
Medical advances are likely to prolong life. For stand-alone policies, delaying the time
of death may cause more claims to be paid than before.
Medical advances also improve screening for diseases, such as for cancer. Earlier
identification of illness will result in earlier claims being paid, increasing their cost to
the insurer, and in some cases make claims occur before the end of a policy term which
hitherto would not have been picked up at all.
On the other hand, an individual's susceptibility to specific diseases, such as heart

attack, may be identified more readily and the disease itself may be prevented or its
onset delayed, thereby improving the claims experience.

Solution 24.12
The experience would relate to entirely different populations. There may be differences
in behaviour and environment, leading to different health. The claim experience may
relate to very different policy wordings, so that the degree of incapacity that triggers a
certain level of benefit in one country may be very different from that of another. (This
may itself be a reflection of different levels of State provision in different countries.)
Different social attitudes to self-help and insurance may have an effect. For example, in
some cultures it may be the norm to attempt to claim an insurance benefit at the first
opportunity, whereas in others an ethic of “keep going till you drop” may result in far
fewer claims for the same physical degree of disability.
Solution 24.13
While not every policyholder will claim under a long-term care policy, a high proportion
of them will: many people need some form of long-term care before they die. The high
claim incidence rates will therefore lead to significant reserves, especially as the
potential cost of the benefits once claims have commenced can be very high.
Solution 24.14
The main problem would be the unknown, and theoretically unlimited, claim amount. It
would encourage the policyholder to have the most luxurious and expensive care
possible.




using the course.

Chapter 25
Nature of risks (3)
Syllabus objective
− data – experience, insured experience, population data, overseas data

inflation
− withdrawals
− competition
− catastrophes
stage
− earlier screening/diagnosis

0 Introduction
In the last two chapters we considered the various sources of risk to a health and care
insurer. In this chapter we shall outline the problems which the existence of these risks
may create.
The actuary plays a key role in helping the company to deal with its problems, and in
this chapter we briefly consider the key areas of company decision making and concerns
with which the actuary is significantly involved. However, remember always that these
are problems that confront the company as a whole, not just the actuary, and all of the
company management needs to be party both to the problems and to their solutions.

1 The aims of the company and of the actuary

The paragraphs of Core Reading in this section are some of the most important in the
course. Ensure you know them (and understand them) well!
The management of an insurance company will have a number of aims. Of most

relevance here, it will want to:
● maximise the profits of the company, whether these go to shareholders or
to mutual policyholders
● maximise the return that the company achieves on its available capital.
Usually these will go hand-in-hand, but the Board will want to be sure that the
capital in the company is being used to the best advantage, particularly where it
needs to decide between a number of competing uses of that capital.
In Chapter 14 we discussed the relative merits of aiming to maximise the present value
of profit or the percentage return on capital. As the Core Reading says, these will
usually lead to the same conclusions and business decisions, but this is not inevitable.
Note that the phrase “mutual policyholders” relates to mutual insurers where all
profits ultimately belong to the with-profits policyholders and the company is
managed on their behalf.
The other extreme is the proprietary company where all profits belong to
shareholders, who own the equity of the organisation. There are other concerns
where profits (possibly deriving from certain sources) are divided in specified
proportions between the participating policyholders and the shareholders.
The aim of the actuary should then be to enable the company to meet its aims, in
the context of:
● its risk profile
● the resources available to it
● the public interest need, as usually expressed in insurance supervisory
legislation, for the company to avoid insolvency, and
● the requirements of other applicable legislation.
There is always likely to be a trade-off between risk and expected return (whether
measured as return on capital or as profit). Depending on your personal views you
might express this as:
● finding the appropriate risk-return combination
● maximising expected return subject to an acceptable degree of risk.

It would clearly be disastrous for a company to be declared insolvent by the regulators.

This is a potential consequence of risk with which an actuary must be particularly
concerned when giving advice to the company. Note that while supervisory insolvency
is a critical business risk for the company, the policyholders will almost certainly
receive most or all of the fair value of their policies, depending on the particular criteria
that are applied by the supervisors to define insolvency. Whether the policies can
continue in force, perhaps administered by a different insurer, will depend on the
circumstances of the case.

2 The problems to which the risks give rise

This section covers the various aspects of the company’s strategic decision-making
processes which depend on risk, and which therefore need actuarial attention.
Question 25.1
Without looking back in the notes, what (in general terms) is the aim of the actuary?
The problems that will then confront the actuary in achieving his or her aim are as
follows:
1. Policy data – Are the data provided by the company complete and
accurate?
2. Product design – What contracts should the company offer and what
benefits and design features should be included in them, given its risk
profile and the resources available to it?
In Chapters 5 and 6 of the course we met factors that an actuary will consider
when he or she is involved in the design of a product. The Core Reading for that
section identified numerous factors which should be considered when assessing
the suitability of a proposed product design.
Question 25.2
List as many of those factors as you can remember.
3. Pricing – What is the expected profit, and its variance, from selling a new
contract at particular premium rates or with particular charges and will the
company have the resources to sell the contract on those terms?
The emphasis here is to find a price that makes selling the policy worthwhile to
the company, and will not over-stretch the company’s capital as a result.

4. Return on capital – What return on capital will the company expect to make
by investing its capital in the development and issue of a new insurance
contract?
Here the issue is more to do with the overall decision to develop and launch
particular products at particular prices. So, whilst from (3) a product might be
potentially profitable and within the company’s capital resources, the volume of
business may not produce sufficient reward (return) for the amount of capital
invested in the project.
These last two closely-related ideas are central to a company’s business aims.
Question 25.3
Explain the conflict that can arise between Points (3) and (4) above.
In Parts 2 and 3 of the course we explored different ways of measuring

profitability and return on capital. We also examined how the actuarial
assumptions may be set when the profitability of new business is assessed.
5. Profitability – What is the expected profit, and its variance, from the
existing business?
The process of checking the profitability of in-force business is not very different
from that for new business. This was also covered in Parts 2 and 3 of the course.
It is important that an insurance company does not stop considering the

profitability of its business once it is written, but continues to monitor it as part
of its control cycle. If the business turns out to be unprofitable then the company
will know that it should be taking action, such as:
● altering current benefit levels if possible
● altering withdrawal payment scales if possible
● altering the expense, sickness or mortality charges if possible
● reducing actual renewal expenses
● ensuring that the contracts currently being sold are not likely to suffer the
same fate (ie they are not too sensitive to whatever has caused the losses
on the existing business).

6. Supervisory reserves – What assumptions should be used so that the

reserves and level of solvency capital required provide adequate security
for policyholders?
Question 25.4
If you had to choose one word to describe the assumptions to be used in a supervisory
valuation, what would it be?
We have already discussed the principles that should be followed in setting the
methods and bases to be used in a supervisory valuation.
7. Investment – How should the company invest its assets so as to maximise

expected return within the resources available to it?
A health and care insurance company may have two conflicting aims:
● to meet any guaranteed benefits with a high degree of certainty, and
● to adopt an adventurous investment policy in pursuit of the best returns.
Its key resource in pursuing high returns is its free assets. These provide it with
a cushion in the event of adverse experience. The greater the free assets, the
more adventurous the investment policy can be, all other things being equal.
8. Capital management – Will the company be able to achieve its short,

medium and long term plans given the resources available to it?
In order to give itself a better idea of its long-term capital position, an insurance
company can project the future expected values of its assets and liabilities. It can
then investigate whether its investment policy, new business plans and expense
control plans represent a coherent and achievable prospect.
Question 25.5
Explain how a product that is marketable and profitable, and provides a good return on
capital, can cause capital management problems for a company.
Question 25.6
Describe the tensions that exist between Point (6) and each of Points (4), (5), (7) and (8)
above.

9. Risk management – How can underwriting and reinsurance be used to

manage risk so that the company can increase profits, whilst keeping its
risk profile within the resources available to it?
Underwriting and reinsurance are two key tools of risk control for a health and
care insurance company. We have already touched on both of these areas and we
shall consider them more fully in the next two chapters.
Question 25.7
Suggest briefly any ways in which increasing the level of underwriting and reinsurance
might be counter-productive to the company’s aims.
In Chapter 28 we shall also cover the monitoring of experience and the feedback
into the control cycle of the information gained.
10. Claims − Are the claims procedures adequate? Are the claims functions
being properly followed? Are there effective fraud control measures in
place?
We covered this risk in the previous two chapters. Remember that with health
and care insurance, the use of third parties increases the risk of claims
deterioration, particularly without adequate procedures and controls.
Specimen Exam Question
A proprietary health and care insurance company transacting critical illness insurance
business is reviewing its premium rates.
The revised premium rates are not competitive. Discuss possible reasons for this and
the courses of action open to the company if it wishes to offer more competitive
premium rates. [9]

Chapter 25 Summary
Aims
A key aim of a healthcare insurer’s management is to maximise profit and return on

capital. The actuary will wish to support this aim, but in the context of:
● the company’s risk profile
● the resources available to the company
● the public interest need for the company to avoid insolvency, and
● applicable legislation.
Problems to which risks give rise
The problems that confront the actuary in achieving his or her aims relate to:
● policy data
● product design
● pricing
● return on capital
● profitability of in-force business
● supervisory reserves and solvency requirements
● investment
● capital management
● risk management
● claims.

summaries together for revision purposes

Solution 25.1
The general aim of the actuary is to allow, and indeed to promote, the aims of the
insurance company, subject to ensuring that the company has the resources available to
meet the risks involved. When recommending solutions to the company the actuary
will aim to give full attention to the interests of all the parties involved, particularly the
policyholders, which should lead the company to develop ethically acceptable solutions
to its problems. (Remember the “Professionalism” bit of the control cycle?)
Solution 25.2
The Core Reading identified the following factors:

● the need for profitability
● the need for an appealing, marketable design
● the need for competitive rates and charges
● the capital requirements of the product
● the risks associated with the product
● the onerousness of any guarantees
● the sensitivity of profit to variations in future experience
● the extent of cross-subsidies
● administration and IT systems
● consistency with other products
● regulatory constraints and opportunities.
Solution 25.3
Higher prices give more potential profit per policy, meeting Point (3), but if this reduces
marketability, business volumes can be adversely affected, thereby reducing the overall
return on capital.

Solution 25.4
I would choose “prudent”.
(An alternative would be “realistic” PROVIDED that an adequate additional amount of

solvency capital were held.)
Solution 25.5
Certain product designs can be very capital inefficient – that is, they produce a lot of
capital strain when they are sold. If this were the case here, the company would need a
large supply of capital in order to prevent supervisory insolvency, following the large
volume of new business expected of a marketable product.
Solution 25.6
Tension with Point (4)
Increasing security by increasing reserves increases the capital needed to finance new
policies, reducing the return on capital produced and thereby making the policies more
expensive. Passing this cost to the policyholder by increasing premiums or charges
could reduce marketability, causing further reduction in returns.
Increasing reserves will cause a deferral of all remaining profit from existing business,
thereby reducing its present value to the providers of capital.
Unless a compensating capital injection is made, increasing reserves will reduce the free
assets (working capital) available to the company, which may reduce investment
freedom.
Increasing reserves reduces the capital available. This can affect the company's ability
to develop and sell business in the volumes it would like, or to follow a particular
approach to smoothing profit distribution over time.

Solution 25.7
Both activities cost money, and so the more carefully you underwrite policies, or the
more reinsurance cover you take out, the less your expected profit will be, all other
things being equal.
Specimen Exam Question
Consider each of the principal elements of the pricing basis:
Critical illness rates
Experience might be heavier than that of competitors, due to (eg):

● weaker underwriting
● different target market
● different distribution channel
● no split by smoker status.
So, the company could:

● strengthen underwriting
● change target market
● change distribution channel
● introduce differential rates for smokers and non-smokers to avoid anti-selection.
Alternatively or in addition, the company could take a less conservative view in setting
the critical illness assumption, if this can be justified by evidence, eg from own data,
industry or reinsurers, or by offering cover on a reviewable basis.
Expenses
May be higher than those of competitors.
Could look to reduce commission (may be paying above market rates).
Reduce sales costs by more efficient marketing and increasing salesforce productivity.
Try to improve admin efficiency and reduce overheads.
May be able to achieve lower price if total profits improved by increased volumes.

Withdrawals
Experience may be worse (heavier) than that of competitors.
Try to improve persistency through improving sales methods and training of sales staff.
Withdrawal rates may differ due to different target market and/or distribution channel,
and so could try to change these.
Profit target
Profit requirement could be too high relative to the market, so reprice at reduced level of
target profitability.
Consider how much contribution is required from this business to overheads; reducing
the required contribution will reduce price.

ST1-26: Reinsurance Page 1
Chapter 26
Reinsurance
Syllabus objective
(h) Understand how insurers use reinsurance to manage their risks and the
reinsurance products involved:
− product design and pricing
− individual risks (large and/or unusual)
− aggregate risks (accumulation from event or portfolio)
− other financial risks.
0 Introduction
Reinsurance is an insurance company’s own insurance. The insurance company passes
on some of its risks to another party − a reinsurer.
There are several different ways an insurance company can pass on risks to a reinsurer,
and there are many different reasons for doing so. In this chapter we first consider the
main reasons why insurance companies might wish to use reinsurance and then describe
the different types of reinsurance and the reasons for using each.
Reinsurance language
There is quite a lot of specialist language in reinsurance. Although you will soon get
used to it, you will find it useful to be familiar with the following terms immediately:
cede = “pass on” or “give away”, as in “cede some risk to a reinsurer”.
facultative = “individual”, as in an individually negotiated arrangement.
treaty = covers a group of policies – reinsurance that the reinsurer is
obliged to accept, subject to conditions set out in a treaty.
direct writer = the insurer with a direct contract with the insured (as opposed to a
reinsurer, who has a contract with the direct writer); also called
the primary insurer or cedant.

Page 2 ST1-26: Reinsurance
1 Reasons for reinsurance

Some of the specific types of reinsurance introduced later in this chapter are referred to
in this section. You may find it useful to come back and re-read this section after you
have completed the chapter.
This section considers the following reasons for using reinsurance:

● limitation of exposure to risk
● avoidance of large single losses
● smoothing of results
● availability of expertise
● increasing capacity to accept risk
● financial assistance.
Health and care insurance payouts will either:

● be linked to a sum insured (for example, under a Critical Illness policy),
● be linked to a sum insured with agreed uplift (some mechanism for automatic
increasing of premium and/or benefit), or
● indemnify the policyholder against medical costs (for example, under a PMI
policy).
In all cases, even the indemnity scenario, the insurer will be reasonably aware of
the potential maximum claim which each policy might produce.
As you saw earlier in the course, even under PMI policies, there are usually limits to the
indemnity provided. Even when there are not, the insurer can estimate a likely
maximum cost of treatment based on past experience.
The insurer will compare this to the available free assets, to assess the manner
in, and the extent to which potential large risks should be “laid-off” with
reinsurers. Key influences will be the insurer’s attitude to risk and the value for
money afforded by the reinsurance market.
For example, if the insurer has few free assets, is risk averse, and reinsurance is good
value for money, then it may decide to have an extensive reinsurance programme in
place. More on this in the following section.

1.1 Limitation of exposure to risk
An insurer with a portfolio of business faces an uncertain future: despite the

best advanced statistical analysis and the utilisation of experienced
underwriters, the claims outgo from any period of risk cannot be predicted to
any degree of accuracy. That is, after all, the insurer’s raison d’être: to cover the
unknown financial consequences of possible future perils of members of the
public.
The following factors will all determine the insurer’s appetite for offsetting its
risks in the direction of reinsurance:
● the size of the insurer
● its experience in the marketplace
● its available free assets
● the size of its portfolio (credibility factor), and
● the degree to which it is felt that the business outcome is predictable
within bounds.
Question 26.1
Describe briefly how “the size of the insurer” and “its experience in the marketplace” is
likely to affect the amount of reinsurance an insurer uses.
The larger a company’s available free assets, the bigger cushion it has to absorb claims
costs that are higher than expected. Hence the higher the free reserves, the less the need
for reinsurance.
Generally, everything else being equal, the larger the portfolio of business, the more
credible the past claims experience will be and the more predictable the business
outcome will be. Hence, the less the need for reinsurance.
We have made some sweeping statements here. There are many factors affecting the
amount and type of reinsurance used and they should all be considered together. An
overriding factor in one case may be a minor factor in a different case.
For example, a company with relatively large free reserves may use more reinsurance
than a company with relatively low free reserves because it writes business with very
volatile claims experience.
Against this has to be set the availability of reinsurance. Some insurers may be
deemed to have a particular approach to underwriting and claims containment
such that some reinsurers are reluctant to offer cover.

For example, reinsurers may generally not be willing to offer cover to a brand new,
inexperienced insurer writing Critical Illness cover without any underwriting (although
hopefully this should not happen in any developed country!).
Just like insurance companies, reinsurers are in the business to make money, usually for
their shareholders. They generally do not wish to write loss-making business. If there
is great uncertainty about the future claims cost then reinsurers may be inclined not to
offer reinsurance cover or at least charge much higher premiums than had previously
been the case.
Question 26.2
When might reinsurers knowingly write loss-making business?
Generally where an insurer has fears of a claim or combination of claims which

would materially (negatively) affect the shape of results within that business line,
reinsurance will be considered. This may occur from a single event (eg outbreak
of insured disease), and/or the insurer has a concentration of risk in a particular
territory.
These are called accumulations of risk. The above considerations could apply to any
line of business.
1.2 Avoidance of large single losses
What is large to an insurer will depend on the size of the free assets available.
Many small to medium sized insurance companies will cede a top slice of
potentially large payouts to reinsurers, to ensure, as far as possible, that claims
payments can be made without detrimental effect to business results and, at the
extreme, solvency.
A simple example of such use of reinsurance is in respect of PMI cover. These claims
can be very large, at least in some territories, running to hundreds of thousands of
pounds, euro, dollars, etc. Insurance companies may want to limit or cap their exposure
to such claims to help control the impact on the free reserves or profits.

1.3 Smoothing of results
The principle whereby reinsurance covers the larger risks or accumulation of

smaller risks above certain limits helps to achieve a smooth development of
accounts year-on-year especially when the portfolio is relatively immature. A
premium is paid to mitigate these fluctuations and the net result is more
predictable for the insurer, a predictability which may also be more acceptable to
shareholders and regulators. Reinsurance thus helps to reduce the variance of
the insurer’s expected disability or mortality experience relative to the mean.
Stop loss is a form of reinsurance which is used for these purposes.
Stop loss will be described in more detail later in this chapter, but as its name suggests it
reduces extreme losses directly and hence helps to smooth profits. However, stop loss
isn’t the only type of reinsurance that will smooth results. Nearly all types of
reinsurance will smooth profits to some degree.
This might be achieved by simply limiting claim amounts (as mentioned above) or by
enabling the insurer to write a larger number of smaller risks and hence achieve a
greater diversification of risk, which will have lower variability.
1.4 Availability of expertise (new risks, unusual risks, new

territories)
When an insurer is adopting a strategy which will take it into new risk areas
where it has little previous experience, the reinsurer can help with product
design, rating/pricing, underwriting and claims management. Often in these
circumstances, the method of coverage will be quota share, possibly with a low
initial retention. Once the insurer’s expertise and confidence has grown, the
reinsurer’s involvement will reduce.
Quota share will also be described in more detail later in this chapter but for now it’s
sufficient to know that it’s a relatively simple type of reinsurance. In the situation
described here it can be initially set up to pass most of the risk to the reinsurer so that
the insurance company retains only a small amount of risk. Over a number of years, the
insurance company is likely to increase the amount of risk it retains and hence the
amount of reinsurance used will decrease as it grows more confident of its own risk
management abilities.

1.5 Increasing capacity to accept risk (singly or cumulatively)
Owing to insufficient capital backing, an insurer may be reluctant to accept, or

incapable of accepting, particular risks by sector or by volume. An insurer may
also be reluctant to accept a particular risk if it would be exposed to an
accumulation of risk as a result. Reinsurance cover can obviate this situation.
The solvency (capital) requirements for a particular line of business are normally
reduced in line with the proportion ceded, though this may be subject to an
upper limit.
There is normally a legal requirement for an insurance company’s free reserves to

exceed a statutory minimum, sometimes called the Required Minimum Margin (RMM).
Using reinsurance can usually reduce the RMM a company needs to hold, but as the
above Core Reading states, this reduction may be subject to an upper limit. In other
words, you can only reduce the RMM so far and there may be a minimum level that you
still need to hold.
Question 26.3
Why might the allowance for reinsurance be limited?
Surplus treaty or excess of loss reinsurance might be used here (and other
forms of reinsurance might also be appropriate depending on the
circumstances).
You should have met excess of loss (XL) reinsurance in an earlier subject (eg Subject
CT6), but if not, all will be revealed later in this chapter.
In fact quota share is a very easy and effective way of reducing the RMM. More
information about this and a description of surplus treaty reinsurance will be given later
in this chapter.
1.6 Financial assistance (new business strain, merger/acquisition,

bolstering free-assets)
Across both long-term and, to a lesser extent, short-term health insurance lines,
reinsurance funds are available to assist financially with particular business
propositions. Where a particular distribution strategy would involve
substantially more cash outflow in the initial stages than premium income,
reinsurance commission may be available to “factor” future surplus streams,
ie lend now against the predicted future flows of premiums less expenses and
claims.

Here, the reinsurer is paying some money to the insurance company to improve its cash
balance, perhaps to set up a new distribution channel or computer system (or both if
using the internet!). This payment is effectively a loan but is “disguised” as a
commission payment for the reinsurance. In return, the insurer will repay the loan out
of the profits it makes on the underlying business.
This type of arrangement may be more attractive to the insurer than, say, a simple bank
loan. This is because the company has no liability to repay the loan unless a surplus has
been made, and so the company does not have to reserve for the future payments (the
arrangement is “off balance sheet”, in accounting terms). It has therefore increased its
assets by the amount of the loan but not increased its liabilities, and hence has improved
its free asset position.
However, the extent to which this is true will depend on the precise requirements of the
supervisory regime concerned.
Occasionally, where the reinsurer can identify a block of renewing business

which is producing regular profits, capital can be found for the insurer to bolster
the free asset position by reinsuring this portfolio of profitable policies. The
reinsurer would pay an initial commission after which the reinsurer would be
entitled to the future surplus of premiums over claims for as long as the
arrangement remained in place.
The arrangement mentioned here is really the same as that described above except that
it’s for a different reason. The reinsurer still loans some money to the insurer and the
loan is repaid out of future profits.
A similar exercise might facilitate the acquisition of an insurance company

where a subset of business (or all policies) within the company being acquired is
identified as profitable and the reinsurer is prepared to advance funds in
anticipation of future surplus.
Here, the buying insurer has the reinsurance in order to give it a cash advance, which
will help it to fund the acquisition.
In each of these cases, quota share reinsurance is the norm, though any form of
proportional reinsurance might be used.
We will see later in this chapter there are also other types of reinsurance that have been
used to improve the free asset position that involve little or no risk transfer from the
insurer to the reinsurer. Such contracts are referred to as financial reinsurance or finite
risk reinsurance.

Question 26.4
The Core Reading has described six of the main reasons for using reinsurance. Can you
think of any more?

2 Types of reinsurance business

There are many variations of the basic types of reinsurance, and contracts are
often tailored to meet the particular needs of the cedant and reinsurer
concerned. However, all reinsurance contracts are based on the same
underlying principles.
As a general rule in healthcare insurance, reinsurance tends to be arranged on a

treaty, rather than a facultative, basis. For long-term products, the treaties tend
to be of a proportional nature (either surplus or quota share). The short-term
contracts, when reinsured, may be reinsured in many different ways,
proportional (quota share) and non-proportional (eg excess of loss). All of these
terms are explained below.
The types of reinsurance covered by the rest of this chapter are:
Facultative
Treaty
Proportional
● original terms (coinsurance)
– quota share
– surplus
● risk premium
− proportionate to full benefit  − quota share
 
− proportionate to sum at risk  − surplus
Non-proportional
● excess of loss
– risk
– aggregate
– catastrophe
● stop loss
Financial
These types are not mutually exclusive − there is some overlap between them, as you
will see.

3 Facultative and treaty reinsurance

Insurers cede risks either facultatively or by treaty according to how they weigh up the
advantages and disadvantages of each basis.
3.1 Facultative
The term “facultative” applied to the ceding company’s part of the agreement
means that it is free to place the reinsurance with any reinsurer. Similarly, so far
as the reinsurer is concerned, facultative means that it may accept or reject the
reinsurance as offered.
The main advantage of facultative reinsurance is the flexibility that both parties have
within the process. For example, the direct writer is under no obligation to use a
particular reinsurer. The direct writer can approach several reinsurers in search of the
best terms for each risk individually. Similarly, the reinsurer is under no obligation to
accept risks.
The main disadvantages to the insurer of facultative reinsurance include:

● it is a time-consuming and costly exercise to place such risks
● there is no certainty that the required cover will be available when needed
● even if cover is available, the price and terms may be unacceptable
● the primary insurer may be unable to accept a large risk until it has been able to
find the required reinsurance cover. This means the insurer cannot accept
business automatically when it is offered, and consequently its standing in the
market may be reduced.
Facultative cessions of long-term insurance risks generally concern individual

proposals which are outside the normal range of policies accepted, eg unusually
large or with unusual underwriting features. The same is true of short-term
insurance risks.
3.2 Treaty
The term “obligatory” indicates the removal of this freedom of action. The
agreement between ceding company and reinsurer may be:
(a) facultative/facultative,
(b) facultative/obligatory, or
(c) obligatory/obligatory.

Here the first word refers to the situation from the direct writer’s perspective, the second
word denoting the reinsurer’s position. Thus “facultative/obligatory” means that the
direct writer can choose whether or not to reinsure the risk; the reinsurer is obliged to
accept the risk if the direct writer decides to cede it.
Type (b) and (c) agreements above will be formalised in a “treaty” between the
two parties. A type (a) agreement may be formalised in a treaty. Insurers tend to
place the bulk of reinsurance cover on a treaty basis.
Arranging reinsurance for each individual risk is administratively messy. Therefore

direct writers may instead set up treaties with reinsurers. This allows them to place
reinsurance automatically. The terms and conditions of the treaty are carefully laid
down so that both parties know exactly where they stand. A treaty overcomes the
disadvantages of facultative reinsurance listed above.
Arrangements (b) and (c) above might seem potentially risky to the reinsurer, if the
reinsuring company is obliged to accept whatever the direct company throws at them.
However, the treaty will only apply to certain specified products, and will only have
been agreed when the reinsurer is satisfied about the direct writer’s underwriting
procedures. It may be that the direct writer is taking on “bad” risks – for example,
critical illness policies sold via direct marketing with no medical underwriting. This is
not a problem for the reinsurer if it is aware of this and can therefore charge appropriate
reinsurance premiums, or pay appropriately low reinsurance commission in the case of
original terms reinsurance.
Question 26.5
What is likely to happen if the direct writer manages to select against the reinsurer so
that the reinsurer’s experience is much worse than the direct writer’s experience?
The great advantage of treaties where the reinsurer’s acceptance is obligatory is that the
direct writer can write large policies without having to refer back to the reinsurer – a
process which might otherwise impede the sale of such policies due to the delay in
acceptance, quite apart from the associated administrative hassle.
An insurer will also wish to use reinsurance to control its solvency and growth
requirements. This can be done more readily by treaty arrangements.
Treaties are usually arranged so that the ceding insurer is obliged under the
terms of the treaty to pass on some of the risk in a defined manner and the
reinsurer is obliged to accept it. The treaty would then be on an
obligatory/obligatory basis.

The features of treaties are very much the reverse of the features of facultative
reinsurance:
Inflexible: Once the treaty is set up, then both parties must operate within the terms
of the treaty (so each should be happy with the terms before they sign the
treaty).
Efficient: Risks are generally reinsured automatically. This is administratively

quicker and cheaper.
Certain: With a treaty, the direct writer knows that reinsurance is available (if the
risk falls within the limits of the treaty) and on what terms.
Terms within the treaty
It is essential for both the direct writer and the reinsurer that the treaty is absolutely
precise in its definition of:
● what is and what is not covered
● the financial arrangements (ie premiums, commissions, timing of payments)
● the obligations of both parties.
The treaty document sets out all the relevant details and obligations under the
arrangement, though the wording differs for different types of reinsurance.
There will also be wide differences of wording between treaties in any one
category.
Note that all treaties precisely specify the scope of risks covered, the financial and
administrative arrangements and the provisions for contingencies.
Question 26.6
List twenty items that might be included in a reinsurance treaty.

4 Proportional reinsurance
Students new to this subject tend to think that reinsurance is where the reinsurer gives
cover against really big claims. Although this is part of the story, you will now see that
there are many types of reinsurance to cover a variety of purposes.
The first type of reinsurance is proportional, whereby the direct writer cedes a
proportion of the risk and the reinsurer pays that proportion of the total sum insured or
sum at risk.
There are several types of proportional reinsurance, as follows.
For long-term health and care insurance business:

● original terms (coinsurance)
● risk premium reinsurance (related either to the full benefit or to the sum-at-risk)
either of which can be on a quota share or surplus basis.
For short-term health and care insurance business:

● quota share (on an original terms basis).
Under proportional reinsurance, the reinsurer covers an agreed proportion of

each risk. This proportion may be constant for all risks covered (ie quota share)
or will relate the insurer’s preferred monetary retention to the overall size of sum
insured (ie surplus, under long-term covers). Both forms have to be
administered automatically, and therefore require a treaty.
These types of proportional reinsurance are discussed in more detail below.
Proportional reinsurance reduces the size of the ceding insurer’s net account,
and so it is used mostly as a means of accepting a larger size of risk than would
otherwise be possible.
Proportional reinsurance is particularly popular with new or inexperienced cedants who

are not comfortable with the uncertainty and possible volatility of a new product or area,
and thus would like to share the experience with another party (the reinsurer).
In certain circumstances, the reinsurance will diminish over time, as the insurer
gains experience of the new product or the new territory. Thus the treaty will
incorporate an increasing monetary retention (surplus) or a reducing
proportional share (quota).

By increasing the retention or reducing the proportional share that the reinsurer takes,
the insurer will keep more of the risk for itself.
These lower cessions would normally only apply to new business, ie the
proportions set for a policy at its inception remain unchanged until the policy
expires. However, on agreement between the two parties, changes in proportion
can apply also to existing business.
A proportional reinsurance arrangement affords the framework through the

commissions payable whereby the insurer’s new business costs or other
appetite for revenue is satisfied by “factoring” the future margins in premiums to
be passed to the reinsurer.
Question 26.7
Explain the last paragraph of Core Reading.
A variant of proportional reinsurance is the concept of sum-at-risk reinsurance

on long-term contracts. Here the proportions are applied, not to the whole sum
insured, but to the insurer’s “sum at risk”, ie the excess of the stated policy
benefit over the reserve which the ceding office holds. For ease of
administration, the terms of the treaty may stipulate the amounts of reserves
from the outset, or the basis on which they are calculated. For unit-linked
products, the sum-at-risk will be the excess of benefit over the bid value of units.
(This process may be further simplified by holding the unit value notionally
constant at its value at the start of the year, for reinsurance calculation
purposes).
The sum-at-risk method is only of use where the benefit is a lump sum, terminating the
contract, and the reserves are large enough to make the adjustment significant. While
commonly used for several kinds of life insurance contract, where reserves are large,
this approach is less usual for healthcare insurance except for unit-linked CI.
Question 26.8
Explain the rationale for reinsuring only a proportion of the sum at risk in these cases,
as opposed to reinsuring a proportion of the whole sum insured. Why is the sum-at-risk
approach only of limited use for healthcare reinsurance?
The premiums under the treaty are risk premiums (see below) and are usually
payable annually.
As for other proportional reinsurance types, sum-at-risk reinsurance can work either
using a quota share or a surplus arrangement.

4.1 Original terms (coinsurance) reinsurance
[In the UK and Ireland this method is usually referred to as “original terms”
reinsurance, whereas in most other countries it is known as “coinsurance”.]
This method involves a sharing of all aspects of the original contract. It applies
to both long and short-term contracts.
Hence the premium is split between the insurer and reinsurer in a fixed proportion and
any claim is split in that same proportion. This will generally mean that the reinsurer
shares in full the risks of the policy, including the risks of investment and early lapse.
A company wishing to place some of its business with a reinsurer is normally

called the “ceding company”, or “cedant”. The ceding company will provide the
reinsurance company with the premium rates it is using for the particular class
of business it wishes to reinsure. This is so that the reinsurer can check that the
cedant’s premium rates are adequate.
The reinsurance company will determine the rates of reinsurance commission it

is prepared to pay to the ceding company for the business. In doing so, it will
have regard to its likely future experience and its knowledge of the quality of the
ceding company’s underwriting.
The level of commission that the reinsurer will pay depends upon the expected
profitability of the business. But:
It will also want to make a profit on the business.
This should always be borne in mind. The reinsurer is accepting the risk, but will
expect to make profit in the long-run at the insurer’s expense.
The reinsurance commission will cover – in respect of the reinsured portion of

the policy – the commission that has been paid by the ceding company and part
or all of the ceding company’s other expenses.
The first part of the commission referred to above is called the return commission, while
the second part is called the override commission.
There may be some provision for the reinsurer to recover some of the initial
commission on early lapse, to reduce exposure to the risk of such lapses. It will often
be just the return commission that is included in this.
Original terms reinsurance can be on either a quota share basis or a surplus basis, both
of which are covered later in this chapter.

Deposits back
In certain countries, the supervisory authority may require the reinsurer to

“deposit back” its share of the total reserve under a reinsured contract with the
ceding company. Even where it is not a requirement, this is sometimes done so
that the ceding company gets the benefit of reinsurance whilst at the same time
being able to maintain a reserve for the whole contract and hence maximise the
funds it has to invest.
Each year the reinsurer would have to give back, to the insurer, enough money to enable
the insurer to set up the full statutory reserve for the policy. The “premium” required to
achieve this would be a function of the supervisory reserving basis. Any investment
profits earned on the statutory reserve then accrue entirely to the direct writing
company. At the same time, the reinsurer takes none of the investment risk under the
contract.
The overall result is that the reinsurer only in effect covers the (reinsured part of) the
sum insured over and above the reserve (called the sum at risk). It makes the
arrangement generally more profitable to the direct writing company, as it will retain all
of its potential investment profit.
However, the arrangement can also be an advantage to the reinsurer. For example, in
the case of a large international reinsurer, it may avoid any problems with having to
invest in an unfamiliar market.
4.2 Risk premium reinsurance
This concept normally applies only to long-term insurance covers.
Here, the reinsurer does not share in the office premium of the ceding office, but
charges a specific premium for the risk which may be level over the term of the
policy or may vary with the annual probability of claim.
Level risk premiums
This approach is called the “net level premium arrangement”. Here the reinsurer
spreads the risk premiums so that they are level over the term of the contract.
These may be guaranteed or not, often in line with the insurer’s product
approach. This method has the advantage that the insurer, if desired, can simply
load the reinsurance charges to obtain the premium payable by the policyholder.
The reinsurer is here charging a level premium for the benefit it is reinsuring, in much
the same way as the insurer will charge a level premium for an insurance contract with
an individual policyholder.

Increasing yearly risk premiums
Here each year’s risk premium represents the expected cost of the claims payable by the
reinsurer during the year.
Example
Contract: Stand-alone CI insurance for sum insured of £100,000, age at entry 50.
Reinsurance: Yearly risk premium, 60% quota share.
In the first year, the reinsurance risk premium will be calculated essentially as:
r
60, 000 i50
where ixr is the reinsurer’s risk premium rate, based on the reinsurer’s expected CI
claim inception rate for the business for the year of age [ x, x + 1] .
In the second year, the reinsurer will charge a different (higher) risk premium, ie:
r
60, 000 i51
and so on.
In reality, the risk premium rates ixr will also include loadings for the reinsurer’s
expenses, contingency margins and profit – as mentioned in the following Core
Reading.
The reinsurance company determines its risk premium rates by assessing the
likely experience of the business that it is to reinsure and then adding expense
and profit margins. It may or may not guarantee these rates for the term of the
policy.
So the reinsurer’s risk premium rates – be they level or yearly increasing – could be
guaranteed or reviewable, in much the same way as the direct writer’s premium rates
can be.
There may additionally be some form of profit participation, whereby a share of any
profits to the reinsurer from the portfolio reinsured is paid back to the direct writer.

No commission is payable. The premium rates as determined above are applied

to the sum reinsured which may be a proportion of the sum insured or of the
sum at risk, as discussed earlier.
This distinction between risk premium and original terms is important. In the case of
risk premium, the reinsurer sets the premium rate, which is independent of the premium
charged by the insurer. In the case of original terms, the insurance company sets the
premium and then negotiates an amount of commission from the reinsurer.
4.3 Quota share
Quota share is a type of proportional reinsurance and is always by treaty. It is a simple

mechanism for ceding a portion of the business. It can be used for long-term business
(either on an original terms or risk premium basis, as already discussed), or for
short-term business (on an original terms basis).
Suppose the direct writer decides that for a particular class it does not want to retain all
the business it writes. So the direct writer enters into a quota share treaty with a
reinsurer. Then a constant proportion of each and every risk within the scope of the
treaty is automatically passed to the reinsurer. The treaty will specify the proportion to
be ceded to the reinsurer, R% say. This is often referred to as an R% quota share treaty.
Premiums
The premiums can either be calculated on a risk premium or original terms basis.
Claims
The reinsurer pays the insurer R% of the claims from risks covered by the treaty.
Question 26.9
A health insurer in Australia has a 50% original terms quota share reinsurance treaty.
For a risk with a gross premium of $10,000, the direct writer pays commission of 15%
and receives 15% return commission from the reinsurer. The reinsurer also pays 5%
override commission.
(i) Calculate how much premium is received by the direct writer and the reinsurer
after allowing for commissions. Do these relative levels of premium look fair?
(ii) If there is subsequently a claim for $50,000, how much will the direct writer be
able to reclaim from the reinsurer?

Practical considerations
The administration of quota share is very straightforward, especially if it is done on an

original terms basis.
In this case, because every risk is automatically reinsured, there is no need for anything
more than a list of all the risks with total premiums and total claims. The premiums and
claims payable between the direct writer and the reinsurer (ignoring commission) are a
straight proportion of the totals.
Risk premium quota share will necessarily be more complicated. This is because we
will need to apply the reinsurer’s premium rates to the reinsured benefit amounts (eg to
R% of the full value of the benefits or to R% of the sum at risk), in order to obtain the
reinsurance premiums payable (as described in Section 4.2).
Reinsurer’s claims experience
The cedant and reinsurer will have proportionately the same overall underwriting
experience on the business included in the treaty, apart from differences in
expenses and commissions. The reinsurer will therefore be concerned at the
outset to establish:
● the nature of the business being offered
● the cedant’s attitude to underwriting and claims settlement
● any previous experience of this business.
The reinsurer will reflect its satisfaction with this information in the level of
commission that it is prepared to write into the treaty. Generally, the reinsurer
will reserve the right via the treaty to be involved in the approval and settlement
process for claims above a certain size. The reinsurer might also negotiate for
part of the commission payment to the cedant to be a profit commission that is
payable only if the business ceded meets specified profitability criteria.
Remember, however, that reinsurance commission is only usually payable when the
reinsurance is on an original terms basis.
The treaty may contain some portfolio volume limits.
This is so that the capacity of the reinsurer to write such business is limited. This limit
will normally be expressed in terms of the original gross premium income of the cedant
for that business.

Purposes of quota share
Quota share is widely used by insurers to spread risk, write larger portfolios of
risk and encourage reciprocal business. It also directly improves the solvency
ratio and helps the insurer to satisfy the statutory solvency (capital) requirement.
Improving the solvency ratio
For short-term business, the solvency ratio is often defined as free assets divided by net
written premiums. Using quota share will reduce net written premiums and hence
increase the solvency ratio in the short term.
Many statutory solvency capital requirements for short-term insurance are based on net
written premiums. The legislation may require that the company has solvency capital at
least as great as a defined percentage of net written premiums. For example, the
solvency capital requirement in Australia includes a minimum of 20% of written
premiums, and in the UK it is similar. Quota share can be used directly to reduce this
type of capital requirement.
Financing
Reinsurance is often used to obtain financing assistance. Quota share is ideal for this
purpose, as it gives the insurer greatest control over the amount of financing it will
receive in relation to the volume of business (new premium income) it sells. If the
company used surplus reinsurance for financing (covered further in Section Error!
Reference source not found.), then the amount of capital support it would obtain
would be a function of the mix of new business by size (which is actually irrelevant),
and not simply of the total volume of business sold. The direct writer’s decision on how
much business to cede will result from considering the company’s future solvency
position as projected using a model office.
Financing (and financial) reinsurance is covered in detail in Section 6.
Spreading risk
A large, established insurer will be far less dependent (if at all) on quota share as
a means of spreading risk than a small, new insurer. However, large insurers
often employ quota share extensively where there is a launch of a product
covering an area of risk where the insurer is inexperienced (eg critical illness) or
a launch of an existing product into a new market (eg medical insurance for
expatriates).

The reinsurance is here being used to reduce the insurer’s exposure to losses arising
from possible mis-pricing of the product – ie parameter risk. The greater uncertainty
the company has regarding the claim experience assumptions in its premium basis, the
larger quota shares it will wish to reinsure.
Another aspect of spreading the risk that can be achieved with quota share is that, for
the same total (net-of-reinsurance) benefits at risk, the insurer will be able to insure
more individual lives. That is, an insurer’s risks are better spread by retaining 50% of
1,000 risks than 100% of 500 risks.
Quota share can also help spread risks through reciprocity. This is where two insurers
agree to swap some business on a reciprocating basis. For example, Company A may
have a 40% quota share treaty with Company B for business it writes directly, while
Company B has a similar quota share treaty with Company A. Provided the two
portfolios are not perfectly correlated, both companies will have achieved a better
spread of risks. An example of this would be two health insurers writing different
business (eg critical illness and PMI), spreading risk to limit the impact of adverse
experience in one or other of these products.
The advantages of quota share to a direct writer are therefore, in summary:

● helps spread the risks, reducing parameter risk in particular
● there might be some reciprocal business from the reinsurer
● administratively simple
● used for financing new business strain
● can help reduce solvency ratios for short-term business.
Limitations of quota share
The main disadvantages to an insurer of ceding business by quota share are:

● it cedes the same proportion of each risk, irrespective of size; the insurer
may, however, wish to cede a greater proportion of the larger risks than
the smaller ones, owing to their greater loss potential
● it passes a share of any profit to the reinsurer.
Question 26.10
Define, briefly, quota share reinsurance.

4.4 Surplus cover
The Glossary contains the following definition:
“Under a surplus reinsurance arrangement, the long-term insurer will cede to the
reinsurer all sums that exceed its retention on each individual life.”
Like quota share, surplus is a proportional form of reinsurance arranged under a treaty.
The key difference is that the proportion of risk ceded will vary from risk to risk,
depending on the size of the sum insured under the policy, in relation to the retention
agreed under the treaty for the class of business concerned. The same retention level
will apply for all business covered by a particular surplus treaty until that treaty is either
amended or abolished.
Example
Policy class: individual critical illness

Retention limit: £75,000 per risk
Policy 1: Sum insured £150,000, so £75,000 (150, 000 - 75, 000) is reinsured.
Policy 2: Sum insured £100,000, so £25,000 (100, 000 - 75, 000) is reinsured.
Policy 3: Sum insured £50,000, so there is no reinsurance (as the sum insured is
below the maximum retention level).
So the proportions reinsured under the three policies turn out to be 50%, 25% and 0
respectively.
This class of reinsurance cover will only apply to policies where there is a fixed
sum insured, chosen at the outset by the policyholder. Thus it will not apply to
private medical insurance business.
The reason for this is that in order to split the risk into proportions (ie that ceded and
that retained), the overall size of the claim must be quantifiable.
Purpose of surplus insurance
Surplus cover enables an insurer to write larger risks, which might otherwise be
beyond its writing capacity. The main value of this type of reinsurance, however,
is to enable the insurer to fine-tune its experience for the policies concerned,
ie the insurer selects a monetary limit at the outset of the treaty and reinsures
the amount of any policy sum insured above this amount.

A company may adopt a mixture of both quota share and surplus, retaining for itself a
percentage of each policy up to a maximum retention.
Example
Suppose the direct writer issues a policy with sum insured $100,000.
With a simple surplus arrangement, supposing the direct writer has a retention of
$40,000 (it is prepared to accept up to $40,000 of “risk” on each policy), the reinsurer
would cover $60,000.
With a simple quota share arrangement – say 30% – the reinsurer would cover $30,000.
Consider now a combined arrangement, assuming a 30% quota share subject to a

retention of $40,000. Looking at the quota share element, the direct writer would retain
$70,000 (70% of the sum insured). But the $70,000 is subject to the maximum
retention of $40,000. So the company retains only $40,000, and so the total amount
reinsured is $60,000.
The critical difference between the surplus and quota share is that for quota share the
same percentage (in the example above 30%) is used for every policyholder, regardless
of the size of the sum insured. For surplus it is the fixed (maximum) retention limit that
is the same ($40,000 in the above example), so for a policy with a sum insured of
$200,000 the $40,000 would be fixed and hence 80% of the risk would be ceded; for
other sums insured, the maximum retention would be the same but the proportion
reinsured would differ accordingly.
Surplus reinsurance is therefore much more efficient at targeting the morbidity risk. To
avoid high risk concentration, and yet to maximise profits, the company would seek to
reinsure a high proportion of its very large risks, but none at all of its small cases. This
is precisely what is achieved using the surplus method, and results in reduced claims
volatility.
Both types of proportional reinsurance will reduce the company’s total exposure to
parameter and model risks in proportion to the total amount reinsured in either case.
Whether the direct writer prefers surplus or a quota share arrangement, or some
combination thereof, will depend on the direct writer’s need for each type of service.

Where the sum insured increases under the basic policy (in line with some
inflationary index or by a fixed percentage accumulation each year), the treaty
will stipulate whether the sum retained remains fixed in money terms or whether
the insurer and reinsurer continue to share the increases in line with the original
proportion.
Pros and cons of surplus
Advantages of surplus to a direct writer are:

● Allows the direct writer to accept risks that would otherwise be too big (more
effectively than quota share).
● Reduces concentration of risk per life and so reduces claims volatility.
Disadvantages of surplus are:

● A company has less control if its protection against parameter risk than under
quota share, as its overall share of the risk will be dependent on the sizes of the
policies taken on.
● Less suitable for financing arrangements.

5 Non-proportional reinsurance
Proportional reinsurance can be used to spread risk and to reduce pro rata the
size of risk retained. However, this does not cap the cost of very large claims
that occur under private medical insurance policies. Under excess of loss (XL)
reinsurance, on the other hand, the cost to an insurer of a large claim is capped
with the liability above a certain level (often called the lower limit, or retention)
being passed to a reinsurer. However, if the claim amount exceeds the upper
limit of the reinsurance, the excess will revert back to the insurer. Variations of
this form of reinsurance cover exist to limit an insurer’s loss from a single event
or over a given period.
With non-proportional reinsurance:

● The lower limit might operate on individual claims (eg to cover against large
individual risks), or on aggregations of claims (eg to cover against widespread
disease).
● There might also be an upper limit, above which the reinsurer’s liability ends.
● The reinsurer might pay for all claims within the limits or perhaps a proportion
of the claims within the limits (eg 90%). This could also be expressed as having
a deductible of 10%.
● The limits might be linked to inflation.
These various types of excess of loss reinsurance are covered in more detail later in this
section.
Non-proportional insurance is unlikely to be found in long-term insurances

where the size of the benefit (sum insured) is known at the outset, though
aggregate excess of loss may be appropriate in group CI or IP covers.
Question 26.11
Explain the reasoning behind the last paragraph of Core Reading.

5.1 Excess of loss reinsurance
How excess of loss (XL) operates
In its simplest form, the reinsurer agrees to indemnify the cedant for the amount
of any loss above a stated excess point. More usually, the reinsurer will give
cover up to a stated upper limit, with the insurer purchasing further layers of XL
cover, which stack on top of the primary layer, from different reinsurers. The
higher layer cover(s) come into operation on any particular loss only when the
lower layer cover has been fully used (or “burnt through”).
The top layer of XL reinsurance might be unlimited (ie there is no upper limit).
The layers of reinsurance should be arranged so that there are no gaps, ie the lower limit
of the second layer of XL reinsurance starts at the upper limit of the first XL
reinsurance.
The expression generally used to describe the cover provided under an excess of loss
reinsurance treaty is:
Amount of layer in excess of lower limit.
So a treaty that provides cover for claim amounts between a lower limit (excess point)
of £50,000 and an upper limit of £200,000 would be described as:
£150,000 in excess of £50,000.
Question 26.12
A direct writer has three excess of loss treaties covering its PMI portfolio:
● £140,000 in excess of £60,000
● £300,000 in excess of £200,000
● £2 million in excess of £700,000.
(i) What is silly about this reinsurance programme?
(ii) How much will the direct writer be able to recover in respect each of the
following claims?
(a) £80,000 (b) £280,000 (c) £2,400,000 (d) £4,000,000 (e) £680,000
(f) £50,000 (g) £500,000

There are three main types of excess of loss reinsurance:

● risk XL
● aggregate XL
● catastrophe XL (rarely appropriate for health covers).
These are described further in Sections 5.2 and 5.3.
Indexed limits
Where inflation has a significant effect on the cost of claims, a stability clause
may be applied to the excess point. This is done to achieve a more equitable
division between the reinsurer and cedant of the inflationary element of claims
covered under the treaty. The cedant will normally be required to pay an extra
premium to compensate the reinsurer for the added risk if the excess point is not
indexed.
The upper limit (where one exists) may similarly be indexed to preserve the
original real value of the cover.
The basis for indexation should be a reliable inflation index that bears some relation to
the inflationary effects on the claim sizes.
5.2 Risk excess of loss (Risk XL)
This is a type of excess of loss reinsurance that relates to individual losses. It

affects only one insured risk at any one time. This is sometimes found under
private medical insurance portfolios where individual large losses sometimes
occur.
The direct writer pays a premium to the reinsurer in return for protection against large
individual claims.
Question 26.13
A direct writer has two layers of risk XL cover. The first is 100,000 in excess of
100,000, the second is 300,000 in excess of 200,000. All limits are indexed, and the
chosen index starts the treaty at a value of 100.
A claim is made which is settled by two payments totalling 400,000, one of 55,000
(when the index was 110) and the other of 345,000 (when the index was 115).
Assuming that the treaties cover this claim, calculate how much each insurer pays.

5.3 Aggregate excess of loss (Aggregate XL)
Aggregate XL reinsurance is a very simple extension of the risk XL reinsurance.

However, rather than operating on large individual claims, the excess point and the
upper limit apply to the aggregation of multiple claims. As you will see, there are
several different ways that the claims might be aggregated.
Provided that the levels of cover are chosen carefully, risk XL should protect an
insurer adequately against losses that affect only one insured risk. However,
events can occur which cause losses to several insured risks at the same time.
Depending on the insurer’s risk portfolio, that event could lead to an aggregation
of claims. Individually, each claim might not be of exceptional size, but
collectively the aggregate cost might be damaging to the insurer’s gross
account.
In this situation, the conventional risk XL treaty, by treating each claim as a

separate loss, will fail to protect the cedant adequately against the aggregate
cost of such losses. Hence the need for aggregate XL reinsurance.
The upper and lower limits in the aggregate XL cover will usually be at a higher level
than for the risk XL cover, and relatively few events leading to an aggregate claim
under the treaty would be expected. There may also be a limit on the aggregate amount
payable in the year from all events.
Usually, an event covered by aggregate XL will be sudden and obviously identifiable.

However, in some cases, the time span of the event may be less easily identifiable and
therefore require careful wording in the treaty definition.
Alternatively, cover may be defined in terms of a common cause or peril, rather

than a single event, over a particular period of time.
Examples of the above might be:

● a chemical explosion (a single event) giving rise to a number of claims
which together might exceed an insurer’s retention, though individually
they would not
● claims arising from the discovery of a new method for diagnosing heart
disease prompting surgery (common peril), which again in combination
necessitates reinsurance payout.
In practice the boundaries between different forms of XL reinsurance are not distinct.
In any given case the treaty will spell out exactly what is covered, and so the name is
not really important.

Aggregation by event
All the claims arising from one event might be added together. If the total amount
exceeds the lower limit, then the direct writer can make a recovery from the reinsurer.
Another example of the event might be a regional epidemic. The insurer of

policyholders living in the area might then be faced with dozens of individual medical
claims, none of which in isolation is too worrying, but which in total could damage the
company.
In its most extreme (and very unlikely) form, an event may be of catastrophic
proportions, involving losses to many hundreds or even thousands of different insured
risks with a potential cost falling beyond the normal capacity and intention of aggregate
treaties and possibly even beyond the finances of a large insurer. The scope of
aggregate XL therefore needs to be extended, to catastrophe XL, to cope with such
disasters.
The main difference between catastrophe XL and aggregate XL lies in the much higher
level of aggregate cover at which catastrophe XL operates. The event also needs to be
defined more carefully than before, since it may be spread over a wide geographical
area.
An example of such an event could be a major country-wide illness, eg influenza.
Again, the boundary between aggregate and catastrophe XL is not distinct.
Aggregation by peril or cause
Another way to define an aggregation of claims is all claims from a common cause or
peril over a specified accounting period. For example, a PMI insurer may seek
aggregate XL reinsurance for all medical claims from asbestosis.
Aggregation by class
The direct writer may get aggregate XL reinsurance to cover all claims from a particular
class. This form of aggregate XL is called stop loss. It is described in Section 5.6.
Commission
Return commission and override commission are not relevant to excess of loss
reinsurance, although profit commission is possible. However, profit commission
would be totally inappropriate for the very high layer excess of loss treaties, where the
reinsurer expects to pay out only in exceptional circumstances.

Brokerage is very likely to be paid, since this type of reinsurance is usually arranged
through brokers.
Proportional within non-proportional
For all forms of XL, it is possible that the reinsurer will cover only a proportion of the
claims within the layer, by applying a deductible.
For example, the cover might be set as 90% of £150,000 in excess of £50,000. In this
case, which has a 10% deductible, a claim of £120,000 would generate a recovery of
£63,000 (ie 90% of £70,000).
The reason for this type of arrangement is to give the direct writer more incentive to
keep the claim settlements low. Otherwise the reinsurer may feel exposed to the “moral
hazard” of the direct writer having sloppy settlement procedures for large medical
claims.
Question 26.14
Why in practice would the direct writer be keen to handle claims above the excess point
prudently, even if 100% of the claim above the excess was being paid by the reinsurer?
5.4 Purposes of non-proportional reinsurance
The main purpose of any form of excess of loss reinsurance is to permit an

insurer to accept risks that could lead to large claims. Large here means large
relative to the insurer’s solvency margin or annual premiums.
Other purposes are to reduce the risk of insolvency from a catastrophe, a large
claim or an aggregation of claims, and to stabilise the technical results of the
insurer by reducing claims fluctuations.
By reducing the variance of the claims outgo, the annual profitability of the direct writer
will be less volatile. Shareholders are not known for their love of profit volatility!
With lower volatility of claims, the direct writer can also make more efficient use of its
capital. High volatility of outgo means that the company must hold large free reserves.
If the volatility is reduced, lower free reserves are required. This means that the
company can write the same amount of business with less capital by using excess of
loss reinsurance.

5.5 Pros and cons of excess of loss
Advantages of excess of loss to a direct writer
Question 26.15
List the advantages of individual excess of loss.
Disadvantages of excess of loss
As with all reinsurance, the insurer will pay a premium to the reinsurer which, in the
long run, will be greater than the expected recoveries under the treaty. An excess of
loss reinsurer’s premium will load the expected claims for expenses, profit and
contingency margins.
From time to time, XL premiums may be considerably greater than the pure risk
premium for the cover. For example, after reinsurers have had a few years of poor
results, the supply of reinsurance falls and premiums rise as reinsurers attempt to restore
their solvency positions.
5.6 Stop loss
As the name suggests, stop loss reinsurance is designed to stop losses. In fact, it doesn’t
actually stop losses altogether, but it can help make bad losses a bit less dire. With stop
loss reinsurance, the aggregation applies to ...
all claims arising ...
in a defined account (eg a specified class) ...
during a defined period (eg a year).
Sometimes a particular class of business gives rise to large variations in the

levels of total claims payable in any one year. Aggregate XL only provides cover
for either one cause over the year or one event. An insurer may therefore wish
to protect the class of business by a form of reinsurance that extends cover to
all causes or all events during the year. Stop loss does this by covering the total
losses for the whole account, above an agreed limit, for a 12-month period. The
whole account can be one or several classes of insurance.
The excess point and upper limit for stop loss are often expressed as a
percentage of the cedant’s premium income for that account. Cover might
typically be given from an excess point of 110% claims ratio up to an upper limit
of 130% or 140%.

The claims ratio is normally defined as total claims incurred divided by the earned
premiums. The calculation of earned premiums was covered in Chapter 21, Reserving.
Profits in long-term insurances are rarely sufficiently volatile to warrant paying

for this protection.
Question 26.16
Why is stop loss cover quoted in terms of claim ratios rather than monetary amounts?
Example
A company that writes just PMI has a stop loss reinsurance treaty for business in 2005:
● lower limit of 105% of earned premium
● upper limit of 125% of earned premium
● reinsurer covers 80% of the claims in the layer.
Suppose that the earned premiums for 2005 were £292 million and the total incurred
claims were £333 million (ie a loss ratio of 114%).
The reinsurance recovery would be 0.8 × (333 – 1.05 × 292) = £21.12 million.
Question 26.17
(i) List several risks relating to the direct writer’s operations that a reinsurer would
face if it made stop loss cover available.
(ii) Given these risks, why would the direct writer probably not want stop loss in
practice?
(iii) Suggest two broad responses to the risks in (i) that the direct writer may well
find preferable in practice.

Question 26.18
(i) Explain why reinsurers are often not prepared to provide stop loss cover.
(ii) If the reinsurer does provide stop loss cover, what conditions is it likely to
impose on the business covered?

6 Financial reinsurance
6.1 Financial reinsurance (short-term contracts)
A wide variety of financial reinsurance contracts exist, although all were devised
primarily as a means of improving the apparent accounting position of the
cedant.
The main feature of a financial reinsurance contract is that it involves only a

small element, if any, of transfer of insurance risk from the cedant to the
reinsurer. There are, however, similar risks to those that relate to investments.
Many forms of financial reinsurance are, in fact, often viewed as being more
similar to investment than to reinsurance. Usually the effective “return” that the
contracts provide is low in comparison to conventional investments.
For example, for a payment of £10 million on 1 January 2006 the financial reinsurer
may agree to pay to the direct writer £1.2 million on 1 January from 2007-2016
inclusive. The reinsurance premium is £10 million and the reinsurance recoveries form
an annuity of £1.2 million pa, payable annually in arrears for ten years.
This does not at all look like a reinsurance policy. The insurer is effectively purchasing
an annuity from the reinsurer. The policy is more similar to an investment than a
reinsurance policy. However, this type of policy has been used in various parts of the
world in order to improve the apparent solvency position of the insurance company.
You may be asking how?
If the relevant authorities can be convinced that the arrangement is reinsurance then the
annuity payments may be treated as reinsurance recoveries (ie negative claim payments)
rather than investment proceeds. If future claim payments and hence reinsurance
recoveries can be shown at face value in the balance sheet, ie the payments don’t have
to be discounted and the present value shown, then in this example the payments would
be taken into account at face value, ie £12 million. Hence, the company has swapped a
cash asset of £10 million (the reinsurance premium) for an asset of £12 million (the
reinsurance recoveries) and its disclosed solvency position appears to increase by
£2 million.
We have deliberately used the words “if” and “may” in the above paragraph. There is
no guarantee that the local supervisory authority will allow such contracts to be valued
at face value. If the insurer is obliged to calculate the present value of the future annuity
payments then there might not be any benefit to the insurer at all, depending on the
discount rate used.

Few financial reinsurance policies are as simple as the one described above. Often they
are “disguised” to look like normal reinsurance contracts. If you come across a
reinsurance policy that seems to be transferring very little claims risk from the insurer to
the reinsurer then it is probably a financial reinsurance policy.
Example
Insurer A has the following aggregate excess of loss arrangement with reinsurer B.
This covers all claims on any PMI policies written by A during the year 2006 in excess
of £0.8 million, with an upper limit of £2 million (ie “£1.2m xs £0.8m”).
At the start of 2006, a reinsurance premium of £1.2 million is paid by A. Return

commission of £200,000 is paid by the reinsurer – giving a net reinsurance premium of
£1 million.
A 98% profit share is payable to A at the end of 2009. This is calculated as 98% of
profit, where profit is calculated as the original premium of £1.2 million less any
recoveries made under the reinsurance treaty.
At the end of 2009, the arrangement is then terminated. At this time, all reinsurance
recoveries and profit share must be paid to insurer A.
What type of reinsurance arrangement is this?
We need to consider the cashflows that insurer A will experience.
In return for a net premium of £1 million paid on 1/1/06, insurer A receives (on
31/12/09):
● £1.176m (ie 98% of 1.2m), if no recoveries are made
● £1.2m as recoveries, if recoveries exceed £1.2m (hence the profit is zero), or
● between £1.176m and £1.2m, if the layer is partially burnt through.
You can see that claims experience has very little effect on insurer A’s finances, so
there is very little transfer of claims risk between the two parties. It is therefore actually
a financial reinsurance contract.
Question 26.19
Discuss the reasons why insurer A may wish to take out this particular arrangement.

Note that the types of financial reinsurance discussed in this section are different from
those mentioned in Section 1.6, and again in Section 6.2 below. Here the initial
payment is from the insurer to the reinsurer. In Sections 1.6 and 6.2, the initial
cashflow, the reinsurance commission, is in the other direction.
6.2 Financing reinsurance (long-term contracts)
The risk premium reinsurance method is one type of arrangement which can be
associated with a financing arrangement whereby the reinsurer relieves the
ceding company of part of its new business financing requirement. A
straightforward loan from the reinsurance company would not achieve the
purpose, as the ceding company would usually have to add the amount of the
loan to its liabilities.
A loan would, of course, increase the company’s assets, but there would be no benefit to
the overall balance sheet if the company had to identify the amount owing as a liability
also.
So, the “loan” is usually presented as a reinsurance commission related to the

volume of business reinsured. The “repayments” – spread over a number of
years – are added to the reinsurance premiums. The reinsurer takes into
account the expected lapse experience of the portfolio of reinsurances in
determining the loan repayments.
Essentially all that is happening is that the reinsurer has increased its risk premium
rates. In return for charging the company higher premiums, the reinsurer is able to offer
the insurer a substantial initial commission. The “loan” received over a period is
therefore equal to the total initial commissions payable under the arrangements over that
time. As far as repayments are concerned, the company simply agrees to pay more for
its reinsurance protection than it would normally have done.
An alternative method is to use original terms reinsurance. Here the reinsured

proportion of the full office premium becomes the reinsurance premium. In return for
the large loadings that the reinsurer receives through these premiums, a substantial total
reinsurance commission would usually be payable back to the insurer, producing a
similar effect to that described above for risk premium. Original terms is actually a
more natural method for this purpose, as the premiums do not need to be increased
“artificially” in order to cover the commission payments.

An alternative approach is to make use of the future profits contained in a block

of new or existing business.
The reinsurer again provides a loan to the direct writing company, but, as the
repayment of the loan is contingent upon the stream of future profits being
generated by the business, the direct writing company does not need to reserve
for the repayment within its supervisory returns.
We described this approach earlier in Section 1.6.
This second approach may also be used where a direct writing company needs
to improve its solvency position, for example after a large drop in asset values,
or where it wishes to fund a new project, for example the setting up of a new
subsidiary overseas.
Example
Another example of how this might work is known as “cash strain financing”, which is
used in Australia.
Suppose a health insurer sells a policy for £100 per month, with a 2-year nil allocation
period. The reinsurer will pay a “commission” when the contract is sold, to reduce the
insurer’s new business strain, say £2,000.
The reinsurer will then receive the £100 per month for the 2 years of the nil allocation
period.
The amount that the reinsurer pays as commission depends upon bank rates plus a
margin for risk. The treaty would be arranged so that the reinsurer avoids losses due to
heavy lapses.
On a final note, notice that sometimes we say financial reinsurance and sometimes we
say financing reinsurance. Both terms are used pretty much interchangeably.

7 Determination of the retention limit

To determine the retention limit to adopt, it is necessary first to estimate the
statistical distribution of the risk experience costs of the portfolio on various
assumed retention limits. One then needs to judge how low a probability should
be aimed at for various degrees of departure from the overall average risk costs.
One approach is to set the retention limit at such a level as to keep the
probability of insolvency below a specified level. Using a stochastic model for
expected claims rates and a model of the business, expected claims can be
projected forward together with the value of the company’s assets and liabilities.
Using simulation a retention level can then be determined such that the company
stays solvent for 995, say, out of 1,000 runs.
Question 26.20
For long-term health insurance contracts with fixed benefits (eg IP, CI):
(i) Which is the most important variable that needs to be modelled stochastically in
this process?
(ii) What would be the most important unknown parameter value or values to
estimate correctly for this purpose (that is, to what assumption(s) in your model
do you think your derived retention level will be most sensitive)?
(iii) How would your answers to (i) and (ii) change if we were considering
short-term contracts with indemnity benefits (eg PMI)?
It should follow from considering the above questions that a company will be moved to
reinsure more:
● the less certain the company is about future claims experience
● the lower is the acceptable probability of future insolvency
● the greater the variance of the benefit level distribution.
This is what you would intuitively expect.
Phrased in terms of retention limits, more reinsurance means lower retention limits.

The size of the company’s free assets will have a major bearing on the reinsurance
requirements as far as claims volatility is concerned. In fact many large companies
have sufficient free assets to be able to dispense with risk premium reinsurance for
normal policies, and will reinsure only exceptionally large policies (eg £1 million sum
at risk) and against catastrophes.
The size of the free assets will also obviously affect the company’s financing
reinsurance requirements – the more capital a company has, the less it needs capital
assistance from reinsurers.
Another possible approach is to consider the total of:

(a) the cost of financing an appropriate risk experience fluctuation reserve,
and
(b) the cost of obtaining reinsurance – the reinsurer naturally incorporates an
expense and profit loading in its reinsurance terms, and the ceding
company incurs administrative expenses.
As the retention limit increases, (a) will increase and (b) will decrease, and a
retention limit can be adopted which minimises the total (a) + (b).
To calculate (a) the simulation approach discussed above would probably need
to be used to determine the reserve the company needs to hold.
Summarising the procedure for determining suitable retention limits and then the
optimal balance between a risk experience fluctuation reserve and reinsurance, one
approach is:
1. Decide on some criterion for claim volatility beyond which the company cannot
go. For example you might want to have only a 1% chance that the net loss from
claims is at least $25m.
2. For differing retention limits, having sounded out reinsurers on terms available
for your business, model the function “{total claims net of reinsurance} less
{total risk premiums net of reinsured risk premiums}”. This modelling will be
done stochastically, varying the risk experience.

3. The function is therefore:
X = C( g ) − C (r ) − P( g ) − P(r )
where C ( g ) = gross claims

C(r ) = claims recovered from reinsurer
P( g ) = risk premium available (from policy) to insurer
P(r ) = risk premium paid to reinsurer
The criterion would therefore be that Pr( X > 25m) = 0.01
4. Look at the results of this modelling to choose the retention limit that will satisfy
your criterion.
5. We could use this as a retention limit (if the cover is available in the market at an
acceptable price). However, we could also check if this protection can be
achieved more cheaply using a risk experience fluctuation reserve.
6. To do this we might assume that some of the cost of the risk premium
reinsurance is instead going to be spent on financing a risk experience
fluctuation reserve. The cost of holding a reserve of size M is equal to:
M ( j − i)
where j is the expected rate of return from the company’s capital, and i is the
expected rate of return from the assets that will back the reserve. This follows
from the fact that, by tying up some of its capital in a risk experience fluctuation
reserve, the company is unable to use that capital to finance other ventures, from
which it would have expected to earn a return of j. Instead, it will earn an
expected return of i, hence the difference is the cost (ie loss of expected return)
to the company over one year.
7. If we decide to redirect, say, 60% of the reinsurance risk premium to the risk
experience fluctuation reserve, then (if j = 9% and i = 7% , say) the amount of
risk experience fluctuation reserve purchased (for one year) is:
0.6 × P(r )
M= = 30 P(r )
(0.09 − 0.07)
We now have only 0.4 P(r ) left with which to buy reinsurance, so we will have
to have a somewhat higher retention level in order for the cost to be only
0.4 P(r ) .

Hence we have exchanged reinsurance for a risk experience fluctuation reserve,

at parity of cost.
8. Now model the distribution of X under this new arrangement, noting that we
now have a higher retention level (so the claims recoveries from the reinsurer
will be lower) and X is now calculated as:
X = C ( g ) − C ′(r ) − P( g ) − P(r ) − M
= C ( g ) − C ′(r ) − P( g ) − 29 P(r )
where C ′(r ) = claims recovered from reinsurer at new level of retention.
9. Compare the protection offered under this new construction against that offered
by the previous arrangement, ie recalculate Pr( X > 25m) . If this probability is
less than the 1% previously obtained, then using a risk experience fluctuation
reserve (to the extent assumed) is cheaper than using reinsurance, and would
therefore be the preferred strategy.
10. Try this for other levels of reinsurance / risk experience fluctuation reserve.
Then decide on which combination offers the most protection for a given cost.
If the degree of protection is increased by use of a risk experience fluctuation
reserve then we can determine (probably by trial and error) the actual amounts of
risk experience fluctuation reserve and retention level that are necessary to meet
our desired ruin criterion, with lowest cost to the insurer.


Chapter 26 Summary
Reinsurance involves a direct-writing company ceding business to another insurance
company, the reinsurer. The reinsurer will have no contact with the policyholders.
Reasons for reinsurance
● limits exposure to risk

● avoids large single losses
● smoothes results
● availability of expertise
● increases capacity to accept risk
● financial assistance.
Types of reinsurance business
Reinsurance can be by treaty or facultative, proportional or non-proportional (or

financial). Arrangements between cedant and reinsurer can be fac/fac, fac/ob or ob/ob.
Proportional reinsurance
For long-term health business, proportional reinsurance can be original terms or risk
premium, and can be quota share or surplus arrangements. For short-term health
business, only quota share is used.
It is useful for reducing the size of the insurer’s net account and allowing it to accept
larger risks.
Risks are shared in proportions. For quota share this proportion is the same for all risks,
but for surplus, it varies. The reinsurer helps the finances of the insurer by paying it
commission.
Under original terms reinsurance, deposits back may be used so that the cedant
maintains the reserves for the whole contract.
Although quota share is inflexible and cedes profit, it is good for:

● spreading risk
● writing larger portfolios
● encouraging reciprocal business
● financing and improving solvency.

Surplus reinsurance enables the insurer to cover individual risks up to an agreed

maximum retention level. This limits the insurer’s concentration of risk on individual
lives and so reduces claims volatility.
Under original terms, the reinsurance premiums are in the same proportion to the
original premium as the reinsured benefit is to the full benefit level.
For risk premium reinsurance:

● a proportion of either the full benefit or (sometimes) the sum at risk is reinsured
● reinsurance premiums can be net level payments or yearly increasing
● reinsurance premiums are determined by the reinsurer.
Non-proportional reinsurance
Non-proportional reinsurance helps to cap claims costs, and is normally only used in
short-term contracts and possibly group long-term contracts. It is also used to smooth
results by reducing claims fluctuations.
It can be excess of loss (risk, aggregate or catastrophe) or stop loss. The limits may be
indexed to allow for inflation.
Risk XL relates to individual losses, found on PMI portfolios.
Aggregate XL covers aggregations of claims, by event, peril or class. When applied to

a whole class, or classes, of business, it is called stop loss. Stop loss is rare for
long-term insurance.
Financial reinsurance
Financial (or financing) reinsurance can help the cedant to relieve part of its new
business financing requirement. It can achieve this by reducing its required solvency
ratio, or it can be structured like a loan, receiving either a lump sum or reinsurance
commissions with repayments incorporated into the reinsurance premium or paid out of
future profits. For short-term business, financing can involve very little transfer of risk.
Determining the retention limit
To do this, we estimate the distribution of claim costs under various retentions, and then
pick one that gives a suitably low probability of adverse net experience. This could be
based on insolvency probabilities using a stochastic model. The model can be used to
find the mix of reinsurance and of holding a risk experience fluctuation reserve that
minimises the cost of the claim fluctuation protection.

Solution 26.1
Larger insurance companies will generally have larger reserves and a more diversified
portfolio of business and hence will be less exposed to random fluctuation of claims
experience. As a result they may require less reinsurance.
However, it could be argued that larger companies are more likely to write types of
business that “need” reinsurance – ie those with large and/or unusual risks. Also, large
companies may be more prone to accumulations.
If a company has a lot of experience in the marketplace then it will hopefully have
sufficient credible data to be able to make an objective estimate of the expected claims
outgo when setting premium rates and reserves. It should also be able to set sensible
policy conditions to help control the risk. As a result the company will be less likely to
use reinsurance.
Solution 26.2
A reinsurance company may write loss-making business if it expects either to obtain

compensating higher future profits or profits from other connected business (from the
same cedant, or perhaps the same reinsurance broker).
At the bottom of the (re)insurance cycle, premiums across the whole market will be low
and so in order to retain market share reinsurance companies will be forced into
accepting loss-making business. Reinsurers will hope that premiums will soon start to
increase and the business becomes profitable once more.
Also, it may write some products as a loss leader knowing that it will also be able to sell
other more profitable business on the back of the initial sales.
Solution 26.3
There might be an upper limit to the amount of reinsurance that can be taken into
account for this purpose, because of the risk of reinsurer default. If the reinsurer was
unable to pay its claims then the insurance company would still be liable to pay the
original claims to its policyholders. Therefore, even if an insurance company reinsured
all of its business, it would still need to hold some reserves in case things went wrong
with the reinsurer(s).

Solution 26.4
Diversification
Since the insurer holds a smaller portion of each policy it can write more policies and
hence achieve greater diversification. Diversification reduces specific risk.
Benefit from cheap reinsurance rates
An insurer will be more likely to purchase reinsurance if it thinks it may be good value
for money. For example, this may be at a time that competition in the reinsurance
market has been driving down prices.
Improve standing in the market
An insurer may want reinsurance in order to demonstrate to other parties, such as rating
agencies, that they are managing their risks appropriately.
Tax or solvency arbitrage
It may be possible to take advantage of being taxed on a different basis from the
reinsurer, or from having a different regulatory solvency requirement.
Solution 26.5
The reinsurer is likely to increase premiums or change the terms of the treaty in favour
of the reinsurer at the next renewal date of the treaty.
The reinsurer may even decide not to reinsure the direct writer again.
Solution 26.6
Depending on the type of reinsurance contract, the details set out in the treaty will
include some of the following:
● names of the parties to the treaty
● period of cover
● territorial limits
● class(es) of business covered
● exclusions to the cover
● definition of loss occurrence
● retention of the ceding company
● cover granted automatically by the reinsurer

● premium rate
● premium payment arrangements
● ceding commissions payable
● profit commission payable to the direct writer and the method of calculation
● commissions payable to reinsurance brokers
● claim notification arrangements
● claim payment arrangements, including special arrangements for large claims
● rendering and settlement of accounts
● a currency clause (if more than one currency is involved)
● access by the reinsurer to risk details
● terms for termination of the treaty (period of notice, etc)
● an arbitration clause, in case of disagreements arising.
Solution 26.7
Future premiums are hopefully more than sufficient to cover all the insurer’s outgo, so
that it makes some profit.
Under a proportional reinsurance arrangement, the reinsurer will therefore take a share
of this profit and yet has not suffered the expense of selling the original business.
It is only fair, then, that the reinsurer “pays” for this benefit, by paying the insurer a
commission. The commission terms will be stipulated in the treaty document.
Solution 26.8
Rationale
The insurer holds assets equal to the size of the reserves at any time. So when a CI
claim occurs the insurer only has to find additional money to the extent that the sum
insured exceeds the reserve. (So, if the sum insured was equal to the reserve value at
the date of claim, it wouldn’t matter to the insurer how many claims occurred, as it
would always have the money available to pay them.) Hence, the insurer is only at risk
from poor claim experience with the respect to this “sum at risk” – which is why it has
this name!
If the company were to reinsure a proportion of the reserve as well as the sum at risk,
then it would be passing additional premiums to the reinsurer for no useful purpose.
Given that using reinsurance will reduce the insurer’s expected profit, then this is a
waste of money.

Limited use
We’re assuming here that the only long-term healthcare insurance product that provides
a terminal lump sum benefit is critical illness insurance. While the sum-at-risk method
is therefore appropriate for this, for conventional business the reserve is small relative to
the size of the benefit, so that the reinsurance premiums based on full-benefit or
sum-at-risk approaches differ little from each other. It is therefore not worth the
administrative hassle of using the more complicated sum-at-risk method.
All other healthcare insurance types pay some kind of income benefit – ie the policies
do not terminate when a claim occurs – so the company cannot “use up” its current
reserve in paying a claim. It is therefore necessary to reinsure (a proportion of) the full
benefit amount in these cases.
Solution 26.9
(i) The first split of the premium is $5,000 to each of the direct writer and the quota
share reinsurer. But the direct writer pays commission of $1,500 (ie 15% of
$10,000) and receives $1,000 (ie 20% of $5,000) from the reinsurer.
This leaves the net of commission premiums as $4,500 for the direct writer and
$4,000 for the quota share reinsurer. This split doesn’t look unfair. (You would
expect the direct writer to have a bigger share to compensate for the initial
work.)
(ii) The direct writer would be able to reclaim $25,000 from the reinsurer on a claim
of $50,000.
Solution 26.10
Quota share is a form of treaty reinsurance whereby all the at-risk benefits for policies
covered within the terms of the treaty are split between cedant and reinsurer in the same
fixed proportion.
The reinsurance premiums can be calculated on a risk premium or original terms basis.
If risk premiums are used, the at-risk benefit can be either the full benefit under the
original contract, or the sum at risk (difference between full benefit and size of reserve
at date of claim).

Solution 26.11
The primary aim of non-proportional reinsurance is that it covers the insurer in the event
of claims being larger than expected. Therefore, you would probably not have it on
individual policies where the sum insured is fixed from the outset, because you already
know the claim size.
However, you might expect an aggregate version of it on group contracts, since the total
claims the insurer pays out could be greater than expected (ie more claims might have
occurred).
Solution 26.12
There is a “hole” in the cover between £500,000 and £700,000. The layers of
reinsurance ought generally to be arranged so that there are no holes.
Recoveries from the treaties are:
Claim 1st layer 2nd layer 3rd layer Total

(a) £20,000 - - £20,000
(b) £140,000 £80,000 - £220,000
(c) £140,000 £300,000 £1,700,000 £2,140,000
(d) £140,000 £300,000 £2,000,000 £2,440,000
(e) £140,000 £300,000 - £440,000
(f) - - - -
(g) £140,000 £300,000 - £440,000
Solution 26.13
The direct writer will pay the first 55k, since this is within the retention for the first XL
treaty. (The reinsurer would only get involved here if the index had fallen by an
enormous amount.)
The second payment takes the claim, in the original money terms of the treaties, to:
100 100
55 ¥ + 345 ¥ = 50 + 300 = 350k
110 115

Hence the direct writer bears, in original money terms, the first 100k (of which the first
55k cash payment equates to 50k) the first XL reinsurer pays 100k, and the second 150k.
Therefore, the payments made are:

Direct writer: 55k (at index value 110) plus 50 × 1.15 = 57.5k (at index value 115)
First XL: 100 × 1.15 = 115k (at index value 115)
Second XL: 150 × 1.15 = 172.5k (at index value 115)
Check: The total cash paid out is 55 + 57.5 + 115 + 172.5 = 400k, as expected.
Solution 26.14
The direct writer will want to handle claims prudently because:

● the direct writer will want to maintain a good long-term relationship with the
reinsurer
● there might be some profit commission
● future premiums will be related to past claims experience.
Solution 26.15
Advantages of risk XL:

● allows direct writer to take on risks that could produce very large claims
● protects company against individual large claims
● helps stabilise profits from year to year
● helps make more efficient use of the capital by reducing the variance of the
claim payments.
Solution 26.16
If it were not, then after taking out the cover the direct writer could write loads more
business, and trigger the stop loss limits that way.
By using claim ratios, the limits (and the premium charged for the cover) rise in
proportion to the amount of business written by the direct writer.

Solution 26.17
(i) Risks to a stop loss reinsurer:

– direct writer’s premiums generally under-priced (eg a competitive
market)
– poor underwriting by direct writer
– poor premium rating structure leading to adverse selection
– adverse claims experience (eg large claims or random events)
– poor claims handling control.
(ii) So why not take stop loss in practice?

The reinsurer would need to charge a very high premium to cover itself against
the risks.
(iii) Better moves for the direct writer:

– set up tight internal controls to ensure good premium rating, underwriting
and claims control
– buy particular types of reinsurance to guard against specific events
(ie buy individual excess of loss and catastrophe excess of loss as
needed).
Solution 26.18
(i) Reinsurers are often not prepared to provide stop loss cover because:
● the reinsurer has only limited control over initial underwriting and claim
payments made
● historically, some stop loss covers have been loss making.
(ii) Conditions the reinsurer may impose before providing stop loss cover are:
● impose a deductible so that insurer retains a proportion of the risk
● require some control over underwriting and claims.

Solution 26.19
The insurer may wish to take out this arrangement:
● To improve its published solvency margin. Depending on local accounting

regulations, it may be able to show the expected return of (at least) £1.176m as
an asset and this could improve its published solvency margin by £0.176m.
● As an investment. It will make between 17.6% and 20% return on the

reinsurance premium over four years, and this may be a good return.
The insurer will also need to consider whether or not 4 years is a good match to the term
of the PMI liabilities covered by the arrangement.
Solution 26.20
(i) This method will only be useful if we model the numbers of claims (eg sickness,
critical illness) stochastically.
(ii) The important unknown here is therefore the variance of the number of claims at
each age/sex/duration/etc grouping. This will depend on the mean claim rate
and the random fluctuations variance for each group. The random fluctuations
variance will be a function of the mean claim rates provided the assumptions
hold about lives being identical and independent. However, we might also wish
to assume a larger random fluctuations variance to the extent that we believe that
lives are not homogeneous or independent.
The expected (mean) claim rate is also unknown (ie subject to parameter error).
Hence it is important also to model the mean claim rate stochastically, and both
the mean and variance of its distribution are key parameters in the determination
of the retention level.
The greater the total variability of the claims experience, the greater the
probability of the total cost of claims exceeding any given limit – and the greater
the probability of insolvency. Clearly, the greater the overall variance assumed,
the more reinsurance will be indicated by the model for a given probability of
ruin.
(iii) We would need to model claim amounts as well as claim incidence rates
stochastically.
We would therefore need additional parameters in order to define the required

probability distribution for the claim amount (in a similar way to the above).

ST1-27: Other risk management techniques Page 1
Chapter 27
Other risk management techniques
Syllabus objective
(i) Describe how insurers manage their risks in ways other than reinsurance:
− review actual experience against pricing basis
− service level agreements with outsourcers
− competence assessments for key in-house staff
− checks on policy data
− surveys on customer service satisfaction
− underwriting as gatekeeper and risk analysis
− claims management − in line with policy conditions and underwriting
− policyholders’ reasonable expectations
− controlling the distribution process.
0 Introduction
Passing risks to a reinsurer is not the only way of mitigating and controlling a health
and care insurer’s risks. This chapter describes other methods to achieve this aim.
Before you read this chapter, you might want to remind yourself of the risks that an
insurer faces, by re-reading the summaries of Chapters 23−25.

Page 2 ST1-27: Other risk management techniques
1 Review actual experience against pricing basis

As part of the actuarial control cycle, the actuary will periodically review the experience
of the company’s own portfolio of healthcare insurance business.
The periodic review of an insurer’s experience in claims, expenses and

distribution is examined in detail in Chapter 28.

2 Service level agreements with outsourcers
2.1 Use third parties to add expertise and efficiency
In many territories of the world, third party specialists have been developed to
assist the insurer in several core areas of business processes. The third party
salesman has been around for a long time and is characterised by the
independent intermediary or broker. Equally now companies have arisen that
will perform other routines: underwriting, claims management, actuarial
functions (for example, pricing and reserving), administration, investment,
marketing, systems and training.
The key offering here is that they provide a level of expertise and efficiency at a
price which may be better than in-house costs, and leave the insurer’s
management to perform the other tasks where they feel most competent,
including, of course, the strategic decisions.
2.2 Ensure agreement mitigates risk and does not add to it
The insurer will have a service agreement with the chosen third parties.
This will be a legal contract, and is often known as a Service Level Agreement (or
SLA).
The SLA should contain precise details of the role that each party agrees to undertake
(very much like a reinsurance treaty). The details depend on what each party agrees and
is prepared to accept, but often problems involving third parties are due to imprecise or
ambiguous SLAs.
In return for fees (unit costs or periodic payments), certain tasks will be
performed to a pre-specified standard and within pre-specified times. The
insurer should be confident that by passing certain processes in the business
chain to experts, the insurer is reducing risks. However, since the tasks are
being performed by third parties, the insurer will need to have regular reports,
checks and inspections in order to ensure that the insurer is not to suffer from
reputational risks, business risks and security issues.
For example, a third party performing the underwriting function on behalf of an insurer
will need to report on, and meet certain required targets in respect of:
• time taken to underwrite cases
• the proportion of cases accepted, declined and rated
• the quality of customer satisfaction.

Question 27.1
What areas should be covered in a contract between an insurer and a third party
provider of services?

3 Competence assessments for key in-house staff
3.1 Operational risk management
The successful performance of a business is down in large measure to the

quality of the staff employed and their exercise of judgement. Thus there needs
to be in place adequate systems of identification of competence levels required
at the various stages of business throughput, of recruitment, of staff training,
allocation and review and of recognition of the need for outside expertise.
Motivation and reward are other key features here.
Part of these systems should monitor for fraudulent as well as incompetent

behaviour.
Health care insurers have to be particularly careful about the competence of their staff.
This is because there is far more opportunity for fraud and judgement in health care
insurance than in, say, life insurance.
That is because, in life insurance, the benefits are generally paid on death. It takes an
extreme scenario to generate a false claim here, although that’s not to say it doesn’t
happen! A typical claims underwriting process in life insurance is simply to have proof
of death (eg death certificate).
In health insurance, however, there is more scope for fraud, since claims can be
exaggerated or falsified more readily. We have all seen cases on television where
someone who is claiming IP benefit and is meant to be sick off work, is filmed surfing
on holiday!
Question 27.2
List areas of competence or expertise in risk control that will be needed by a health and
care insurer.

3.2 External checking – audit
The external dimension may necessitate the occasional audit of staff

competence. Time and motions analysis by independent experts may also
indicate the need for staff reallocation and training.
You may have been involved in a time and motion study at work if you have been asked
to record exactly what tasks you have carried out, and how much time was spent on
each one, over a period of time. The results can indicate who does what in a company
and for how long. Hence, it can be the first stage in identifying where improvements
can be made, but the results do depend on the accuracy of the information recorded.

4 Checks on policy and claims data

The accuracy of policy and claims data is a major risk for any insurer. Not only
do policy data record necessary information for administration and client contact
and claims data the necessary information for benefit payout, but both, in
combination, will also provide the basis for policy experience against which
future business is priced and current risks are reserved. It is vital for experience
analysis that the claims data are accurate. Part of the internal and external audit
functions of the insurance operation will be to consider the reliability of the
information on which the business is conducted.
There are many methods that can be used to check the accuracy of policy and claims
data. We will now look at some examples of such methods.
4.1 Regular vetting, spot checks
The auditing of the accuracy of information will entail the regular inspection of
the processes by which data are accepted by the system, as well as considering
whether the data captured are comprehensive. This will involve a systematic
comparison of paper records on a periodic basis against the facts stored, and
deviations noted. It is also advisable that the systems which process the
information should have modules which query any possible inconsistency or
unusual features in the data.
4.2 Controls on data acceptance
At the time of data input, the software for accepting policyholder information,
claims details, agent particulars and areas, should have inbuilt checks that
prevent erroneous items from being accepted. Examples of this would be a sex
field other than M or F, an age at entry in excess of 120, a sum insured in pence
(cents or other trivial amount). The features of the product itself will impose
further restrictions on the data acceptable.
As well as looking at individual values, it may also be possible to group items and look
at how well distributed they are. For example, an unusually high clustering of birth
month may represent a data input error worthy of further investigation.
Certain “errors” may have exceptions that can only be overwritten by persons of
a pre-specified status within the organisation. An audit trail of such special
exceptions will be stored by the system. It may be that the company has agreed
on a one-off basis, to offer a non-standard policy to a particular customer. This
may need special permission as well as special premium rates.

4.3 Compulsory fields
An individual policy record will have certain fields that are mandatory; the input
will not be accepted unless all such information is included. Typical of these are
age, sex and benefit. A claim record will not be accepted unless there is a policy
number for cross-reference.
As a minimum, all the information that is used to price the policy (ie the rating factors)
will be required.
4.4 Staff training
Training of staff responsible for input is of the utmost importance, to establish a

culture of the value of accuracy of data, to develop a nose for information which
may have been submitted wrongly (either deliberately or accidentally) and to
ensure that data are input speedily and efficiently. There will be a close liaison
between the staff responsibility for establishing the software to accept the new
data and the staff involved in the training. Feedback from the staff responsible
for data input should be encouraged.
Staff really need to understand how the data they are inputting are used and the
implications to the business if the data are wrong. This means that an open and trusting
relationship should be established between the inputting staff and the users of the data.
Question 27.3
What other checks might be made on policy and claims data?

5 Surveys on customer service satisfaction

In an age where customer sophistication is growing, there are many more considerations
other than price alone, when buying a health product.
5.1 Understanding what has been bought
A customer buys an insurance product expecting it to provide a service, ie to

cover a certain aspect of health and care risks that might befall the customer
after the insurance comes into being. Much investment in terms of time and
money has been made in the process of purchase and sale; thus it is imperative
that both insurer and insured share the same conviction of what the product
entails.
The risk of misunderstanding is great. There is the wastage of that investment

plus the potential for reputational damage and the loss of future sales from an
existing client. In an extreme circumstance, regulators could enforce the insurer
to meet the policyholder’s expectations (against the insurer’s own intentions)
where the product was missold or other literature was misleading.
This is not as uncommon as you might expect (or hope). In recent years, there have
been many examples of mis-selling, although most of the concerns have been in life and
pensions business rather than in health and care. As a result, the regulators across
Europe are continually reviewing legislation in the hope that this can be prevented from
happening in the future.
A survey of client understanding can serve the purpose of ensuring policyholder

satisfaction with both the sales process and the product itself. Results of this
survey, performed as part of an after-sales service, will be fed back into the
literature provided and into the routines by which products are explained and
sold.
Example
In the UK, the insurance industry body (the ABI) undertook consumer research to
identify what consumers would find most useful as an aid to understanding and
comparing income protection products. The results of this research formed the basis for
what has developed into a Statement of Best Practice for the selling of IP. This outlines
the sales process that must be followed and the information that must be provided to the
customer. Similar statements are in force in the UK for the selling of CI, LTCI and
PMI.

5.2 Meeting needs
The best way to ensure customer satisfaction is to provide a product that meets
the needs that the person has identified as providing grounds for insurance
protection. The more artificial the needs creation through the sales process, the
less likely the policyholder is to maintain the product itself, let alone purchase
further covers from the insurer. The aim should be to meet needs at an
affordable price. Any other outcome raises the likelihood that insurer
profitability will not be realised.
This was discussed at length in Chapter 5.
If policyholder needs are not met, there is a strong chance that the policy will lapse.
Lapses can be a source of loss for insurers, depending on the type of product and the
precise benefits on lapsing. At the very least, an earlier-than-expected lapse may cause
problems if the initial expenses have yet to be recouped.
Question 27.4
A non-linked critical illness policy with level regular premiums is sold for a term of 30
years, on fully guaranteed terms. The policyholder lapses after 25 years. No surrender
benefit is paid.
The experience of the company over the past 25 years has been, in aggregate,
considerably worse than expected when the policy was priced, and the result is that the
policy now has a negative asset share. Discuss whether the company’s profitability is
likely to have been adversely affected by this lapse.
5.3 Receiving information and literature as expected
The customer will expect to receive information on a regular basis as promised.

This may include:
• statements of unit values under certain policies
• the results of any product reviews
• contract renewal details under short term insurances.
Further information if appropriate and timely may enhance the client

relationship. Any excessive attempts to cross-sell products will incur customer
dissatisfaction and may result in early termination of the existing policy.
In the extreme, policies are sometimes sold as “loss-leaders”. In this case, it is the
cross-selling opportunities that turn a profit into a loss. However, the effectiveness of
this approach should be monitored closely.

5.4 Claims payment satisfaction
The customer will expect efficient payment of claims amounts in line with
product promises. There is a balance to be drawn here between the need for
sufficient information to verify the entitlement to claim and the client’s
expectations at a time when there is a breakdown in health and a need for
financial compensation.
Question 27.5
Explain why healthcare insurance claims have sometimes been paid even though they
were not valid as defined by the contract wording.
5.5 An unhappy customer walks
In most instances, the insurer has an expectation of future profit from existing
customers. The phrases “embedded value” and “customer lifetime value” are
apposite (relevant) here. The insurer runs the risk of losing much of this asset if
customer satisfaction is not a priority of the whole operation. A policyholder
lapsing his policy deprives the insurer not only of the future margins in the
existing contract but also, probably, of the potential to sell further products,
where dissatisfaction is the reason for the termination.
You will have met the concept of embedded values in Chapter 19, and you will meet it
again in more detail in Chapter 28.
Question 27.6
Define embedded value.
Customer lifetime value is a concept used within any business. It is an attempt to

quantify the profit that a customer is expected to bring to the insurer, taking into
account the entire future lifetime of his needs and the extent of cross-selling possible.
Other anecdotal evidence shows that whereas a happy customer only tells one other
person about his experiences, an unhappy customer will tell many more people about
his. Customer satisfaction therefore has a gearing effect on profit (or losses).

6 Underwriting as gatekeeper and risk analysis
6.1 The process of medical underwriting
The process of medical underwriting will vary by market practice, by product and
possibly by regulatory control. The following are some of the more usual steps
to be found for health and care insurance.
Medical and other evidence
Where the company is at risk on sickness (or death) under a contract, it will
obtain evidence about the health of the applicant so as to assess whether he or
she attains the company’s required standard of health, and if not what their state
of health is relative to that standard, ie what additional risk premium loading is
required.
Medical evidence can be obtained from the following sources:

• questions on the proposal form completed by the applicant
• reports from medical doctors that the applicant has consulted, eg a
primary medical attendant’s report (PMAR)
• a medical examination carried out on the applicant at the request of the
insurer, (eg an examination undertaken by a doctor or nurse appointed by the
insurance company)
• specialist medical tests on the applicant (eg an HIV test).
The proposal form will ask for demographic information and include a series of
questions about the insured’s medical history. The questions must be factual and not
require technical knowledge. For example, it is acceptable to ask when and why the
insured has been an in-patient in hospital, but not to ask if their heart attack was serious.
The last three sources will usually involve the insurance company in additional
expense. Hence the extent to which they are used in a particular case depends
on the extent of the loss the company will make if it mis-estimates the state of
health of the applicant.
These three sources will also require the consent of the proposer. This is usually
obtained when the proposal form is completed. The expected losses from limited
underwriting will be greater for larger sums at risk. So the decision to seek extra
evidence will usually be limited to policies with a large sum at risk.

Question 27.7
Suggest the types of rules that might be used to identify the IP policies for which an
insurer should automatically seek extra medical evidence.
Besides the state of health of the applicant, other factors that can affect the
mortality or sickness risk need to be investigated, namely any risks associated
with:
• the applicant’s occupation
• the leisure pursuits of the applicant
• the applicant’s normal country of residence.
To counter the risk of over-insurance, financial details of the applicant may be

obtained.
All these items will be addressed by questions on the proposal form.
Question 27.8
Why is it not acceptable to ask, “Do you have a dangerous job?” on a proposal form?
How could you identify those applicants with jobs that put them in a higher risk
category?
Interpretation of the evidence
The evidence obtained needs to be interpreted in terms of the standard level of

health required by the health insurance company. This will be done by specialist
underwriters employed by the insurer, who will make use of:
• any doctors specifically employed by the company for this purpose, and
• underwriting manuals prepared by the major reinsurance companies.
Specification of terms/Acceptance
Applicants whose state of health reaches the required standard can be offered
the company’s normal or standard terms for the particular contract. Other
applicants will be offered special terms, unless their state of health is such that
the company will not accept them on any terms, in which case they will be
declined – at least temporarily.

The main ways in which the special terms can be specified are as follows:
• An addition may be made to the premium, commensurate with the degree
of extra risk.
• A deduction may be made from the benefit, again commensurate with the
degree of extra risk.
• An exclusion clause, to be appended to the contract, which excludes
payment of benefit for claims that arise due to specified causes (see
Section 6.2).
The example starting on the next page shows an entry for Asthma which might be found
in a PMI underwriting manual. The medical details are not important.
You will notice that the individuals are classified into five rating groups (types 1 to 5)
based on the use of three risk factors (frequency of bronchodilator use, frequency of
steroid use and history of hospitalisations or emergency treatment). Age and smoking
status are also used as rating factors.
In our example there are several underwriting decisions:

• to accept at standard rates, but with an additional policy condition that restricts
the cover offered
• to accept with a loading on the premium (+20% and +40% in our example)
• to accept with the exclusion clause and a premium loading
• to decline the proposal.
In the example, the exclusion clause could be replaced by an increase in the policy
excess for claims related to this condition. This increased excess effectively acts as a
reduction in benefit.
In addition to the decisions in the example, another decision would be to accept the
proposer at standard premium rates and on standard policy terms.

Example
Asthma and Bronchial Asthma
This is a disease characterised by airway inflammation and bronchospasm that results in

airflow obstruction causing dyspnea. Early and continued treatment with inhaled
anti-inflammatory agents is the norm for most individuals with asthma. Asthma used to
be classified as being extrinsic (due to outside factors) or intrinsic (aetiology unknown).
It is now felt that all asthma is extrinsic in nature even though a cause may not be
readily apparent. The causes of asthma are often discussed in terms of triggers or
inducers.
It used to be believed that the use of inhaled steroids was a sign of increased risk,
however, recent studies have shown that individuals who regularly use inhaled steroids
appear to have improved morbidity over those who do not. It should be noted however,
that individuals who use inhaled steroids on a regular basis do have a more severe form
of asthma than those who only use bronchodilators.
It is recommended that the underwriting of asthma concentrate on four factors:

• frequency of bronchodilator use
• frequency of steroid use
• hospitalisations or emergency treatment
• age.
Classification
Type 1 Bronchodilator use no more than once per week, no inhaled or oral
steroids, no hospitalisations.
Type 2 Bronchodilator or inhaled steroid use 1 – 2 times per day on a seasonal
basis (5 times per year with durations not over one month), no
hospitalisations in the past 5 years, no oral steroid use.
Type 3 Bronchodilator use no more than 3 times per day, or inhaled steroid use
no more than 2 times per day, no oral steroids, no hospitalisations in past
2 years.
Type 4 Bronchodilator or inhaled steroid use up to 4 times per day on a year
round basis, no hospitalisations, no oral steroid use in past year.
Type 5 Oral or inhaled steroids more than above, hospitalisations, no oral steroid
use in past year.

Suggested Action
Ages 3 – 12 Ages 13 – 44 Ages 45 and older
Type 1 Exclusion clause 20% Exclusion clause *
Type 2 Exclusion clause 50% Exclusion clause *
Exclusion clause
Type 3 Exclusion clause Exclusion clause
+ 50%
Exclusion clause
Type 4 Decline Decline
+ 50%
Type 5 Decline Decline Decline
* If age of onset over age 50, underwrite as Type 3
Smokers Add 20% for Type 1; Decline others
Status Asthmaticus within 10 years Decline
Children under 2 Decline
Exercise induced Underwrite as Type 1
Higher deductible instead of exclusion
£1,000 Types 1 and 2 only
clause
Exclusion clause: Asthma, bronchitis, allergies, allergic rhinitis or reactive airway

disease, including any treatment or diagnostic evaluation for.
6.2 Special considerations under short-term insurances
While the above methods of underwriting and acceptance may be applied to

short-term insurances (in particular PMI policies), other procedures are often
found:
(1) Moratorium.
Because of the short-term nature of the commitment (typically one year at

a time) and because of marketing considerations, the insurer encourages
the purchase by offering the prospect of immediate cover subject only to
a blanket exclusion on pre-existing conditions. This exclusion is usually
defined as conditions that have received treatment in a recent period prior
to application to the insurer (often five years). The exclusion is waived
after a period of time (usually two or three years) if the policyholder
receives no further treatment for the condition. It is this latter period
which gives rise to the name moratorium.

No formal underwriting is carried out at the point of acceptance, but past

medical history is examined at the time of claim. This process
encourages sales and reduces new business costs. It has, however, been
criticised because the insured cannot be sure for what illnesses or
treatments he/she is on risk, unless he/she is sufficiently medically aware
to understand the connectivity of medical conditions.
The difficulty here is that the policy excludes not only recurrences of the
pre-existing conditions, but also any conditions directly relating to them.
Question 27.9
Why is the cost per policy of moratorium underwriting much less than the cost per
policy of normal underwriting?
(2) Exclusions.
A process that is arguably clearer from a policyholder viewpoint is that of

exclusions. Here the proposer is medically underwritten at the time of
application and information on medical history gathered. The applicant is
accepted at standard premium terms but the policy is endorsed so that
any pre-existing conditions are specifically excluded.
For example, someone with as history of back trouble may have “disorders of
the back and associated conditions” specifically excluded from cover.
6.3 Managing risk
Ways in which medical underwriting can manage risk
Medical underwriting can be used to manage risk in the following ways:
• It can protect an insurance company from anti-selection and in particular

from lives whose health is so seriously impaired that it is impossible to
assess the risk accurately, leading to increasing frequency of claims and
increased average cost of claims.
• The medical underwriting process enables insurers to identify lives with a

substandard health risk for whom special terms must be quoted. A
company may, however, aim to write a large proportion of the business it
accepts at its standard premium rates.

Question 27.10
Explain why an insurer will aim to accept most of its business at standard rates?
• For the substandard risks, the medical underwriting process will identify
the most suitable approach and premium level for the special terms to be
offered.
Question 27.11
What different forms could the special terms for a PMI policy take?
• Adequate risk classification within the underwriting process will help to

ensure that all risks are rated fairly.
The aim should be to create risk groups that are homogeneous in terms of their
expected claims costs. The variation in claims costs within each group should
be smaller than the variation between the risk groups.
• Medical underwriting will help in ensuring that actual morbidity

experience does not depart too far from that assumed in the pricing of the
contracts being sold.
• For larger proposals the medical underwriting process will help to reduce
the risk from over-insurance.
Over-insurance is an issue for the policyholder when the insurer’s indemnity is

limited to a maximum payment (eg an IP policy where payments are limited to
60% of salary before the period of sickness). If a policyholder selects benefits
much greater than this, then some of the insurance is “wasted”, as there is
normally a limit on benefits (a maximum income replacement ratio –
see Chapter 1) to maintain the financial incentive for the insured to return to
work.
The process of checking that the benefits chosen match the insured's
circumstances is often referred to as financial, rather than medical, underwriting.
Question 27.12
Why is over-insurance not usually an issue for PMI policies?

Lives accepted consistently with pricing assumptions
The pricing actuary will establish a pricing structure against particular classes of
risks. Typically he will set a price for all critical illness customers who are aged
34 next birthday, who are female, who are non-smokers and who have no
adverse medical history.
The above is just one example – he will, of course, also set prices for other homogenous
groups of policyholders.
The actuary will use data from various sources, discussed in Chapter 10, to
calculate this price and will make any adjustments necessary to make his
calculations consistent on average with the categories of lives who will pay this
price.
The general idea is that the actuary, given (hopefully) vast volumes of credible, reliable
past data, can use his models and expertise to put together a set of premium rates going
forward, for the what we could call “standard” policyholders.
The actuary will rely on the underwriter, in processing the application forms, to
accept lives in accordance with these principles, ie that each policyholder
should be charged a price consistent with the risk undertaken. This will require
the underwriter to have detailed knowledge of the assumptions used by the
actuary in gathering data and calculating prices, in terms of the expected range
of risks to be insured. The underwriter will also need to demonstrate expertise in
assessing the degree to which any individual proposer, in terms of occupation,
previous medical conditions, family history and other potential claim factor,
represents a risk within the boundaries of the pricing expectations.
The actuary and underwriter will therefore agree a set of guidelines within which a
so-called standard policyholder will fall.
A close working relationship between pricing actuary and underwriter is very

important. Frequently also the reinsurer is on hand to assist both in reaching a
consistent structure for risks assessment and policy acceptance.
Heavier risks declined or loaded
The underwriter’s key responsibility is what to do with risks that do not fall naturally
within this group of standard lives.

When an application is deemed to represent a higher risk than that assumed by

the pricing assumptions, the underwriter still has a number of choices. These
will be a product of company culture and a decision most appropriate to the
particular application. Cases which are considered to bring higher risks than
acceptable at standard rates:
(a) can be offered higher (loaded) premiums
(b) can be deferred (if the period of higher risk is deemed temporary)
(c) can be declined (if the additional risk is thought to be too high)
(d) can be offered a different (less risk intensive) type of policy
(e) can be offered to a reinsurer facultatively with zero retention
(f) can have certain specific perils excluded.
These and other options were discussed in Section 6.1.
Question 27.13
Explain the difference between a moratorium and an exclusion.
The underwriter is attempting to match the risk with the pricing assumptions and
ultimately ensure that a suitable premium is charged.
New business acceptances analysed against expected
The actuary (and underwriter) will look very carefully at the actual level of new
business against that expected, broken down, where possible and credible, into
the various homogeneous risk cells. The reason for any significant departure
will be analysed to see whether this is a feature of the new business acceptance
process. Here the experience of other companies operating in the same lines of
business will be very informative. The discovery of significant differences from
expectation will require either a change to procedures or a change to the pricing
assumptions.
This is covered further in Chapter 28, when we look at monitoring and feedback.
Rated cases compared with standard acceptances
The actuary, after some years’ of experience has been accumulated, will review
the claims accepted under business underwritten on special terms in
comparison with those accepted at standard terms, in order to judge the
appropriateness of the loadings or other adjustments applied. It may well be that
reinsurers’ more voluminous experience can provide valuable and credible input
into this process.

This, in theory at least, becomes possible because as experience grows, what was once
“non-standard” in terms of proposer characteristics becomes a credible volume of
experience that can be rated using standard actuarial techniques.
However, business accepted on non-standard terms is horribly heterogeneous. There

may be enough data to get a feel for whether the level of loadings in the portfolio as a
whole is appropriate, but such an investigation would probably not help at all in
investigating individual rating terms.
It is hard to look at experience on individual rating terms because there is often not
enough properly coded data to do so. Even if in reality the experience is sufficient then
the data quality may not be good enough to allow analysis.
Underwriters involved in product development
The underwriters’ knowledge of new business procedures, their awareness of

the risks presented and their position often at the front line of contact with
distributor and/or customer, give them a significant contribution to make to the
product development process. Additionally, their involvement in the deliberation
of policy conditions and in aspects of the pricing will give them a first hand
understanding of the intentions of the policy and the risks which the premiums
were intended to include.
For example, underwriters could be involved in the development of a Critical Illness

product at the stage when the exact medical conditions covered are put into the policy
wording. Their experience of dealing with unusual conditions (for example, for the
purpose of deciding exclusions) should put them in a good position to know exactly
how certain conditions and exclusions should be worded within the policy.

7 Claims management
The underwriters act as “gatekeepers”, ie deciding at the proposal stage which risks are
allowed through the door.
But just as important is having a gatekeeper at the other end of the policy − the claim
stage. Health and care products can have complex claim conditions, and clearly the
skill of the claims management team will have a big influence on the claims experience
of the insurer.
7.1 Claims admitted in line with policy conditions
A key component of risk management lies in ensuring that the claims accepted
are consistent with the assumptions made when the product was designed and
priced. To this end, the claims management team should be a party to the
process of product development and there should be regular dialogue between
the claims and pricing/design teams.
7.2 Claim conditions compared with admissions at proposal stage
Equally, there should be close liaison between underwriting and claims

managers to ensure that the medical conditions giving rise to a long term care
insurance claim, for example, are consistent with the information provided at the
proposal stage, ie that such health impairments were not present at initial
application, or were explicitly admitted.
The medical investigations required to substantiate a claim can sometimes

contradict the information provided when the policy was taken out. The insurer's
decision will depend on the materiality of the discrepancy and whether there are
attempts to act fraudulently or withhold information.
Every large claim should be investigated, and the information at proposal verified to
ensure that the claim is not fraudulent or subject to non-disclosure. For example,
following an IP claim, a policyholder’s medical practitioner may be contacted to
confirm that the cause of the current illness was not an undisclosed pre-existing
condition at the time of the policy’s inception.

7.3 Product-specific risk management techniques
Specific risk management techniques are found in particular healthcare lines.
Income protection insurance
Replacement ratios
Under income protection insurance, it is deemed necessary to provide a benefit

at such a level that the claimant has an incentive to return to work. Thus, in
many territories, insurers impose policy conditions limiting the amount of benefit
relative to salary at time of disability. These limits are sometimes known as
replacement ratios and can be of the order of two-thirds or a half of gross salary.
Part of the risk control will be thus to require the policyholder to inform the
insurer if for any reason his regular employment income falls. The benefit under
his policy can thus be reviewed and the premium adjusted. The alternative is the
application of these limits only at the claim stage, which will involve a lot more
client dissatisfaction at a time of ill-health when the benefit for which premiums
have been paid is refused.
Question 27.14
Why does the policyholder not have to inform the insurer if his regular employment
income rises?
Disability counselling
Also under income protection insurance, insurers in some territories will often
use disability counselling services at the time that a claim is accepted. This
entails a visit to the home of the beneficiary at the time of commencement of
claim payment, by a specialist representative of the insurer or of a third party
support service. This process is often welcomed by the claimant in that it can
assist with information on state welfare payments and local assistance services.
From the insurer’s point of view, it can help to establish the severity of the
illness and establish a likely date for a return to work.
Another advantage of the insurer getting more actively involved at the claim stage like
this, is to promote the idea of returning to work as soon as is practically and reasonably
possible. This keeps claims costs to a minimum.

Pre-authorisation
Under private medical insurance, the insurer can lose control where treatment is
envisaged, with the claimant’s personal doctor often the only gatekeeper as
regards the medical need for such treatment and its manner of delivery. Some
insurers have put pre-authorisation procedures in place. By such means, claims
can be authenticated against the conditions in the policy and medical need can
be established. Further, the process can attempt to direct the patient into a
service provider or hospital that will be best equipped to handle the treatment (at
a cost acceptable to the insurer). In some territories pre-authorisation of claims
has not been widely accepted by customers because it is deemed to infringe on
their perceived rights to receive treatment where and when they want.
Under pre-authorisation, when a policyholder becomes aware of the need to claim

(eg what the GP refers him for treatment), he should call the insurer to advise them of
his condition, discuss the proposed treatment and check whether it is covered under the
policy. Emergency treatment, where it has not been possible to contact the insurer prior
to treatment, may still be covered automatically subject to the benefit conditions in the
policy.
Question 27.15
What are the main advantages to the insurer of pre-authorisation of claims?

8 Policyholders’ Reasonable Expectations (PRE)
8.1 PRE as additional policy conditions
In most territories where consumer protection is high on the agenda for

regulators, the reasonable expectations of policyholders have become additional
conditions which contracts have to meet. These additional PREs can arise
through the sales process through literature provided and often from generally
accepted provisions that products of a particular genre should encompass.
Question 27.16
(i) List factors affecting PRE.
(ii) List the aspects about which policyholders will have expectations as a result of
these factors.
Any insurer that does not ensure that the reasonable expectations of policyholders are
being met runs the risk that the regulator will take action against it for not meeting its
statutory requirements. For example, it may impose fines or restrictions on the insurer.
Even in countries with no such regulations, policyholders are more likely to lapse (or
complain) if their expectations are not being met.
The risk of not meeting PRE can be mitigated in several ways.
The insurer will avoid promising more than the scope of the product in such
ways, making all product conditions clear and explicit and will accordingly
monitor sales processes.
This monitoring should ensure that customers’ expectations are being kept in line with
what the policies provide.
8.2 Overselling can add to risk
Continued customer satisfaction relies upon the customer having been sold
products which meet needs at a price which the policyholder regards as
reasonable and affordable. An over-rapacious salesman may attempt, in the
short term, to boost his/her own commission but will endanger the whole client
relationship, when at some future date, the customer reviews his/her finances
and identifies that the coverage is surplus to needs. In these circumstances, the
likelihood is a total policy lapse, rather than a reduction in its scope, with
subsequent impact on insurer profits.

It is also possible that this one bad experience will cause the policyholder to lapse other
policies held with the insurer. The policyholder may discuss his experiences with his
partner, friends or colleagues and encourage them either not to deal with this insurer or
to lapse their existing policies too. Bad news spreads fast.
Sales staff must be trained to put the needs of the customer first, on the
understanding that only in this way can contracts be retained (especially true in
the annually renewable environment of private medical insurance) and further
policies sold.

9 Controlling the distribution process

The salesman, whether employed or independent, is the front-line first contact
between the insurer and the customer. In summary, in order to protect the
insurer’s relationship with the client (on whom the insurer is dependent for
receipt of future premiums), the insurer must:
Monitor the sales message
• Ensure the promises made are consistent with the conditions in the
insurance contract.
Beware business churning
• Ensure that salesmen are not encouraging policyholders to lapse policies

with a view to taking out others (with the same or a different insurer) and
thus undergoing a second set of initial charges.
• Ensure that its products offer value when measured against new business
terms.
• Ensure an adequate process of commission clawback.
Commission clawback is a process whereby in the event of a policy lapsing, part

of the commission already paid to the salesperson or intermediary is paid back to
the insurer. This discourages mis-selling and helps to ensure that the customer’s
needs are met.
Analyse the quality of sales staff
• Ensure that the record of sales agents is analysed for volumes written and
for persistency.
• Check for complaints (and plaudits) against each agent.
Capturing this information means that it is essential that your data systems also
capture the “agent code” on each sale.

Beware overgenerous commission
• Ensure that the commission is commensurate with the sales effort.
Question 27.17
Why is this necessary?
• Ensure that the commission is commensurate with the policy loadings

(ie the loading for commission in the premium is consistent with that actually
paid).
• Ensure that the commission levels do not introduce product bias.
• Ensure that the commission does not encourage over-selling.
• Ensure that the commission is matched with clawback controls on early
lapse.
Monitor premium receipts
• Ensure that premiums are received from agents/brokers.

• Ensure that policies are not issued without evidence of premium receipt.
In addition, premiums should be received in a timely manner as the insurer

cannot earn investment income on premiums being held by brokers.
Invest in sales training and literature
• Ensure that salesmen and sales support staff are adequately trained on
sales processes (including the need to elicit customers’ healthcare
insurance needs and their ability to pay).
Many of these sales processes may be recommended or imposed by regulatory

or industry bodies.
• Ensure that salesmen and sales support staff are adequately trained on
products and acceptance procedures, such as medical underwriting
procedures.
• Ensure that literature to support the product and its sale is customer
friendly, clear and appropriate (ie does not over-sell).

10 End of Part 5
Review
review the key areas of Part 5, or maybe re-read the summaries at the end of Chapters
23 to 27.
Assignments


Chapter 27 Summary
Other risk management techniques
Review actual experience against pricing basis:

• covered in next chapter.
Set service level agreements with outsourcers:

• use third parties for their expertise
• ensure the agreement mitigates risk.
Ensure staff are competent:

• monitor in-house operational risk
• audit outsourcers.
Check policy and claims data:

• use regular vetting and spot checks
• have controls on data acceptance
• use compulsory fields
• ensure staff are trained.
Survey levels of customer service satisfaction:

• make sure customers know what has been bought
• make sure it meets their needs
• make sure they receive information as expected
• make sure claims are paid correctly and promptly
• keep customers happy, so that they don’t leave.

Use underwriting to mitigate risk:

• use evidence (medical, lifestyle or financial) collected on each risk to classify
into homogeneous groups so that they can be priced reliably and in line with
pricing assumptions
• deal with heavier risks appropriately, eg premium loading or exclusion clause
• analyse new business acceptances against expected
• have close link between underwriters and product developers.
Short-term policies (eg PMI) use particular types of underwriting. Two common
approaches are moratorium and the exclusion of specific pre-existing conditions.
Claims management control:

• ensure claims are paid in line with policy conditions
• check a claim’s validity with the proposal.
Product-specific controls:
• for income protection, insist on notice of income reductions, and use disability
counselling services
• for private medical insurance, use pre-authorisation procedures.
PRE:
• be aware of PRE, and of the factors influencing PRE
• ensure your sales staff do not oversell products.
Control the distribution process:

• monitor the sales message
• beware of business churning
• analyse the quality of sales staff
• beware of overgenerous commission
• monitor premium receipts
• invest in sales training.

Solution 27.1
The contract agreement or SLA should include details of:

• dates for which the agreement is in force
• who the parties are, who the main contacts are, who is going to carry out the
work and who the ultimate responsibility lies with
• what the third party will provide, including to what level and at what frequency
• payments to be made to the third party (amounts, frequency, methods, any
conditions, etc)
• any other obligations on the insurer’s part
• how, and how often, the standard of service will be monitored
• what action will be taken if service standards are failed (eg penalties)
• cancellation agreements (get-out clauses).
Solution 27.2
The main area is in claims assessment and management:

• initial assessment of validity of a claim, including collection of the required
evidence
• assessment of suitable treatment process
• knowledge of likely inflationary pressures on health claims costs
• knowledge of medical procedures available
• ongoing assessment and management of the claim (for IP, LTCI, PMI).
In addition, expertise will be required in the initial underwriting of policies.

Solution 27.3
Other checks might include:

• reconciliation checks, ie that the data at the previous investigation plus the
business coming onto the books minus the business going off the books equals
the current data
• consistency checks, eg that premiums are consistent with sums insured.
Solution 27.4
The company will probably still be holding quite high reserves for this policy, reflecting
the high expected claim costs over the final five years of the policy relative to the (now
relatively small) remaining premiums to be paid. All else being equal, therefore, the
company would be better off if the policy were to lapse, as the reserve would be
released into surplus (instead of being needed to pay claims).
However, all is not likely to be equal. In particular, it is more likely that the
policyholder who lapses is in good health rather than in poor health. This is particularly
the case here, as the premiums being paid here are far lower than could now be obtained
by taking out a new policy for the remaining five years of cover, so anyone with a
feasible chance of claiming would be likely to keep their policies in force. As a result
of this selection, the company would have been likely to have made a profit from the
policy, if it had continued in force (by paying five more years’ worth of premiums and
not claiming), and so the company is likely to be worse off as a result of the lapse.
Solution 27.5
Poor or ambiguous policy wording can result in disgruntled policyholders, at a time

when they need financial assistance for deteriorating health. In the interests of customer
satisfaction and public relations, it may be beneficial for an insurer to pay the claim
even though strictly speaking it does not have to. Indeed the courts, or supervisory
authorities (such as the financial ombudsman in the UK), may rule that such claims
should be paid, particularly if it can be proved that customer expectations were that such
claims would be paid. In some cases, the insurer may decide to settle claims out of
court, thus avoiding any adverse publicity and/or legal expenses.
Solution 27.6
An embedded value is the expected present value of future profits on existing business.
Usually, the value of any net assets attributable to shareholders is also included in the
embedded value.

Solution 27.7
The benefit from the policy is a regular income, which could continue from the end of
the deferred period until the end of the policy term. If we multiply the weekly benefit
by the maximum number of weeks for which the benefit could be paid, then we will
obtain the maximum sum at risk.
There are several possibilities for obtaining extra medical evidence:

• A questionnaire completed by the doctor who usually treats the proposer. The
doctor would be able to use the proposer’s medical records. This is sometimes
called a primary medical attendant’s report (PMAR).
• A limited medical examination conducted by a nurse.
• A full medical examination conducted by a doctor.
• Special medical tests completed by a nurse or doctor or conducted at a clinic.
The first three items are listed in increasing order of their usual cost. The cost of
medical tests depends on what tests are carried out.
To be effective, the expected decrease in claim costs as a result of a procedure must be

greater than the cost of the procedure. The expected saving will increase with the
effectiveness of the procedure in reducing claim costs, and with the sum at risk.
We can estimate the effectiveness of each procedure, and we will know the cost of each
procedure. Using this information we can determine the sum at risk at which each
procedure would become cost effective. For example, we might use rules like:
Sum at risk Decision

No additional
Up to £100,000
underwriting
£100,000 – £250,000 PMAR
£250,000 – £500,000 Examination by a nurse
More than £500,000 Examination by a doctor
There would usually be a different set of decision rules for proposers of different ages,
with the cut-off sums at risk being lower for older proposers.

Solution 27.8
In general, the questions asked must relate to facts that will be within the proposer’s
knowledge. Matters of opinion, or any questions that might require expert knowledge,
medical or otherwise, are not advisable.
Whether or not a job is dangerous is a matter of opinion, and it might be argued that you
need some expert knowledge about health and safety at work to be able to provide an
answer.
It is perfectly legitimate to ask questions about the nature of a person’s job, but these
must relate to facts within the person’s knowledge.
So we need to decide what aspects of danger are important to us, as an

insurer (eg working at heights, working with dangerous chemicals) and ask directly
about these aspects of the job.
For example, the proposal form could ask:

• Do you work at unprotected heights of over 50 feet?
• Does your job involve travelling by air as a non-fare-paying passenger on
unscheduled flights?
• Does your job involve manual or physical work?
• Does your job involve working offshore (such as oil/gas rig or ship) or travelling
or residing abroad?
Solution 27.9
If underwriting is completed at the time of the proposal, then it is an expense for all
policies. Moratorium underwriting is completed at the time of a claim, so it is only
done for the proportion of policies that result in a claim.

Solution 27.10
The alternative to accepting business at standard rates, ie charging loaded premiums or

imposing special terms, will often cause bad feeling to the applicant and requires
additional administration, and hence expense, for the insurer.
This could be a significant barrier to sales. For example, if brokers are aware that a
large majority of an insurer’s applicants ended up being rated, they would not be keen
to sell that insurer’s products.
Solution 27.11
Possible special terms:

• exclude claims for specified conditions (effectively reducing the benefit to zero)
• charge a higher premium, eg 120% of the standard premium, (often described as
a 20% loading)
• impose an increased policy excess for particular conditions (in effect this is
reducing the benefit payable for those conditions)
• any combination of the above three schemes.
Solution 27.12
PMI seeks to be an indemnity product. It pays for the actual costs of treatment
(sometimes subject to an overriding maximum), so it is not possible for the insured to
buy more insurance than is necessary, at least from one insurance company.
Solution 27.13
A moratorium is an initial period of blanket exclusion for any pre-existing conditions,

the proposer not being medically underwritten unless a claim is made. If no further
treatment is received for these conditions within, say, two years, then the exclusions
may be lifted.
An exclusion is where the proposer is medically underwritten, and the policy when
issued is endorsed so that any conditions from which the prospect has suffered (and any
related conditions linked to these) are specifically excluded.

Solution 27.14
If the level of income rises, then the insurer will not be financially disadvantaged
following a claim, since the benefit actually paid will still be based on the previous
lower salary.
It may, however, be in the policyholder’s interest to tell the company of the increase,
since, assuming he still needs cover, he will want to ensure his replacement ratio is
unchanged (albeit for a higher premium). Normally, though, the cover is pitched at a
level sufficient to ensure all essentials would be met in the event of a claim.
Solution 27.15
Generally, pre-authorisation gives the insurer more control over the claim process. For
example, it may allow it to influence (or force) the choice of treatment provider.
It will ensure that the claimant is aware of exactly what treatment will and will not be
covered by the policy, and so should reduce the likelihood of disputes.
It also gives the insurer early warning of impending claims. This gives better
management information and should improve the accuracy of reserves held.
Solution 27.16
(i) Factors affecting PRE
• literature, advice and illustrations provided at the point of sale

• literature provided before or after the point of sale (eg notices of benefit change,
or marketing literature)
• competitors’ rates, benefits, conditions and processes
• premiums paid
• moral obligations of the insurer
• benefits paid in the past.

(ii) Expectations
• how the policy is sold (eg cooling off periods)

• benefits to be paid
• period of cover and guarantees
• reviewability conditions (ie if premiums and/or benefits are reviewable)
• counselling and post-claim support
• premiums to be paid (and changes thereto in the future)
• customer service (eg 24-hour access to staff)
• claims eligibility and process (including speed of payment)
• documentation (including regular communication)
• complaints and arbitration processes
• ability to make amendments (eg changes in risk)
• security of financial transaction made (eg if sold over the internet) and data
protection.
Solution 27.17
If the two are not consistent, the intermediary will simply sell the products that are
quickest and easiest to sell, thus maximising his commission. This may result in a
business mix not compatible with expectations.




using the course.

ST1-28: Monitoring and feedback into the control cycle Page 1
Chapter 28
Monitoring and feedback into the control cycle
Syllabus objective
(o) Describe the principles by which the experience of a health insurance operation
is used to refocus business planning:
– reasons for monitoring experience
– data required
– analysis of mortality, disability, claim amount, recovery and withdrawal
rates
− analysis of expenses, sales rates and investment experience
– analysis of surplus and profit, cause and effect
– use of results to revise the models used and the underlying assumptions.
0 Introduction
In this chapter we look mainly at how the actuary will complete the control cycle loop:
by monitoring experience in order to check the validity of the assumptions made earlier
in the cycle. If the assumptions are not supported by the experience analyses, then we
may want to revise them or take some alternative action.
Remember from earlier in the course that the decisions taken by the company in the past
are only as good as the models used to formulate them. If the assumptions are not borne
out in practice, then on the basis of up-to-date knowledge, we know that the decisions
taken in the past will not have been the best. Our experience investigations allow us to
revise our assumptions and our models so that the decisions the company takes remain
as “best” as possible, within the practical limitations imposed by the operation of the
business.

Page 2 ST1-28: Monitoring and feedback into the control cycle
As part of the actuarial control cycle, the actuary will periodically review the
experience on the company’s own portfolio of healthcare insurance business.
The management of risk will depend on adequate knowledge of the business in
force and its deviation from expectation in the pricing and subsequent reserving
calculations.
Question 28.1
How often should this periodic review take place?
The experience monitoring for this purpose has two strands:
● First, experience can be investigated directly – for example, we want to

investigate morbidity so we do an investigation of the sort described in Subject
CT4. These “explicit” investigations are described here for new business,
renewals, mortality and morbidity (or other contingencies), claims amounts,
withdrawal rates, expenses, investment returns and sales rates.
Question 28.2
What other areas might be monitored?
This will tell us how much, for example, our actual morbidity differs from our
expected morbidity experience (where the “expected” experience could be the
assumption used in our pricing model, for example). We can refer to this as an
“actual versus expected” investigation.
● Secondly, we can investigate the financial impact of any difference between

actual and expected by performing an analysis of surplus. In other words, while
an “actual versus expected” investigation may tell us that morbidity over the last
three years has been 50% higher “than expected”, the analysis of surplus will tell
us if the 50% higher morbidity has made a big dent in the company’s profits – in
which case remedial action should be taken – or whether it has hardly mattered.
There are other reasons for analysing the experience, which are listed in the next
section.

1 Reasons for monitoring experience

Experience will be monitored so as to:
● update assumptions as to future experience
● monitor any changed trends in experience so as to take corrective actions
● provide management information
● make more informed pricing decisions.
Question 28.3
As actuary to a health and care insurer, in what areas of work would you require
assumptions about future experience?
Question 28.4
What kinds of corrective action might be taken if your investigations identify adverse
trends in experience?
The second and third Core Reading bullets points above are closely linked – one of the
key reasons for providing management information is so that necessary corrective action
can be taken. However, management of an insurance company is not just a reactive
process (responding to adverse experience) but also a pro-active one. Hence, while the
company may not be suffering particularly adverse experience, it may still be able to
identify ways in which it can make its operation more profitable. Therefore it will be
interested as much in its profitable activities as it is in its unprofitable ones.
Thus, by keeping its experience under review, it may be able to identify such things as:
● profitable products
● profitable sales channels or agents
● profitable markets
● efficient sections of the business
● successful investment strategies.

We must bear in mind why the management information is being provided – it is to

allow management to manage the company. This is stating the obvious, but following
on from that we realise that information must be reliable, timely and provided at an
appropriate level of detail, so as to allow management to manage effectively, make the
right decisions and take the right actions.
The design of an investigation is about “fitness for purpose”. We need to design our
investigations so that they produce information of sufficient quality and quantity for
effective decisions to be made. Insufficient information will lead to poor decisions,
whereas more than sufficient information will not improve decisions and will lead to
wasted resources.

2 Data required
The basic requirement is that there is a reasonable volume of stable, consistent
data, from which future experience and trends can be deduced.
By “consistent” here we mean that, when we are comparing the experience of one group
of lives with another, the data we use as a basis for the calculations for each group
should be in a similar form, preferably extracted from the same source, grouped
according to the same criteria and equal in terms of reliability. Examples of inconsistent
data include:
● where “age” for one group is calculated as “calendar year of claim minus
calendar year of birth”, and for another is calculated as “age last birthday at date
of claim”
● where lives counted as smokers in one time period are counted as non-smokers
in another time period, due to a change in the definition of what is meant by
“smoker” and “non-smoker”.
The data ideally need to be divided into sufficiently homogeneous risk groups,
according to the relevant risk factors described below. However, this ideal has
to be balanced against the danger of creating data cells that have too little data
in them to be credible.
The problem with grouping together heterogeneous lives into single cells for analysis, is
that we would not be able to tell whether a change in some observed variable was
genuine or just the result of having a different mix of lives within the cell.
For example, if smokers and non-smokers are not separated, an increase in observed
morbidity rates over time might be just the result of having a greater proportion of
smokers in the more recent data.
So that’s why, ideally, we need to subdivide our data into purely homogeneous
groupings. We will know, then, that the interpretations we make about any observed
changes in experience will be valid.
One of the key decisions in conducting any investigation is the length of the period of
the investigation. In order to have reasonably sized cells, we want the period to be as
long as possible, and normally greater than, say, one year. However, we want to
investigate recent experience, not an average of recent and ancient; so this will place an
upper limit on the length of the period. This upper limit will depend on what we are
investigating; for instance an expense investigation would normally be confined to
twelve months, whereas morbidity investigations would often be based on a three or
four year span.

In practice the level of detail in the classification of the data, therefore, depends
upon the volumes of data available. It would, however, at least be desirable to
separate different classes of contract.

3 Analysis of experience
3.1 Introduction
In this section we consider the various demographic and financial investigations that an
actuary might conduct. These might concern:
● new business rates
● renewal rates
● mortality and sickness rates (and other contingency rates)
● claims amounts
● expenses
● investment returns.
3.2 New business
The analysis of experience will commence with the monitoring of sales against
targets.
The purposes here will be:
(a) To check the strains caused by the volume of new business sold against
the capital set aside for this purpose.
Question 28.5
Define new business strain.
Here, the aim is to ensure that the capital allocated to a line of business is
sufficient to support writing the volume of business sold.
Question 28.6
Explain why even single premium, profitable business could cause a new business
strain.

(b) To check the mix of business in each of the significant homogeneous

cohorts against the mix assumed in the pricing basis.
In fact, a particular mix of business will have been assumed when performing
any of the work in Question 28.3 above. If experience turns out to be different,
some of these analyses may need to be revised.
The effect of a mix of business different from that expected can be substantial.
For example, in PMI, there can be significant cross-subsidy within age-groups,
whereby the young subsidise the old. If this is the case and a health insurer sells
more PMI policies to older people than allowed for in the pricing basis, it may
find that profits suffer as there are not enough younger policyholders to
compensate.
(c) To check the staffing levels in terms of numbers and competence against
those required by the business written.
Too few trained staff can cause major problems for a health insurer selling
policies in volumes greater than that expected.
(d) To check commissions paid against those assumed (where averages

were estimated in the pricing bases).
For example, a different amount of commission paid could indicate a change in

the mix of sales across the different distribution methods. This could in turn
indicate problems with our pricing structure.
3.3 Renewals
Renewals are just as important as new business, for policies where renewal is an option,
such as PMI products.
The actuary will review the lapse experience of the business written. Lapse
rates will be compared with those assumed by region, by policy type and by
distribution channel (by particular agent if numbers permit). Such analyses will
be important from the viewpoints of sales management, commission clawback
and marketing impact. The impact of lapses will be more crucial to profitability,
where the pricing bases have amortised initial costs over a number of years of
renewal.

Short-term products such as PMI do not normally make a profit until the policy has been
with the same company for perhaps two, three or more years. This is because the high
expenses of selling the business in the first place (eg marketing, commission and set-up
costs) are not recouped fully in the first year’s premium.
Question 28.7
Why not?
3.4 Mortality and sickness experience
Subdividing the data
The data would ideally be analysed, where relevant, by:

● type of contract
● age
● sex
● duration from entry (or from start of claim for sickness terminations)
● smoker / non-smoker status
● underwritten status
● source of business
● occupation, or industry for group business
● benefit conditions, for example length of deferred period.
We need to be careful about the length of the period of investigation used. This is for
various reasons. First, we expect mortality and morbidity to change over time due to
advances in medical science, changes in cultural attitudes, improvements in standard of
living, new diseases, etc. This would lead us to consider a period of at most five years
as the basis for the investigation.
Question 28.8
What are the other constraints on the length of the period of an investigation?

In addition, for PMI, the following factors might be considered:

● hospital band
● amount of excess
● NCD level
● geographical location
● size of group (for company contracts).
Question 28.9
What is the deferred period for an IP contract? Why is it relevant?
Question 28.10
What other benefit conditions might there be on an IP contract?
Question 28.11
For an investigation into critical illness claim rates, what factor might it be desirable to
include in the investigation in addition to those listed so far?
The process
The process of analysing experience has been examined in Subject CT4.
Nevertheless, Subject ST1 questions might require you to outline the process.
Question 28.12
Suppose you are analysing the morbidity and mortality experience of a large portfolio of
IP policies. For each homogeneous group, what summary statistics would you calculate
in order to perform an “observed versus expected” type of investigation?

3.5 Claims amount experience
In classes of business where the claim amount is not fixed nor rising according
to an index, the actuarial monitoring of experience will seek to compare the
amounts of claims paid with those expected, subdividing by each risk cell and,
in the case of private medical insurance, by each type of procedure performed.
Question 28.13
State the other health product where cover may be provided on an indemnity basis.
Other areas for analysis will include claim amounts by hospital band, by hospital
chain and possibly down to the level of individual surgeons and other
consultants.
Of key importance here may not be the actual absolute amounts, but the trend
(rate of “inflation”) of claim amount escalation, in relation to a standard
inflationary index, and in relation to any other market information or other
insurers in this class of business.
The trend in claim escalation gives an overall indication of claim cost experience. It is
very important as often the general escalation in costs has a greater effect on the
insurer’s experience in the long term than the day-to-day volatility of claims.
In classes where the sum insured is chosen by the proposer, a special analysis
of incidence, split into broad categories of amounts of sums insured, will be
highly informative in the monitoring of the underwriting function and possibly of
the sales techniques.
For example, an analysis may reveal that sales techniques or underwriting practices are
encouraging anti-selection from policyholders, ie those choosing higher sums insured
have higher claim rates.

3.6 Other factors of importance
Analyse trends
The actuary will use various sources of data to improve the estimation of future
experience. The actuary will use insurance market intelligence and published
population data in addition to that derived from the in-house portfolio in order to
discern trends in buying attitudes and more particularly in the propensity to
claim.
Question 28.14
Describe the advantages and disadvantages of using market data as opposed to that
derived from the in-house portfolio, for the purposes of analysing trends.
Question 28.15
List other sources of data the actuary may use in these investigations.
An example of this is where an accelerating economic downturn may encourage

staff members to “use” the coverage under a group medical expenses policy
prior to the possibility of unemployment. A further example is a government
campaign to encourage breast screening for cancer, which may produce an
upward trend in the number of female critical illness claims.
Disaggregate causes to credible cell level
The actuary will balance the need for subdivision of information into risk cohorts
which are subject to homogeneous risk experience, against the need for
adequate data to produce meaningful results. Own experience will be analysed
initially at a portfolio level, prior to greater subdivision. The actuary will look to
market/population data or reinsurer information on an ongoing basis to provide
insights at a cohort level and analyse the comparative risk levels.
Question 28.16
What are the advantages and disadvantages of using reinsurers’ information?

Compare to market experience
The actuary’s analysis of competitors’ products and processes is a necessary

part of experience monitoring. A competitor’s approach to risk selection in
pricing can present problems when the competitor is subdividing the population
by more rating factors and thus altering the likely population over which the first
company’s business will be averaged; this will amount to cherry-picking of the
better risks and the first company’s experience will deteriorate. It can also
present opportunities where the market has failed to recognise key features of
the risk and thus a more profitable experience can be created by more
appropriate segmentation and pricing.
By offering more “accurate” pricing to customers, an insurer can ensure that it offers
less risky customers cheaper premiums, and is therefore likely to attract a portfolio of
healthy lives. The more risky customers will be put off by the more expensive
premiums and instead go to an insurer that does not differentiate between customers
using more detailed rating factors.
Similar strategies can be devised by examining the market’s approach to

accepting risks by looking at their underwriting methodologies.
The competitors’ underwriting methodologies will indicate the ways in which they
classify applicants for the purpose of deciding on the premium to charge in each case.
The actuary will need to understand whether the risks contained in his or her
own portfolio of policyholders are inherently different from those of competitors
before drawing conclusions. Such differences can arise through differences in
product features, in sales methods, in regional representation and in
underwriting stance.
For example, an insurer may be covering a large number of risks in a part of the country
where medical care is very expensive compared to the rest of the country. If
competitors are not in the same position, then the insurer should expect its claims
experience to be very different from that of its competitors.
Competitors’ performance
The actuary will keep a close eye on what competitors are doing in terms of risk
selection, policy coverage, pricing, volumes of business written (if available) and
methods of distribution.
For example, you may be at a significant disadvantage if your competitors are all
offering health cover over the internet and you are not, and so you need to keep an eye
on what they are doing.

3.7 Withdrawal experience
The factors by which the data could be analysed – in rough order of importance
(though there will be some variation by type of contract) – are:
1 Type of contract – long-term insurance policies have different withdrawal

rates from private medical (general insurance) contracts, for example, as
the policyholder loses little on withdrawing from the latter and may find
his premium increasing discouragingly at renewal.
Question 28.17
What does a PMI policyholder lose on withdrawal?
2 Duration in force – withdrawal rates are generally higher near the start of
a contract.
This is because a new policy is scrutinised carefully by the policyholder to assess

its suitability. It may be that, after all, the policy does not meet the customer’s
needs.
3 Sales method used and target market – the degree of care taken in
ensuring that a suitable product is sold may depend on the sales method
and target market. The more suitable the product the lower will usually
be the withdrawal experience.
4 Frequency and size of premium – with monthly premiums there are more
opportunities to withdraw than if premiums are annual. A high premium
relative to income will be harder to afford than a smaller one, but a small
one may not be considered worthwhile continuing with.
5 Premium payment method – premiums paid in cash are more noticeable

than premiums paid directly from a bank account and so lead to higher
withdrawal rates.
6 Original term of contract.
For example, a longer-term contract is more of a commitment and so may attract

higher withdrawal rates.
7 Sex and age – experience tends to be worse for females and for younger
ages.

8 Claims experience/NCD level for PMI contracts.
Policyholders with good claims records (eg never claimed) are more likely to
lapse than those who claim frequently.
Note that these are the factors by which withdrawal experience could be analysed. In
practice, often only the first three factors will be considered, so that you do not end up
with a large number of almost empty cells.
The fourth and fifth points are not necessarily independent. For example, annual
premiums are more often paid in cash than monthly premiums, which are often paid
directly from a bank account. Hence, annual premiums are usually more noticeable than
monthly premiums for two reasons: being in cash and being large amounts. Withdrawal
experience is likely to be higher on both counts.
Question 28.18
How would you expect withdrawal rates to compare for the following sales methods?
● broker
● direct sales force
● direct marketing telephone sales in response to newspaper advertising.
Withdrawal rates in the future are also affected amongst other things by:
● the current economic situation
● the competitive situation of the product
● the perceived value of the product to the customer
but these would not usually be allowed for in an analysis of past experience.
Future experience is mentioned here because all we are doing is using past experience as
a starting point for making assumptions about the future. In using the results of a
withdrawal investigation to set parameters for pricing and model office work, the
actuary should bear in mind the effect of any changes in the economic situation – which
is volatile and unpredictable – or in the competitive situation of the company’s products.
The estimates based on experience would usually be projected before use.

The process
For each homogeneous group being analysed, withdrawal rates can be

determined as follows.
The number of contracts issued in the company’s last financial year is divided
into the corresponding number that survive until the first policy anniversary in
force to give a first year persistency rate. The first year withdrawal rate can be
determined as one less the persistency rate.
A similar procedure can be adopted to obtain the second year, third year, etc
withdrawal rates, by looking at the number surviving from the number of
contracts, in each group, that have their first, second, etc policy anniversary in
the last financial year.
The calculations should be adjusted to exclude the effects of deaths and

maturities, where these are material.
The above procedure will give correct answers, but by virtue of its rigour will involve
some delay in obtaining the information.
Question 28.19
What is the possible delay if the above calculation procedure is used?
Given that one of the reasons for analysing withdrawal rates is to indicate potential
problem areas where management action might be required, the time delay renders the
information less useful for this purpose. So it might be necessary to try to measure
withdrawal rates approximately using a much quicker method.
For example, one expedient would be to look at persistency over the most recent quarter
of a year period. By measuring persistency over this period of all policies that are in
their first policy year, the first year persistency of policies can be estimated; in this way,
the company has some information perhaps six months from the start date of the interval
considered. For a new product launch, even a not-very-accurate estimate of persistency
over the first quarter of a year following the launch might be valuable information,
particularly if there are significant sales costs which require a substantial policy term to
fully recoup them (as is often the case with direct marketing policies).

If reaction time is not a factor then the correct approach is clearly preferable. As the
results are examined, it will be clear that for some groups there is little difference. For
example, there may be little difference in the withdrawal rates at durations twelve years
and thirteen years. Intuitively a difference would not be expected. For some groups the
differences emerging might be the result of large standard errors in the estimates
stemming from small cell sizes (eg withdrawal rates for eighty-six year old
policyholders). As a result of these considerations, the actuary would regroup the data
and recalculate withdrawal rates for broader groups.
An alternative approach is to use the methods described in Subject CT4, and divide a
suitably categorised withdrawal count by an appropriate corresponding central exposed
to risk. The central exposed to risk would require similar data for each policy to those
required for a mortality investigation (though the policies would probably be grouped
differently), and so this approach might be relatively easy to perform alongside the
company’s mortality (or morbidity) analysis.
After having finished this investigation with as much disaggregation as possible

(ie regrouping to avoid spuriously small groups), the presentation of results for
management information purposes would probably require further consolidation
depending on the level of management involved. For instance, senior management
would probably want results split by broad product class, not by every product.
3.8 Expense experience
One way to think of an expense analysis is to consider what the required outcomes of
the process are. The required outcomes will depend on the purpose of the investigation.
An analysis of expenses is mainly concerned with the allocation of expenses

correctly between the different classes and rating groups in the portfolio. This
enables the insurer to measure the past performance of each insurance class
and to quantify the different elements of expenses that should be allowed for in
any future premium-rating exercise. In addition, expense analysis will also form
an important input into any financial plans that the insurer is developing.
The expenses incurred in writing the class of business, in its administration and
in the payment of claims will be compared against the assumptions in the
pricing basis. Revisions to expense allocations can then be made where
appropriate.
For some purposes it may simply be sufficient to know the expenses in total. For
example a company can calculate its total profit over a year without performing a
detailed expense analysis.

However, for other purposes this would be completely inadequate. For example, for
pricing and reserving it is essential that you establish a policy’s fair share of the
company’s costs, so that the correct premiums or charges can be levied.
Ultimately, the expenses are a function of the work that the company does –
administering a portfolio of health insurance policies. If you want to project the
company’s future expected expenses, then you will need to determine the relationship
between the company’s business – the policies it sells and maintains in force – and the
expenses incurred in doing so.
In most of these cases, therefore, the main idea is that you want to be able to attribute
the historical expenses to each policy that the company had on its books over the period
during which the expenses were incurred. In other words, to estimate what was policy
X’s fair share of the company’s actual expenses over (say) calendar year Y.
But we need to be more sophisticated than this, in order to avoid significant model error
at the modelling stage. For example, we need to identify a policy’s share of the initial
expenses separately from its renewal expenses. This is vital, for example, in order to
estimate the likely capital strains of writing new business and therefore how much
business you can afford to write.
Similar arguments lead to the conclusion that we need each policy’s share of the
expenses to be subdivided as follows:
● expenses relating to new business
● expenses relating to existing business
● expenses relating to terminations (eg deaths and lapses − and possibly for each
of these separately)
● expenses relating to paying claims (eg sickness)
● expenses relating to investment management.
And for each of the first three categories we need to identify whether the expenses are:
● proportionate to the premium payable under the policy
● proportionate to the benefit level (eg monthly income benefit) under the policy
● fixed amounts per policy.

Example
Suppose the historical expenses over one year for a portfolio of CI policies are as
follows (arbitrary units):
New business Existing Terminations
Per premium 500 1,000 0
Per sum assured 100 0 750
Per policy 200 5,000 250
Define:
P(new) = total new annual premiums received during year
P(exist) = total premiums received from existing policies during year
S(new) = total sums assured under policies issued during year
S(term) = total sums assured under policies terminating during year
N(new) = total number of new policies issued during year
N(exist) = average number of policies in force (excluding new business) during year
N(term) = total number of policy terminations during year
Then we would calculate a policy’s share as:
500
Initial expenses = per unit premium
P(new)
100
+ per unit sum assured
S (new)
200
+ per policy
N (new)

1, 000
Renewal expenses = per unit premium
P(exist )
5,000
+ per policy
N (exist )
750
and termination expenses = per unit sum assured
S (term)
250
+ per policy
N (term)
After suitable adjustment for expected future changes to the experience, we could now
use these results as assumptions in our projection models.
You will notice in the above example that we have described the amounts as all relating
to a particular product line. Whether or not you subdivide your expense experience by
product line, or by some other classification, depends on the nature of your business
(and in particular, whether the expense contribution differs significantly between
categories and whether the volume or quality of the data justify it).
An important consideration for an expense investigation is the length of the period of

the investigation.
Question 28.20
What period would you expect to use for an expense investigation?

The other important consideration in an expense analysis is the subdivision between

direct and overhead expenses.
In theory, the expenses of an insurance company can be divided into:

● direct – the expenses that depend on either the volume of new business
or the level of in-force business
● overheads – the balance of the expenses, ie those that relate to general
management and service departments which are not directly involved in
new business or policy maintenance activities and which are insensitive
to either the volume of new business or the level of in-force business.
In practice, there is not a clear dividing line between these two categories.
In analysing historical data, you therefore need to consider what should be regarded as
direct expenses and what as overhead expenses. In practice, nearly all of the overhead
expenses can be considered as per policy, while the direct expenses fall into all three
groups. This means that the per premium and per sum assured categories are (very
broadly) 100% direct expenses, while the per policy expenses are a mix between
overhead and direct. Remember that for some modelling purposes, particularly those
involving full model office projections, it is important to model the overhead expenses
as a global assumption (ie they should be modelled independently of the number of
policies in force).
Summary: subdividing expense data
The Core Reading provides a summary of what we are trying to achieve in an expense
investigation.
To begin with, commission is normally excluded from the expenses on the basis
that its format is known and can be added in later by a formula approach.
While we haven’t mentioned this before, it should be obvious, as this is one of the few
items of future experience which is known with certainty. Commission can therefore be
loaded for explicitly in the pricing basis (as a proportion of premium or however it is
actually paid), so that past commission costs are actually irrelevant. The expense
investigation proper is therefore concerned with an analysis of the non-commission
expenses only.

For the purpose of an expense analysis, the non-commission expenses can then
be split into:
● initial expenses, which arise at the start of the policy term
● renewal expenses, which arise regularly during the policy term
● termination expenses, which arise when the policy terminates
● claims expenses, which are incurred in the paying of benefits
● investment expenses, which relate to the management of the company’s
assets.
Each of the first three can be further split according to whether the expense is
proportional to:
● the number of contracts written or in force
● the amount of benefit written or in force
● the amount of premium written or in force.
It is found in practice that most of these expenses are proportional to the

number of contracts written or in force. Exceptions include:
● marketing expenses – typically related to the amount of initial
commission paid
● underwriting expenses – mainly related to size of benefit
● sickness and long-term care claim costs – typically related to the size of
benefit.
Question 28.21
Explain the justification for the factors that drive the last three types of expenses.
Expenses will need to be split down and analysed into the required “cells”.
Typically the cells may be:
● the whole business of the insurer
● the whole business of a particular accounting fund; or
● each main product line of the insurer
and these may be further sub-divided between regular and single premium
business.
The choice of cells will vary across offices depending upon the types and
volumes of business written and what are the requirements of the analysis. The
cells chosen should not be so small that the analysis becomes unreliable.

The process
The next stage is to consider how to split the company’s various expense items into the
subdivisions we require. Commission, as mentioned above, is easy to do. Other than
commission, the main items of expense are:
● salaries and salary-related expenses
● property costs (rent, property taxes, heating, lighting and cleaning)
● computer costs
● investment costs (investment department, stamp duty, commission, etc).
(Stamp duty is a form of tax found in the UK that may be incurred on certain investment
transactions. Similar taxes might be found in other countries.)
There is no definitive approach to splitting these. One possible approach

follows.
Salaries and salary-related expenses
These will be the major expense of a health and care insurance company.
A large part of the expenses are staff-related, owing to the labour-intensive

nature of administering the business. In the short term, much of this may
remain fixed in real terms. In the longer term staff costs (and accommodation
costs) will vary to meet changing levels of new and existing business and
changes in services provided and the degree of automation used to provide
those services.
Staff can be split into three groups:

(i) staff whose work comes entirely within a single cell of the analysis
(ii) staff whose work comes within more than one cell
(iii) other staff.
In the approach described here, we are treating all expenses which can be directly
attributed to a particular product line as direct expenses. Hence categories (i) and (ii)
will be 100% direct, while category (iii) will be partly direct and partly (in some cases
100%) overhead. But, as we said earlier, this is not the only possible view you can take
about the split between direct and overhead expenses: expense allocation is not an exact
science.

The salaries etc of staff in (i) can be directly allocated to the appropriate cell.
An example of a single cell would be “the initial expenses of product X which are
proportionate to the sum assured”, and an example of the staff whose costs you might
attribute to this cell might be certain members of the company’s underwriting
department. However, if the analysis involves cells for every product then it is likely
that there will not be any category (i) staff, because it is rare for staff to be dedicated to
individual products.
For group (ii), staff time-sheets can be used to split their salaries etc between
the appropriate cells.
Example
An administration department services two products. A staff member, who cost the
company £30,000 in salary, pension and other benefits over the previous calendar year,
recorded her activities over the same period as:
Product X Product Y
Initial: 30% 40%
Renewal: 20% 10%
Termination: 0 0
The amounts to be attributed as expenses from this person would then be:
Product X Product Y
Initial: £9,000 £12,000
Renewal: £6,000 £3,000
Termination: 0 0
The work of the group (iii) staff will straddle both overheads and direct
expenses. The split between the two is likely to be made pragmatically. The
direct part can be split further in proportion to the overall split of the group (i)
and (ii) staff.

For instance, some such staff – such as the company’s catering staff – would be entirely
overhead. Other group (iii) staff might spend some of their time identifiably involved
with some of the cells. For example, a computer support department might find that
some of their work, such as repairing a crashed quotes system, was clearly “new
business”, while other work, such as switching on the Managing Director’s PC, would
not be classified as a direct expense, and so must be treated as an overhead.
Having dealt with the direct part of group (iii), how do we deal with the overhead
component? The key word here is pragmatically. There is no rigorously right or wrong
method here, and different companies will take different approaches. Common
approaches include:
● splitting them down in proportion to the direct expenses already identified
● splitting them in proportion to expense charges from the policies (as it should be
easy to calculate total initial expense charges, renewal charges, etc)
● splitting them down in proportion to something else! For instance, in proportion
to the number of “new business” / “renewal” etc staff they serve, if we are
talking about a department such as catering or PC support.
Question 28.22
In which of groups (i) to (iii) would you place the following staff? For group (iii) staff,
indicate if they are entirely overhead or mixed overhead / direct.
(a) staff in the valuation area
(b) staff in the secretarial pool
(c) an actuary doing an expense investigation.
Property costs
If the company owns, as an asset in its long-term fund, any of the buildings it
occupies, a notional rent needs to be charged to the relevant departments.
This is because, as an asset of the long-term fund, the property ought to be earning a
return (rental income) from its tenant. However, owner occupation means that no such
rental is forthcoming, so that occupation has the effect of costing the company the
annual rental that it could have earned if the property were let. This is the “notional
rent”: it is an expense to the company, we need the policy expense loadings to cover it,
and it must therefore be included in the expense analysis.

Of course, if the company actually rents its office buildings, it would have a real rental
cost for each year: the treatment of actual or notional rent in the analysis would be the
same.
“Long-term fund” is the normal term given to the policyholders’ fund in the UK.
However, the same concept of charging a notional rent applies whether the property is
owned within a policyholders’ fund or as part of the shareholders’ assets.
This rent, plus property taxes, heating costs etc, can be split, for example, by
floor space occupied, between departments and then allocated in proportion to
salaries. So once property and associated expenses have been allocated to departments,
they can then be allocated to cells in the same proportion as staff expenses in that
department. As with the allocation of any overheads, this is not the only way of doing
the allocation, just one sensible and pragmatic solution.
Computer costs
The cost of purchasing a new computer could be amortised over its useful
lifetime and then added to the ongoing computer costs. These can then be
allocated according to computer usage.
Most computer usage should be readily identifiable as belonging to one of the cells. For
instance, valuation runs would be a renewal expense while quote calculations would be
new business. Some expenses, eg a company’s internal electronic mail system, would
not be readily identifiable and would have to be split between the cells pragmatically –
perhaps in proportion to the other (known) computer costs, or allocated to departments
in proportion to staff numbers and from there to cells.
Investment costs
These would be directly allocated to investment expenses and hence allowed for
in assessing the investment return to use for pricing etc.
The common approach for the allocation of investment expenses is to represent them as
a reduction in yield. So, in doing a profit test for example, initial, renewal, claim and
termination expenses would be modelled explicitly and investment expenses would be
included implicitly via a lower yield. In profit testing and model office work,
investment expenses could be modelled explicitly if required (as a percentage of
reserves), but the yield reduction approach may be better when an “equating present
values” formula is being used for pricing.

Question 28.23
What other reasons are there for including investment expenses as a reduction in yield?
One-off capital costs (other than purchase of a new computer)
The expenses analysed exclude large one-off capital costs, which need to be
amortised over the expected useful lifetime of the item purchased. The
amortised cost may then simply be treated as part of the overheads.
If the item can be treated as an asset in the long-term fund, eg a new head-office
building, the cost would not be amortised, instead a charge, eg a notional rent,
would usually be made.
Exceptional items, which are not likely to recur, would be excluded completely
from the analysis.
Question 28.24
Why would we exclude exceptional items from the analysis?
Summary: the process
We start by knowing the expenses, such as salary costs, computer costs, etc.
We know commission, so this can be excluded from the analysis.
We then need to subdivide the non-commission costs into the required “cells” – ie into
initial, renewal, termination, claim and investment, and whether related to per policy,
premium, or sum assured.
Some expenses can be allocated directly to a particular cell.
Staff expenses may need to be subdivided between cells by the use of timesheets.
Overhead expenses need to be allocated pragmatically, eg in proportion to the split in

direct expenses.
Property expenses can be allowed for by charging a notional rent to each department in
proportion to the floor space occupied, then allocated to the different cells in proportion
to the department’s salary costs.

Costs of new computer equipment can be spread over their future expected lifetimes and
then allocated to departments in proportion to usage.
Investment costs would be subdivided by asset class and usually allowed for by a
reduction in yield for each class.
One-off capital costs would be spread over the expected future lifetime of the item, then
just treated as an overhead.
Exceptional expense items may be ignored in the analysis, but their future incidence
may be allowed for in margins in the future expense assumptions or risk discount rate.
Having now reached the end of the expense investigation, it would be normal to
reconcile the results (summing expenses for new, in-force and terminated policies over
all policies) with the total expenses in the published accounts.
Question 28.25
What other checks could we make at this stage?
3.9 Investment experience
A company will want to assess the return it is achieving on its investments. The
methods to use to do this are examined in Subject CA1 and in other areas of the
syllabus.
The calculated rate of return on assets is a function of the method used to value the
assets.
An approximate formula for the rate of return over the time period [t , t + 1] might be:
At +1 - ( At + CFt )
it =
At + 12 CFt
where:
At = value of assets at time t
CFt = amount of net positive cash flow over [t , t + 1]
I t = investment income over [t , t + 1] = At +1 + At - CFt

This means that, for example, a market value basis for At and At +1 will lead to all
realised and unrealised gains being included in it , whereas a book value of At and At +1
will lead only to realised gains being included.
Which basis you use for measuring your actual investment return will depend on your
purpose. For example, if you wished to compare the investment performance of two
different unit fund links, you would use market values.
The experience is likely to be analysed by main asset types and may be done
both gross and net of investment expenses.

4 The analysis of surplus/profit

A company will want to analyse the surplus, for example on its supervisory
basis, arising over a year in order to:
● show the financial effect of divergences between the valuation
assumptions and the actual experience, exposing which assumptions are
the more financially significant
● show the financial effect of writing new business
● provide a check on the valuation data and process, if carried out
independently
● to identify non-recurring components of surplus, thus enabling
appropriate decisions to be made about the distribution of surplus to
with-profits policyholders so entitled or shareholders
● to give information on trends in the experience of the company.
4.1 Valuation surplus arising
Question 28.26
Define the surplus arising over a year.
An analysis of surplus is a breakdown of the surplus arising over a year into elements
such as “surplus arising attributable to investment return experience exceeding valuation
expectation”.
Question 28.27
What other contributors to surplus (or loss) might you expect to see in an analysis of
surplus?
You are not required to do an analysis of surplus for the Subject ST1 exam. However,
you should know the uses of the analysis, and your understanding of the financial
dynamics of an insurer could be tested by questions relating to the surplus.
In any question on surpluses arising you should always consider whether the valuation
basis involved is statutory or not. This can affect what you might expect to see in the
analysis.
We now examine the five uses of analyses of surplus listed in the Core Reading.

4.2 The financial effect of A v E
As experience differs from the assumptions in the valuation basis, a surplus or loss will
arise. For instance, looking at critical illness, the morbidity surplus / loss will be
expected morbidity strain – actual morbidity strain
where
expected morbidity strain = expected morbidity × (sum insured – reserves)
actual morbidity strain = actual morbidity × (sum insured – reserves)
(We are ignoring expenses, the effect of premiums not being paid after claim, and the
effect of interest for part of the year.)
For the elements interest, mortality, morbidity, expenses, medical care costs and
withdrawals, the analysis of surplus tells us:
● if actual experience has been better or worse than expected, and
● the financial impact of this variation.
By definition, the prudence of the valuation assumptions means that, in any analysis of
surplus on the supervisory basis, we should always expect to see a surplus. So alarm
bells should start to ring if any item is negative. But we might be doing the analysis on
some internal realistic basis. What surplus do we expect to see, and how does the actual
result compare with that?
For instance, again looking at morbidity, we would in effect be comparing

● a realistic morbidity expectation, and
● the actual morbidity.
So we would expect to see negatives just as often as positives, especially if the portfolio
of business is fairly small. A negative result is not in itself a big worry, but would be if
it were very large, or were to be repeated year after year.
Question 28.28
What action might you take if the surplus arising from a particular source is less than
expected?

4.3 The financial effect of writing new business
One of the more interesting influences on surplus is new business.
Question 28.29
How would you expect surplus on a supervisory basis to be affected by writing new
business?
Question 28.30
How would your answer to the above question change if we were using a realistic basis?
4.4 Valuation check
If we derive the analysis of surplus components from scratch (rather than working
backwards from the valuation result), and they total to give the surplus arising then we
have performed a valuable check on the valuation process. Even if the analysis is not
done with completely independent data, it can still highlight errors, and so it has a useful
checking function.
4.5 Information on trends
Just as the mortality and withdrawal investigations described earlier would normally be
done over a period of several years, so too the valuation surplus investigations will
normally be most useful when we look at several consecutive years’ investigations
together.
This will allow us to see any significant trends that are emerging, for instance a gradual
increase in withdrawal surplus.
Question 28.31
What is the other advantage of looking at the results over several years?

4.6 Analysis of embedded value profit
A company may analyse the change over a year in its embedded value, that is
the present value of the expected profit from its existing business.
The embedded value is the present value of expected profits from existing business, plus
the free assets attributable to shareholders. The Core Reading here is taking the free
assets to be implicit in those expected profits.
This will allow the company to:

● validate the calculations, assumptions and data used
● reconcile the values for successive years
● provide detailed information for publication in the company’s accounts or
those of any parent company, in particular the value of new business
taken on by the company.
Validation of calculations, assumptions and data
The key here is the validation of assumptions. It is common to use the same
assumptions for embedded value work as for pricing (other than the risk discount rate
which is often set higher for pricing to take account of the extra risks involved in
acquiring business). It is crucial that the assumptions used in product pricing be valid,
and their continuing validity can be monitored by the analysis of embedded value
movement.
Reconciliation of successive years’ values
Due to the complexity of the models used to determine embedded values, and all of the
other opportunities for error to creep in (for instance, insufficiently representative model
points), it is essential to check the results thoroughly. One of the best ways of doing this
is to reconcile the embedded value with the previous result, ie to identify in an analysis
every contribution to the movement in embedded value. So we are really talking about a
very detailed check here, which will in turn validate the calculations and data.
The details of how the surplus arising and the change in embedded value can be
analysed will not be examined in this Subject, but in the relevant Specialist
Applications subject.

Management information
The sort of management information that an analysis of embedded value movement will
give is:
● the value of new business written, normally by product
● the amount of any expense profit or loss
● the amount of any morbidity (or other transition) profit or loss
● the amount of any withdrawal profit or loss
● the impact of free assets on embedded value growth (ie is spare capital being
used efficiently, or is it just sitting around earning market yields and hence
reducing the overall return achieved by the company?)
● the impact of supervisory solvency capital requirements on the rate of return
achieved.
Question 28.32
What use are these expense, transition and withdrawal profits given that we already
know them from the analysis of supervisory surplus?
Information for accounts
In some countries, it has become common practice for proprietary companies to publish
the embedded value in their accounts.
Question 28.33
What is the purpose of adding embedded value information to published accounts?
Where this is so, companies may also want to highlight the changes in embedded value
from one year to the next. This information will allow shareholders and financial
analysts to see what the real drivers of the company’s profitability are.

5 Using the results

We now consider how the results of all these investigations can be fed back into the
Control Cycle.
The results of analysing the experience, the surplus arising and the change in
the embedded value will be used by the actuary to reassess his or her view of
the future with regard to the company. This may result in changes to the
assumptions or models used for pricing or reserving.
Thus, we go around the Control Cycle loop. This will be repeated continually.
The experience analysis will point the way to controlling risks in a number of
different areas:
(a) improving the pricing basis
For example, a deterioration in morbidity experience generally could be

mitigated by raising premium rates in the future (for new business only, unless
premiums on existing policies are reviewable).
(b) establishing/revising the reserving basis
The reserving basis will normally be based loosely on past experience, subject to
other constraints such as regulations. However, regular changes to the reserving
basis every year are not the aim, as it makes year-on-year comparisons of
reserving strength difficult to quantify.
(c) changing/improving the marketing message
For example, an analysis that shows poor new business volumes in one particular
product may indicate that the advertising spend should be reviewed or that the
product should be marketed in a different way.
(d) revising sales procedures in terms of training and selection of

distributors, wording and format of literature and the mechanics of
commission payments and clawback
Monitoring cashflows may indicate, for example, that one particular broker has a
poor administrative process resulting in lengthy delays in premium receipt. A
tightening of the premium collection procedures might help in this case.

(e) providing for the adequacy of staffing (numbers and competence)
The obvious example here is a rapid increase in new business increasing the
number of staff required in a particular area or product.
(f) revising underwriting processes
(g) revising claims handling processes
(h) altering the capital allocation methodology
Question 28.34
Give an example of how experience may lead to an alteration of capital allocation

methodology.
(i) improving the systems and data recording processes
(j) rewording of policy contracts to remove hidden mistakes in policy design

which have surfaced.
This last example is particularly prevalent in health insurance, for example in CI

policies where the conditions covered by a particular contract are not as clear-cut
as was originally intended.
In essence, this is an iterative process. The actuary is trying to estimate how the
company will progress in the future, based on what has happened in the past.
As time goes by, the actuary will have more information and the assumptions
and models resulting from this should, in an idealised sense, get closer to what
will actually happen. Given that actuaries are not fortune-tellers, however, they
will never exactly predict the future.
Although assumptions should gradually home in on reality in the case of a static world,
in the real world the ever-changing nature of actual experience will prevent the actuary’s
assumptions from getting really close to reality. Thus our assumptions will normally
need to contain margins to allow for model error.

6 End of Part 6
Review
the key areas of Part 6, or maybe re-read the summary at the end of Chapter 28.
Assignments
End of the course
This is also the end of the course (since you should already have mastered the
Glossary!). You should therefore now start your revision. This should include all of the
following:
• re-reading all chapter summaries

• re-reading all the Core Reading, including the Glossary
• looking at each Syllabus item
• doing all the questions in the Q&A Bank
• doing the Mock exam and having it marked
● looking at all the old Subject ST1 exam papers, including the specimen paper –
use them as further mock exams, and mark them yourself using the examiners’
reports or the ST1 ASET (we recommend that you refer to both, as there are
often valid alternative solutions to any particular question)
• reviewing old assignments
● looking at old Subject 302, Subject 303 and Subject 105 past papers, and
attempting questions relevant to this subject.
Good luck!


Chapter 28 Summary

● update assumptions about future experience
● monitor any adverse trends in experience so as to take corrective actions
● make better informed pricing decisions.
A reasonable volume of stable consistent data will be required for experience

investigations, preferably of sufficient size to allow credible analysis down to the level
of broad product groups split by statistically important risk factors.
Experience investigations would include:

● new business and renewal rates
● mortality, sickness and other contingencies
● claims amounts
● expenses
● investment return.
New business analyses
The purposes of these are to check:

● new business strain
● business mix against that assumed in the pricing basis
● adequacy of staffing levels
● commissions paid against those assumed.

Expense investigations
Expense investigations aim to convert known total costs such as salaries, systems etc
into initial, renewal, termination and investment costs per policy. The allocation will
need to assume that some policy costs are independent of policy premium size, some
vary by premium size and some vary by benefit size. Many assumptions, some rather
arbitrary and pragmatic, will be needed in allocating costs down to cells. (See also the
two intermediate summaries in the course notes.)
Other sources of information
Important and useful information on experience can also be obtained from analyses of
valuation surplus, and analyses of embedded value movement.
Analysing trends can improve the estimates obtained from experience analyses.
Analysing market experience and competitor activity is important.

Solution 28.1
It depends on a number of factors, predominantly the class of business and the

parameter of experience being monitored. For example, there’s little point in analysing
long-term care claim rate experience more frequently than annually, because these rates
do not change that quickly over time. On the other hand, it might be an idea to monitor
expense experience under any new product quarterly or even more frequently, because
the experience will be more volatile.
Solution 28.2
● cancellation rates
● option take-up rates
● significance of any guarantees
● NTUs – Not-Taken-Up policies, ie policies issued but cancelled during the
cooling-off period (period during which the policyholder has a right to cancel at
the start of the policy without obligation)
● sales appointments made/executed
● investment returns
● reinsurance performance and price
● solvency levels
● levels of customer satisfaction
● competition
● regulation and fiscal changes.
Solution 28.3
Assumptions as to future experience will be required for:

● model office work (which will include embedded value work, profitability
monitoring, financial projections, asset/liability modelling for help in setting
investment strategy, determination of reinsurance requirements)
● product pricing
● valuations
● setting discontinuance terms.

Solution 28.4
The corrective actions that might be taken include:

● re-pricing of products
● re-design of products
● change the investment strategy
● change the sales strategy – eg which products are marketed through which
distribution channel; change the sales reward (eg commission) structures; etc
● change the reinsurance strategy
● change the underwriting strategy
● change the profit distribution strategy – eg to shareholders
● re-organise the workforce and IT systems to make more efficient use of
expensive resources.
In order for appropriate action to be taken, it is therefore imperative that the company
understands the reasons for any adverse trends in the experience.
Solution 28.5
New business strain is deemed to occur when the cost of setting up a reserve on a
statutory basis at the start of a contract is greater than the available funds (asset share) at
that time.
Solution 28.6
If the reserving basis at time zero is sufficiently strong (which is particularly possible
when reserving for statutory reasons), then the capital required may be more than the
asset share (ie the premium less initial expenses) at time zero. In these cases, we have a
new business strain.
Solution 28.7
Because the initial premium would be too high and uncompetitive. Instead, the high
initial costs are recouped over the years that the policy is renewed, by keeping premiums
level throughout (all else being equal). If a policy is not renewed for enough years, that
policy will, overall, cause the insurer to make a loss.

Solution 28.8
The period needs to be large enough to ensure that there is a sizeable amount of data,
and that seasonal influences do not affect the data. For instance a study of pensioners’
morbidity over a hard winter would give rather misleading results.
However, the period of investigation should not be too great, because we want to be
able to act as quickly as possible on any recent changes in experience, in particular as
regards product pricing. Thus looking at an investigation based on the last five years of
data, for instance, will imply a reaction time three years slower than if we were to use
just two years of data.
The length of period is therefore influenced by the rate at which experience changes in
the insured population.
Solution 28.9
The deferred period is the length of time that the policyholder must wait after becoming
ill before benefit payment starts. When set to a low level, for instance 4 weeks is
common, it serves to reduce trivial claims. As it increases, the types of illness/condition
which trigger it will change dramatically. For instance a badly broken leg might trigger
benefit payment with a four week deferred period, but it would not trigger benefits if the
deferred period were 26 weeks (as the leg should have healed by then). Hence
morbidity experience will differ significantly by the length of the deferred period on the
policy, being heavier for policies with the shortest deferred period.
Solution 28.10
Other benefit conditions might include:
Linked-claims period: if a claimant returns to work after illness, but falls ill again
within the linked claim period, he or she can start to claim again (rather than having to
serve out another deferred period). The existence of linked claim periods encourages
claimants to return to work.
Waiting period: the period that must elapse after taking out a policy before an illness or
accident is allowable as a claim; this discourages anti-selection.

Solution 28.11
For critical illness it would be desirable to break the investigation down according to the
various illnesses (cause of claim) involved.
Solution 28.12
You would need to calculate the exposed to risk for each group, noting that there would
be separate exposed to risk calculations for lives in the healthy (not claiming) state, and
for lives in the sick (claiming benefit) states.
The expected numbers of transitions for each group would then be worked out by
multiplying the appropriate exposed to risk by the relevant expected rate of transition
(according to the “expected” basis that you wish to compare against). This would be
done for each transition of interest, so here it would be one or more of healthy-to-sick,
sick-to-healthy, healthy-to-dead, and sick-to-dead. You would then probably sum over
all ages, and compare against the actual number of observed transitions of each type for
the group.
Solution 28.13
Long-term care insurance.
Solution 28.14
Advantages of using market data to spot trends
It will be drawn from a wider pool of experience and so trends may be spotted earlier.
Trends in your own data might be put down to statistical variation.
Your product may be new and you might not have any experience at all.
Disadvantages of using market data to spot trends
The experience of others may not be applicable to your own experience, for example
due to different policy designs and underwriting conditions.
There will be delays between the period of investigation and the date of publication of
the market data.

Market data may be heterogeneous and observed trends may therefore be spurious.
Not all the market will be included, or suitable data may not be available in the right
format or at the right time. In addition, it may be subject to errors and you will not be
able to verify the data.
Solution 28.15
Other sources of data:

● reinsurers
● competitors (if available)
● similar contracts.
Solution 28.16
Reinsurers have access to the health experience of many direct writers. Sometimes,
their data may be the most relevant available. This is most likely to be the case for a
recently established health insurer that will have little data of its own, or in the case of a
new or substantially revised contract.
However, reinsurers’ data suffer from the disadvantage that they relate to a large number
of companies. Each of these companies will have their own target market, and
underwriting and claims procedures.
There may also be confidentiality issues in the amount of detail that the reinsurer can
provide, especially if the reinsurer is closely connected with one major insurer in the
market.
In some circumstances, even the reinsurer may have little or no suitable data.
The reinsurer will almost certainly want something other than gratitude for help in
monitoring market experience. If you wished to reinsure anyway, then there may be no
real loss. However, if reinsurers’ technical assistance forces you to reinsure more than
you would otherwise choose to do, the cost of that extra reinsurance is a problem.

Solution 28.17
The policyholder is stopping coverage, and so he or she may lose out on the possibility
of obtaining cover (at the desired rates) in the future, because any new contract would be
underwritten afresh. This could lead to exclusions as a result of poor health, which may
not have been present in the previous policy.
Solution 28.18
We might expect the following:

● highest withdrawal rates: direct sales force
● “medium” withdrawal rates: direct marketing
● lowest withdrawal rates: broker
Broker sales will be initiated by the policyholder in response to some perceived

financial need, and the broker should be able to advise the person well on the most
appropriate policy. There should not therefore be many policyholders who later feel that
they do not need the policy.
Policies sold by the direct sales force may have been generated by some insistent
salesman making contact with a potential policyholder and convincing them that they
need the policy. A number of these will eventually no longer feel the need to keep
paying premiums.
The direct marketing policies should have a persistency that lies between these two.
Policyholders will have reacted of their own accord to newspaper advertising, although
the telephone response and any associated policy literature would “push” some people
into taking out a policy which they did not really need, and therefore lapse later on.
There may also be a number of people who take out the policy just to obtain a free gift
(eg alarm clock) and lapse their policies after receipt of their gift.
Solution 28.19
Suppose we are interested in the first year persistency of policies written in 2004.
Although in theory there will be some policies written in January which we could
examine in January 2005, one year later, there will not be a credible body of policies
until perhaps halfway through the year. This will give us results in July 2005 at the
earliest, ie 18 months later, and this would become 24 months if we wanted a year’s
worth of data.

Solution 28.20
It depends on the purpose and context of the investigation. In practice, companies will
often look to perform an expense investigation annually, which would suggest using just
the latest year’s data. If a shorter period were to be used, then the long-term effect of
any seasonally-influenced expenses will be either under- or over-represented in the
totals. New business figures are often sensitive to the time of year, in which case
expenses associated with selling or processing new business would be particularly
distorted by only looking at part of a year.
On the other hand, the company would not just look at its most recent year’s expenses in
isolation. It would also need to look at, say, the most recent 3-5 years of expense
experience, to identify and if necessary allow for unusual or “random” influences, and to
identify any trends over time. When looking over several years it would be necessary to
adjust the figures for inflation, so that each year’s costs could be compared in current
money values, for example.
The period of investigation for an expense analysis should therefore be long enough to
smooth out seasonal fluctuations, but short enough so that the underlying pattern of
expenses has not changed.
Solution 28.21
Marketing expenses: initial commission payments to agents will determine the

importance of each sale to the agent. It is reasonable that the marketing department of
the insurer relates the effort and time dedicated to assisting agents in their sales to the
worth of the sale to the agent – ie the initial commission.
Underwriting expenses: the extent of the medical and financial underwriting required
will increase with the size of the benefit.
Sickness and long-term care claim costs: a major claim cost will be claims underwriting,
and this will increase as the benefit size increases. The company might also expend
some effort in helping the claimants to get back to work, and such effort would be
applied in proportion to the size of benefit being claimed.

Solution 28.22
Valuation staff
Group (i) – all of their work could be attributed to renewals; or group (ii), if the analysis
needs to break time down between different products; or group (iii), if we consider part
of the valuation work as an overhead cost: for example, the number of valuation staff
may be insensitive to whether there are 100 or 100,000 critical illness policies in force.
Secretarial staff
Group (iii), mixed direct / overhead.
Actuary doing expense investigation (lucky individual!)
Group (iii), entirely overhead since the work will not relate directly to any product.
Solution 28.23
In this way investment yields will be more comparable between different asset classes.
For instance, it would be misleading to compare the yields of government bonds and
large property shopping mall developments without taking into account the vastly
greater investment management expenses of the latter. So it is important to subdivide
the investment expenses by broad asset class, and obtain the appropriate reduction in
yield for each asset class separately.
Comparing net (of expenses) returns is therefore likely to be less misleading than
comparing gross returns.
Solution 28.24
The expense investigation results are going to be the starting point for setting
assumptions for pricing, reserving and embedded value work. These one-off expenses
are defined as “non-recurring”, but nevertheless they have each occurred once, and
others like them (though not necessarily having the same causes) are likely to occur in
the future. However, their unpredictability means that the past experience is not likely
to form a reliable basis for future projection, and it would probably be more appropriate
to allow for them through a margin in the expense assumption, either directly or by
increasing the risk discount rate (where applicable).

Solution 28.25
It would be normal to compare results with those of the previous expense

investigation(s), both to look for any trends that may indicate the need for action, and as
an immediate check. Such comparisons should take account of expense inflation.
It could also be interesting to compare results with industry statistics, again both as a
check and to indicate possible problem areas.
Solution 28.26
The surplus at any point in time is the value of the assets less the value of the liabilities.
So using the notation A for assets, V for liabilities, the surplus arising from time 0 to
time 1 will be:
(A1 – V1) – (A0 – V0).
You should therefore be aghast that the course, and actuaries everywhere, talk about
surplus when they really mean surplus arising. But it is convention to do so, and it is
normally obvious from the context which is meant (ie surplus or surplus arising).
Solution 28.27
Surplus/loss due to the difference between actual experience and valuation assumptions
for:
● mortality and other contingencies
● expenses
● and the impact of new business.

Solution 28.28
Consider changing your best estimate assumption for that parameter. If the
phenomenon is of significant size, and the same thing happened the previous year or
couple of years, then it is likely your current assumption is incorrect and should be
revised. If profit testing on this revised basis shows unsatisfactory profitability, this
might then make you consider repricing the product.
You might also need to consider changing the appropriate valuation assumption
(especially for a statutory basis, where you might need to justify the prudence of your
assumptions to the regulators).
Note that earning a positive supervisory surplus year after year is not normally grounds
for changing your real assumptions, or for repricing, because the valuation basis will
normally be very prudent – so you should expect to see a surplus.
Solution 28.29
New business will normally contribute negatively to the revenue account in the year of
inception, because the premiums will need to pay acquisition costs, administration costs,
contribute to company overheads and set up supervisory reserves. On regular premium
business, this will lead to a large reduction in surplus arising; the effect will normally be
much less significant with single premium business because of lower acquisition
expenses relative to the size of premium.
Solution 28.30
If using a realistic basis, the initial reserves would be much lower, perhaps even
negative. The reserves should reflect the future profits expected from the business,
which should more than offset the initial costs involved (otherwise there is something
wrong with the pricing basis). We should not therefore get any new business strain.
Solution 28.31
We are less at risk of being unduly influenced by random fluctuations, and so this helps
to establish that any observed differences are due to parameter error, and hence more
likely to be worthy of remedial attention.

Solution 28.32
The embedded value basis will be much closer to reality than the statutory valuation
basis, and so deviations from expected will immediately tell you something useful,
compared with the valuation analysis deviation which arises from using an extremely
prudent assumption.
The embedded value deviation from expected will take account of the future loss of
profits on transition (ie the change in the present value of future profits due to
transitions) while the valuation analysis looks only at free assets.
For instance, if critical illness claim rates are greater than expected for a block of
business, there is a reduction in embedded value because the free assets will have
decreased due to the extra claims; but the future profits will also have suffered due to
there now being fewer policies than expected left to generate future profits.
Also, the embedded value may have expenses and withdrawals modelled much more
accurately than would be possible in a valuation basis.
Solution 28.33
Published accounts normally misrepresent the real financial situation of a company

because they do not take any credit for the future profits expected to arise from business
already written. This is a particular problem if a company is expanding quickly, because
it will be making large revenue account losses (unless using heavy financial reinsurance)
and will seem to be in a bad way, even if in reality it is writing a lot of good business
which will generate large profits in the future.
Accounts also ignore the potential of a company to sell profitable business in the future,
for example due to a new product launch or reorganisation of its salesforce.
Reporting embedded values will show a truer picture, although it is also much less
prudent because it is entirely based on the idea of taking credit for future profits.
Solution 28.34
One example might be that monitoring persistency in one particular product shows poor
results because it is over-priced, and thus uncompetitive. It could be over-priced
because of a high profit loading, or the need to give a high return on the capital allocated
to that particular line of business. A lower capital allocation (if justified) would result
in a lower profit loading, and consequently more competitive prices.




using the course.

ST1-29: Glossary Page 1
Chapter 29
Glossary
Syllabus objective
(a) Understand the principal terms in health and care.
0 Introduction
This chapter includes the Core Reading definitions with which you need to be familiar.
These definitions are shown in a different typeface and are an easy target for a short
bookwork question. You do not have to reproduce them word-for-word, but you must
be able to express the ideas with equal precision.
The Glossary also contains some additional definitions that are not required by the
Syllabus. These are either not in the special typeface, or are marked “(UK)”. It is
important that you understand these, and it may be useful to read these to help your
understanding. However, you are unlikely to be asked to produce them by the examiners.
Note – Terms which are marked (UK) are deemed to be examinable under Subject
SA1 only.
The Glossary is also a useful reference as you study the course, where many of the ideas
are explored in more depth.
In using the glossary you may need to refer to more than one entry. There are explicit
links between the entries. In addition, when a word appears in italics, this indicates that
there is also an entry in the glossary for this word or phrase.

Page 2 ST1-29: Glossary
1 Definitions
ABI (UK)
The Association of British Insurers, is the trade association for insurance

companies in the United Kingdom.
Accelerated critical illness benefit
This benefit is provided when a policy pays the sum insured upon death or
diagnosis of a critical illness, whichever occurs first. If the life assured suffers a
critical illness, then the sum assured is paid and the policy is terminated, ie
payment of benefit is “accelerated” forward from payment on death. Some
policies accelerate a portion of the sum assured in which case the contract stays
in force and pays the balance of the sum assured upon subsequent death. Most
policies accelerate 100% of the sum assured.
Access to Medical Records Act (UK)
This legislation sets down the rights that an individual has in relation to the
disclosure of the information contained in their medical records. It applies to
reports obtained for insurance purposes (ie underwriting and claims) or in
connection with employment.
Acute illnesses
Illnesses or conditions of a non-degenerative nature where a cure is a

reasonable prospect. In the UK, PMI generally only covers surgery and other
treatment for illnesses deemed acute.
See Chronic illnesses.
Additional conditions
The critical illness conditions, apart from the core conditions and total
permanent disability, for which model wordings are available.
Note that in the UK the insurance industry has stopped using the categories of “core”
and “additional” to describe CI conditions.
ADLs
Activities of Daily Living, a number of functional tests against which incapacity

(disability) can be measured.
See Incapacity.

ADWs
Activities of Daily Work, a number of functional tests specifically related to tasks that
might be encountered in the workplace, against which incapacity (disability) can be
measured (eg dexterity, ability to follow instructions).
See Incapacity.
Affinity group
A group of people with something definitive in common, often membership of a

particular organisation, but not common employment.
See Voluntary Group.
Age-at-entry pricing
This phrase relates to the practice in some PMI markets of calculating premiums
with due allowance for the increasing age of the policyholder over the
prospective period of cover (often to age 65).
Provided the insured renews his or her policy each year, premiums will not increase
because of the policyholder’s increasing age.
The insurer usually retains the right to increase premiums subsequently to allow
for medical inflation or medical inflation in excess of levels assumed in the
original calculation.
AIDS exclusion (UK)
Virtually all companies writing individual IP business have some form of AIDS
exclusion. Since the introduction of the Disability Discrimination Act there has
been a move away from the cancellation type clause. There is a wide variety of
wording. In practice, many of the terms used are defined at length to ensure that
clauses are legally watertight and provision is usually made elsewhere in the
contracts for appropriate blood testing.
There are two broad categories of AIDS exclusion found within the individual IP
market:
Category 1: Companies which exclude disability “caused” directly or indirectly

by HIV infection.
Category 2: No benefits are payable once HIV infection has been established.

Association of Independent Financial Advisers (AIFA) (UK)
The Association of Independent Financial Advisers. This is a trade body set up

(previously known as NFIFA) to advance the interests and status of IFAs.
See IFA.
Anti-selection
People will be more likely to take out insurance contracts when they believe their
risk is higher than the insurance company has allowed for in the premium. This
is known as anti-selection.
An example in critical illness cover may be where an individual begins to suffer

pains in the chest. He takes out a policy without mentioning the chest pains and
then goes to the doctor to see if the pains are due to heart disease. If they are,
then there is a greater likelihood of a claim for benefit.
Anti-selection is also recognised in the tendency for sick or sub-standard lives

legitimately to renew policies or take up options providing additional cover
without evidence of health.
Appointed representatives
See Tied Agents.
Assessment period
The period during which the insurer will assess a condition before making a
decision on whether or not to accept a critical illness claim. The assessment
period will not normally be longer than 12 months, as long as all the evidence
needed has been provided. Also, the assessment period should only apply to
claims for the conditions which must be permanent for cover to apply.
Asset share
The asset share is the retrospective accumulation of past premiums, less

expenses and the cost of cover, at the actual rate of return on the assets. The
accumulation could be done for a single contract or a group of contracts. It is
also referred to as the earned asset share or the retrospective earned asset
share.

ASU insurance
Short-term insurance covering accident, sickness and unemployment.
See Creditor insurance.
Bancassurers (Bancassurance)
This term is generally used to describe companies who offer financial services
that encompass both banking and assurance operations. A major objective is to
cross sell the products of one operation to the customers of the other.
Benefit limitation
Benefit limitation is required so that the claimant with an IP policy retains a

financial incentive to return to work.
Many companies impose more stringent limitations for higher salaries in excess
of specified limits, and many companies have an overall maximum benefit.
When calculating the amount to be paid to the policyholder, many companies
deduct any other income that the claimant may receive if benefits are up to the
maximum. The effect on income net of tax is also very relevant as there may be
certain circumstances where the benefit permitted by the formula is more than
that required to maintain a claimant’s net income at his or her pre-disability level.
Benefit limitation (UK)
A comprehensive guideline on benefit limitation is included in the ABI Statement

of Best Practice. The guideline covers monetary maxima, percentage limitations
and offsetting other sources of income. The move away from a formula based
on 75% of gross pre-disability income has continued since the Budget in
November 1995 in which individual IP benefits became tax-free.
Brokers
See IFA.

Budget policies
These are cheaper policies (generally PMI policies) with restricted cover.
Examples of these are PMI policies with excesses (the insured bears the first
tranche, a pre-specified fixed sum, of each claim), policies contingent on public
service waiting periods (cover is only provided where the official waiting list is
longer than a pre-specified time, often six weeks) and policies that provide in-
patient cover only.
The term can also apply to CI policies (restricted list of diseases covered) and IP
policies (limited benefit period).
See Limited benefits, Excess.
Bulk rate or Unit rate
These refer to a premium rate applied uniformly per head on large schemes
across a membership type (independent of actual members’ ages or sex).
Burning cost
Typically burning cost is the estimated cost of claims in the forthcoming

insurance period, calculated from previous years’ experience adjusted for
changes in the numbers insured, the nature of cover and medical inflation. The
term can also be used to describe the historic cost of claims only.
Capitation
This term relates to the practice of charging for cover by forecasting the likely
claims on an individual basis and charging this, adjusted for expenses and
profit, as the premium.
In effect, the insurance company “carves out” a set of medical benefits (such as
dental claims or mental health claims) and passes this risk onto the provider, by
giving a proportion of the insurance premium for each person managed to the
provider up-front rather than an amount per claim.
Capitation (UK)
It is found in the UK in the field of dental covers where the dentist anticipates the
costs incurred by his/her patient.

Career break
A career break clause allows the policyholder to resume his or her coverage
after a break in employment (eg study, retrain, travel, start a family), subject to time
restrictions. Career break is becoming an increasingly common feature of IP
contracts.
Cash plans or Hospital cash plans
These products pay a pre-specified cash sum on the occurrence of certain

medical events (hospital stays, physiotherapy, need for spectacles, etc).
Typically the benefits paid are low relative to the true cost and represent cash in
hand rather than indemnity benefits.
In the USA, “hospital cash plan” is the term used for an indemnity product.
Change of occupation
A requirement on IP and possibly CI insurances is that the insured must notify

the insurer of a change in occupation, possibly resulting in the insurer
reclassifying the policyholder to a different occupation class and so revising
premiums or disability definition.
Change of occupation (UK)
This has now largely been dropped in the UK.
In the UK, the ABI Statement of Best Practice says that where the insurer
periodically writes to the policyholder because of the need to review premium
rates or to increase premiums or benefits, it should bring to the policyholder’s
attention his or her duty to notify any change of occupation.
Chronic illnesses
Chronic illnesses are degenerative and/or generally incurable. The purpose of

any treatment is palliative.
See Acute illnesses.
Chronic illnesses (UK)
In the UK, PMI does not generally cover treatment for chronic illnesses, although
some insurers will offer treatment for cancer that includes palliative care.

Claim escalation rates
This is the rate at which claims, in the course of payment, escalate under IP or
LTCI policies. Unless otherwise stated, they compound annually.
Claim escalation rates (UK)
In the UK, escalation rates for claims fall into three specific categories:
• benefits increase in line with the Retail Price Index (RPI)
• benefits increase in line with National Average Earnings (NAE)
• the policyholder is offered a choice of set percentage increases.
Increases may be subject to a maximum or minimum rate. The majority of

escalating policies today in the UK link to an index and benefits increase both
prior to and during claim payment.
Claim notification period
In order to improve claims handling procedures, many companies require that

claimants notify them of potential claims at an early stage. Currently the
notification requirements of companies fall into two broad categories:
• The insured is required to notify the company a set time after the
incapacity begins, irrespective of the deferred period.
• The insured is required to notify the company at a set time before the end
of the deferred period.
The purpose of this period is twofold. Firstly, to ensure valid claims are ready to
be paid at the end of the deferred period. Secondly, for the purposes of early
intervention from a claims management perspective.
Claim notification period (UK)
In the UK, the ABI Statement of Best Practice includes a Guidance Note on claim
notification period.

Claims – late notification (IP)
To protect itself from financial disadvantage, an insurer will set up rules for
dealing with claims that are notified very late (ie notification occurs after the end
of the deferred period).
Practice on the late notification of a claim varies greatly.
The options might be:

• Backdate the claim to the end of the deferred period if supporting medical
evidence can be provided.
• Subject all claims to individual consideration.
• Treat the date of notification as the date benefit becomes payable.
• Assume that incapacity started at a set period prior to notification. The
set period is normally in line with the claim notification period required.
• Assume the commencement of incapacity (disability) to be the date of
notification.
• Postpone the commencement of the deferred period.
• Do not backdate benefits, so that benefits will be lost.
• Reduce the benefit payable.
• Delay benefit payment if notification is not received within six months of
the end of the deferred period.
• Refuse claims where written notification is not received within 90 days of
the end of the deferred period.
Claims paid, claims incurred
When certain group insurance policies are to be renewed, prospective insurers

are given information on claims history over previous scheme years. This
comes in one of two forms:
• Claims paid, where the amounts actually paid by previous insurers in
each scheme year are totalled, or
• Claims incurred, where the amounts relative to all claims that commenced
in a particular year of insurance are totalled; this equates to amounts paid
plus outstanding reserves.
Claims paid or incurred will also be integral components in many forms of

reporting (eg the assessment of profitability in management reports) and
appropriate usage is important.

Claims pre-authorisation
Some PMI insurers require (others recommend) that intended courses of

treatment or surgery be approved by them for policy coverage before costs are
incurred. This process can often provide opportunity for the insurer to manage
care provision or reduce after-the-event claim denials.
Coinsurance
The general term given to a PMI policy condition whereby the policyholder is
required to pay, at least in part, for medical expenses incurred, maybe on a
percentage basis.
See also Excess.
The insured and the insurer share the cost of the claim in fixed proportions (eg insured
pays 20% of the claim).
In other contexts, coinsurance also refers to the situation where two insurers
share the contract with the policyholder and also may refer to reinsurance on an
original terms basis.
Combined ratio
See Loss ratio.
Community rating
Community rating most often refers to the practice of charging all policyholders
or a significant subset of the persons insured the same premium rate
irrespective of rating factors such as age, sex and medical history.
Community rating sometimes refers to the process of applying tabular rates to

applicants irrespective of claims history.
Comprehensive cover
The standard or comprehensive PMI cover provides for full reimbursement of all
medical costs incurred in hospitals within the appropriate bands and for such
other treatments as the policy stipulates. Occasionally some high policy limits
will apply (per year or per section of risk).
See Policy limits.

Continuation option
A continuation option describes a benefit under an insurance policy whereby the

insured can choose, without having to provide evidence of health, to continue to
avail of the cover provided by the policy under circumstances where the policy
cover has otherwise ceased. Such circumstances might apply where the
individual has left his place of work and is thus no longer covered by an
employer-sponsored scheme or where an individual policy has expired. The
terms under which the option is effected are those applicable to a healthy life for
the age at the date when the option arises.
Continued Personal Medical Exclusions (CPME)
This is a variant of No Worse Terms acceptance whereby the new PMI insurer
promises only to carry forward such cover for medical conditions as existed
under the previous insurance policy.
See No worse terms.
Core conditions (critical illness) (UK)
The core conditions are cancer, coronary artery by-pass surgery, heart attack,
kidney failure, major organ transplant, multiple sclerosis and stroke (stipulated
by ABI prior to April 2006).
See Additional conditions.
Cost plus
Many of the largest group PMI schemes will self-insure. Some of these will seek
to limit the possible downside by insuring against an extreme experience.
Insurance will be arranged to cover the excess of a pre-agreed claims fund.
Such an arrangement is called Cost Plus cover or Stop Loss cover
See Stop loss.
Credible, Credibility
See Experience rating.

Creditor insurance
This is a form of cover that is effected to protect a loan or mortgage. It may

consist solely of life assurance that will repay the outstanding loan if the
borrower dies before it is repaid. Often cover is extended to pay off the loan
following a total and permanent disability and, more recently, critical illness.
Cover can also be effected to cover repayments during temporary disability or
unemployment.
Critical illness
An illness or condition that is perceived by the public to be serious (ie life threatening or
lifestyle threatening), and to occur frequently.
CI policies pay a sum insured on the diagnosis of an insured critical illness. Illnesses
are usually divided into core conditions (eg cancer, heart attack), and additional
conditions (eg loss of speech, motor neurone disease).
Day case admissions
This term relates to the increasing practice of treating the more straightforward
operations in hospital surgical units on the day of admission, occupying a bed
but being discharged the same day.
Deductible
See Excess, Deductible.
Deferred period
This is a term most often encountered in IP insurance. The meaning is given as

“the period of incapacity before any benefit is paid”.
Deferred period (UK)
In the UK, deferred period is a generic term under the ABI Statement of Best
Practice. Terms such as “waiting period” and “elimination period” should no
longer be used for this concept.
The Statement also includes a Guidance Note on deferred period.
The standard deferred periods offered by companies are 4, 8, 13, 26 and 52

weeks or their equivalents in terms of months, ie 1, 2, 3, 6 or 12 months. Group
schemes may offer 28 weeks deferment.
See Waiting period.

Definition of incapacity
The majority of companies effectively have a standard definition of incapacity

which means “totally unable through sickness or accident to follow own
occupation and not following any other for profit or reward” although the exact
words used are by no means the same. This definition is normally applied
throughout the duration of the contract.
Some companies amend their definition of incapacity after a certain claim period
has elapsed (usually two years).
Most companies reserve the right to apply an alternative definition of incapacity

depending upon the occupation of the insured.
Some companies have introduced a definition of incapacity based on an abilities

test. Under this plan, benefit payments are limited to a maximum of 24 months if
the person is incapacitated under the mental health section. The mental health
limit of 24 months can, in theory, be applied to any product. It is not a
requirement of a contract with an ADW trigger (and many ADW plans do not have
the 24-month limit).
Companies will also generally use different definitions of incapacity when cover
is offered to housepersons and where cover is maintained on a restricted basis
during a period of unemployment.
See Housepersons, Unemployment, ADWs.
Definition of incapacity (UK)
In the UK, the ABI Statement of Best Practice includes a Guidance Note on
Definition of Incapacity (own occupation) under IP policies.
Direct marketing
The marketing of products directly to the potential customers with no

intermediary or sales person involved. This could be via the mail, by advertising
in newspapers or periodicals, by telephone, email or the internet. In all
situations the customer is invited to apply for the product, usually directly to the
insurance company.
Direct sales force
An insurance company that employs the services of sales people to sell only
their products directly to the customer is said to operate a direct sales force.
The sales people may operate on a self-employed basis.

Earned premium
Earned premium is the proportion of premiums written and received that relates
directly to the expired period of cover.
For example, consider:

• A policy commencing on 1 October 2007 with an annual premium of £300.
This £300 would contribute £75 to earned premiums in the year 2007 and
£225 to earned premiums in the year 2008. The second annual premium
would contribute £75 to earned premiums in 2008 and £225 to those in
2009 etc.
• A policy commencing on 1 October 2007 with a single premium of £800 for
two years’ cover. Such a policy would contribute £100 to earned
premiums in the year 2007, £400 to earned premiums in 2008 and £300 to
earned premiums in the year 2009.
Elective surgery
Surgery that is deemed non-emergency.
Excess, Deductible
These terms (the latter more often in the United States) are used to describe the
policy condition whereby the insured is responsible for the first £x or $x of any
claim.
The excess/deductible may also operate not on individual claims but on the
aggregate of claims over a policy year; it may also be applied per life or per
policy.

Exclusions
These are causes of disability (or “perils”) that are explicitly excluded from the
cover provided by a policy.
The most common exclusions are:

• war, terrorism, acts of violence, civil unrest and such things
• self-inflicted injury or attempted suicide
• drugs
• alcohol
• hazardous past-times or sports
• aerial activity other than as a fare-paying passenger
• criminal acts
• failure to seek or follow medical advice
• complications of pregnancy
• AIDS/HIV.
Experience rating
Experience rating is the process by which partial or full credibility is given to the
past claims history of the risk in assessing the premium payable at renewal.
If the premium for a risk is assessed by only using the claims history for that risk, the
experience is said to be 100% or fully credible. If the risk is assessed using both the
clams history for the risk and the claims history for the rating group to which the risk
belongs, the experience is less than 100% or partially credible.
Facultative
Meaning optional, is a process of reinsurance where there are no obligations on

either the insurance company or the reinsurer to offer and accept risks. The
insurance company offers facultative business when and where it chooses, and
the reinsurer can decide whether or not to accept it.

Fixed price surgery
This phrase relates to an agreement between a PMI insurer and a hospital (or
hospital chain) whereby all surgical procedures of a particular type will be
charged at a particular cost per case rate, regardless of the individual
complexity. These rates are commonly referred to as “case rates” or “procedure
pricing”.
The price includes all care, including any that may be necessary following
complications.
Free cover
This term refers to a benefit level in a group risk arrangement, below which the
member is not subject to individual underwriting. Free cover is usually a
function of the number of members or aggregate of benefits provided.
Free cover limits are also known as “non-selection limits”.
General Practitioner (GP)
This phrase refers to the individual’s own doctor, who provides primary medical
care and is normally the first port-of-call for all health concerns. The GP may or
may not hold all individual health records pertinent to that person.
GP referral
Normal medical protocols would involve the patient being referred for secondary
care after an initial consultation with his or her general practitioner.
GP referral (UK)
Most UK PMI policies require a GP Referral as a pre-condition to cover.
Group business
Insurance covering a number of individuals under a single policy document. The

members of the group are linked in some way (eg employees in the same
company or holders of the same credit card) and there is often a sponsor
(eg employer) who facilitates in the payment of premiums and administrative
matters. Membership may be compulsory or voluntary.

Guaranteed premium rates
This describes the situation where the benefit/premium relationship is set from
the outset for the duration of the policy.
See Reviewable premiums.
Health Maintenance Organisation (HMO)
A form of health organisation akin to insurance which combines a range of

coverages in a group basis. A group of doctors and other medical professionals
offer care through the HMO for a monthly subscription. However, only visits to
professionals within the HMO network are covered by the policy. All visits,
prescriptions and other care must be cleared by the HMO in order to be covered.
A primary doctor within the HMO handles referrals. They are more common in
the US.
HES (Hospital Episode Statistics) (UK)
Collection of statistics concerning personal, medical and administrative details

of all patients admitted to, and treated in, NHS hospitals in England.
Hospital bands
The PMI insurer generally splits the hospitals permitted under the policy into
categories (by price of treatment), known as hospital bands, usually three in
number. The policy premium is generally scaled in line with the policyholder’s
choice of hospital group.
Hospital bands (UK)
A typical classification UK would be:

• Band A – London teaching hospitals and other top-ranking
establishments.
• Band B – other London hospitals and certain hospitals in other large
cities.
• Band C – other provincial hospitals.
In the UK, many insurers are moving away from this classification and using
more sophisticated methods of rating, such as geographical rating factors.
Hospital cash plan
See Cash plans.

Housepersons
People who are not in paid employment but whose contribution to a family might
be measured in financial terms.
The majority of IP insurers also provide housepersons cover.
Two categories have been identified by reference to the definition of incapacity,

as follows:
Category 1: Ability to perform certain activities of daily living (ADLs).
Category 2: Confinement to home or hospital or inability to perform normal

household duties.
See ADLs.
ICD (International Classification of Diseases)
A classification of diseases and surgical operations, by both coding and

wording, in order to maintain an international standard. Most countries classify
diseases using ICD-9 or ICD-10 codes.
IFA (UK)
This is an abbreviation for Independent Financial Adviser. These people are

independent of any particular financial services company (contrasted to a
member of a direct sales force above). They select and recommend the products
they consider the best of their type using various criteria. They are known in
some territories as brokers.
See Direct sales force and Tied agent.
Immediate needs annuity
A way of providing long-term care benefits in the form of an impaired life annuity paid
for by a single premium at the time at which care is needed.
Incapacity
According to the ABI Statement of Best Practice for IP in the UK, …
The term “incapacity” should be used instead of the term “disability”, in

particular as regards the definition of disability clause in the policy contract,
which should be called the definition of incapacity clause.

Increase options
There are two types of option under which increases in the benefit can be
secured without formal underwriting.
The first covers those options whereby the increases in benefit are incorporated
in the original contract and operate automatically.
They may be subject to pre-ordained premiums, which may:

• be level throughout the lifetime of the policy
• increase in line with the benefit
• increase by some other specified pattern.
Alternatively, increments may be costed as they arise. The increase can be a

fixed money sum, or be in line with a fixed percentage or some form of earnings
or prices index. This second type of option is that which includes a periodic
opportunity for the policyholder to increase the benefit by a fixed percentage,
with the new policy being costed in the normal way, based on the then-current
age and outstanding term. Increase options are found under critical illness and
income protection policies.
Incurred but not reported (IBNR)
This term relates to claims that have commenced but for which the insurer has
yet to receive notification. The insurer is required to hold reserves against such
events when assessing results or submitting accounts for a particular period.
Indemnity policy
A policy that provides benefits or cash that is sufficient to restore the insured to the
position he or she was in prior to the occurrence of an insured event. PMI is usually an
indemnity contract.
Some policies incorporate cash limits in particular circumstances, and so do not provide
full indemnity.
Individual business
Insurance covering an individual under a single policy document. Where the

insurance additionally covers immediate family members on a joint life basis,
this is also considered to be individual business.

In-patient
A person who is admitted to hospital and occupies a bed overnight.
Insurance Premium Tax (IPT) (UK)
Insurance premiums are exempt from VAT in the UK, but most general insurance
premiums are subject to an insurance premium tax (IPT), currently (May 2007) at
the rate of 5%.
So, for example, this tax is levied on PMI premiums.
Investigative surgery
Surgery that is undergone in order to advance the diagnosis (nature and extent
of the complaint). It is generally covered under PMI products but may not be so
under MME products.
IP insurance
Income Protection insurance (formerly known as Permanent Health Insurance

(PHI)) provides cover against incapacity. Benefit is paid as an income (usually
monthly) for as long as the disability exists up to a pre-defined age, usually 60 or
65, or retirement, if earlier.
It is a protection policy that insures against the temporary loss of income, as a result of
sickness or injury, during the term of the policy. Benefits are paid up to a maximum of
the sum insured, subject to benefit limits based on an income replacement ratio
specified in the policy.
Irreversible
Cannot be cured by medical treatment and/or surgical procedures at the time of

the claim.
This term is generally used to define CI conditions – for example, blindness, deafness,
loss of speech and paralysis of the limbs.

Key Features document (UK)
This was first introduced as a legislative requirement for regulated plans in 1995.
It aims to give a “short and punchy synopsis of the product which is easy to read
and capable of being understood by the investor”. It sets out the required
information such as aims and purposes of the policy, nature of the
policyholders’ commitment, a description of the risk factors and illustrative
projections.
Keyperson cover
Keyperson products fall into 2 categories:

• Those designed to provide compensation for loss of profits.
• Life of another type policies which are taken out by the employer to cover
the key employee’s salary (to facilitate the temporary recruitment of a
replacement).
Limited benefits/budget plans
A number of IP providers are now offering policies where in the event of a claim,
benefit payments are restricted to a certain number of years. These policies are
sometimes referred to as budget plans because they are cheaper than contracts
that provide benefit to the terminal age.
See Budget policies.
Linked claims
These relate to IP claims whereby a claimant, having been in receipt of claim

payments, recovers and returns to work, but within a specified period (the “link
period”) suffers a recurrence of the same disability, and is eligible for immediate
claim payments without the imposition of another deferred period.
The standard definition refers to a linked period of 6 months.
The link period is also sometimes called the “off-benefit” period.
Long-term care insurance policy
A policy, either pre-funded or funded at the time of need, which provides cash-limited
benefits if the insured qualifies for nursing or personal care in old age. To qualify the
insured needs to satisfy disability conditions. These conditions are often specified in
terms of ADLs.

Loss ratio
The ratio of claims incurred, including allowance for ultimate settlement

amounts, to the relevant premium. In some instances, the ratio is calculated with
expenses also in the numerator; but this statistic should be more properly
termed the combined or operating ratio.
Major medical expenses (MME)
MME in the UK is a PMI product variant that pays a fixed amount (from a
schedule relating to severity) to policyholders who undergo surgery of a non-
investigative and non-cosmetic nature.
MME in the USA is a comprehensive PMI product type offering reimbursement

for the costs of primary, secondary and tertiary care as defined in the policy.
Managed care
Managed care is the term given to a process whereby an insurer intervenes in

the provision of medical care with the dual objective of optimising the quality of
treatment for the policyholder and controlling the cost (by such means as
preferred provider utilisation and claims pre-authorisation).
Medical history disregarded (MHD)
An individual’s proposal to effect insurance will be underwritten without regard

to that individual’s past medical history, ie there are no exclusions for pre-
existing medical conditions.
Medical inflation
This term generally refers to the annual increase in the average cost of medical
treatment.
Moratorium
Certain PMI products, in place of medical underwriting, do not cover medical

conditions that existed during a pre-specified period, usually between two and
five years, but will then cover these conditions if no treatment, symptoms or
advice takes place for a period of, typically, two consecutive years after taking
out the policy. The insurer is however on immediate risk for all other conditions.
See Pre-existing conditions.

MSGP (Morbidity Statistics from General Practice) (UK)
A study carried out by the Royal College of General Practitioners, the Office for
National Statistics and the Department of Health. A fourth such study took place
in 1991–1992, and presents statistics on the reasons, as perceived by the doctor
or practice nurse, for which people consult in general practice.
National Average Earnings Index (NAEI) (UK)
An index published monthly by the Office of National Statistics (ONS) in the UK.
The average earnings index measures changes in gross earnings per person, based on
survey returns from around 8,500 employers. Each employer in the survey provides
details of the total pay bill, excluding employers’ contributions (National Insurance etc)
and the number of people covered by the pay bill, with no distinction between full and
part-time staff. It therefore includes basic pay, overtime, shift payments, bonuses and
profit-related pay.
See ONS.
National Health Service (NHS) (UK)
The NHS is the UK’s public health service, originally formed to provide
cradle-to-grave or womb-to-tomb free medical care, funded by general taxation.
Increasingly, however, certain aspects require some individual payment at the
point of claim with copays or coinsurance for prescriptions, dental care, eye
glasses and other items.
No Claims Discount (NCD)
Under PMI, the insured, not having claimed in a policy year (or other specified
period), will be subject to a lower premium than would have arisen if a claim had
been made. An NCD system is used as own-experience proxy for more accurate
risk segmentation.
No Worse Terms (NWT)
In certain circumstances, on PMI policy renewal, a new insurer will agree to offer
cover at least as comprehensive and with no additional underwriting conditions
as the policyholder’s current policy; the renewal or “switch” is accepted on no
worse terms.

Non-medical limits
Non-medical limits denote the maximum (long-term) policy benefits for which
one can propose without needing an automatic medical examination or PMAR.
The fact that a benefit falls within the non-medical limit is no guarantee that the
proposer will not be asked to attend a medical examination. In the majority of
cases the proposal will be supported by a medical report from the proposer’s
medical attendant, but insurers always reserve the right to call for any additional
medical evidence they feel is necessary in the light of any information that they
already have.
See PMAR.
Non-proportional reinsurance
In non-proportional reinsurance, the reinsurance protection covers amounts

above certain pre-defined limits, rather than splitting individual claims in given
percentages. Under PMI, it will often apply to a portfolio of risks as a whole, not
individual risks; the reinsurer will pay when the losses on the whole portfolio
exceed an agreed limit. Examples of non-proportional reinsurance include Stop
Loss and Catastrophe excess of loss cover.
Occupational classes
Occupational classes are used to rate proposers in many lines of health and care
insurance.
Examples of occupations that fall into different sample classes are:

• Class 1 – actuary, accountant, archaeologist, astrologer, author.
• Class 2 – doctor, dog breeder, counsellor.
• Class 3 – teacher, plumber.
• Class 4 – roofer, Heavy Goods Vehicle driver.
Occupational classes (UK)
Under IP insurance in the UK, companies use a varying number of occupational

classes – ranging from 3 to 6, as well as certain special ones for particular
occupations.

ONS (Office for National Statistics) (UK)
The Office for National Statistics is the Government Agency responsible for
compiling and analysing many of the United Kingdom’s economic, social and
demographic statistics. These include the retail price index, trade figures and
labour market data as well as the periodic census of the population and health
statistics.
Open enrolment
Open enrolment refers to the process in some markets whereby an insurer is

obliged to accept all proposers for insurance at standard rates.
Operating ratio
See Loss ratio.
Original terms
Original terms method of reinsurance is where the reinsurer has a virtually

identical contract to the insurance company in respect of the reinsured portion
of the risk. The reinsurer receives the same gross premiums for its share as the
insurance company, except that the policy fee is normally retained in full. The
reinsurer is responsible for its full proportionate share of the sum assured in the
event of a claim, and, likewise, for any surrender values which are paid.
Out-patient
A person who attends hospital for treatment or consultation but who does not
occupy a bed. In some markets this is known as “ambulatory treatment”.
Pay beds (UK)
Beds or wards, within an NHS hospital, that are made available for private self-
pay or privately insured patients. The patient or his insurer is billed accordingly
for this accommodation and all treatment provided.
Permanent
Usually referring to a health condition that is expected to last throughout the

insured person’s life, irrespective of when the cover ends or the insured person
retires.
This definition would be used, for example, in relation to a claim for total permanent
disablement (TPD) benefit under a CI contract.

Personal accident insurance
A policy that pays specified cash benefits in the insured suffers an accident resulting in
(usually permanent) bodily injury (eg loss of a finger).
Personal capability assessment (PCA)
An alternative way of assessing disability that is largely independent of the age and the
occupation (if any) of the person being assessed.
Personal capability assessment involves assessment of the ability to complete everyday

tasks of living (eg climbing stairs, bending, lifting and carrying).
See ADLs, ADWs.
PMAR
Private medical attendant’s report which is sought by the insurer to provide

further insight into an individual’s state of health at the proposal or claim stage.
Policy limits
Some indemnity policies limit the benefits payable under particular sections of the
policy (eg PMI policies may limit payments for physiotherapy to £500 in any policy
year). Such policies only provide partial indemnity.
See Indemnity policy.
Pre-existing conditions (PEC) exclusion
This is an exclusion used in non-underwritten critical illness contracts. Under

the terms of the exclusion, cover is not provided in respect of any of the critical
illnesses listed in the policy which the life assured has already suffered, ie where
the condition pre-existed at the commencement of cover. It is also usual to
exclude cover for any critical illness where the life assured has previously
suffered from a medical condition that gives a greater risk of that critical illness
occurring.
PEC exclusions are also to be found in PMI and IP contracts.
See Moratorium.

Preferred Provider Organisation (PPO)
A PMI policy may restrict cover to such treatment as is carried out in certain
medical establishments (with whom it has special arrangements, often financial)
or may limit the scale of reimbursement outside these establishments. The
premium for such policies where treatment must take place in a PPO will usually
be cheaper than if the claimant had the choice of any possible provider.
Pregnancy clause (UK)
The pregnancy clause is an IP policy term covered by the ABI Statement of Best
Practice in the UK. The Statement of Best Practice recommends that insurers
should:
(a) Cover claims arising from complications of pregnancy diagnosed by a

doctor, or a consultant who specialises in obstetrics.
(b) Cover such complications from the date on which they become
incapacitated, ie without any extension of the standard deferred period.
There is currently considerable variation in practice. The most common

approach is that “disability attributable to pregnancy or complications thereof is
not covered unless the condition continues for more than 13 weeks after the
termination of the pregnancy. The deferred period is then deemed to
commence”.
Primary care
Primary care is the term given to such advice and treatment as provided by a
general practitioner. This is not typically covered by a PMI policy in the UK,
although elsewhere, primary care would be an insured benefit.
See Secondary care, Tertiary care.
Private Medical Insurance (PMI)
A product under which in return for premiums, an insurer promises to pay

certain sums of money on the occurrence of certain medical events. The product
is generally one of a short term insurance class, the events are frequently
surgical in nature (predominantly so in the UK) and the amounts paid usually
indemnify costs incurred by the individual in receiving treatment.

Profit sharing
Profit sharing relates to the practice under group scheme business whereby the
insurer rewards the group for better than expected experience with some share
in the profit arising. This share might be expressed as a cash refund or as a
discount against the future premium.
Proportionate benefit
Under IP policies, if a claimant takes up employment in an occupation that is

different to the one from which he or she was originally incapacitated, it is usual
for the continuing benefit to be reduced. 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.
It is a standard requirement that disability from the original occupation continues

whilst a proportionate benefit is being paid. Some companies require a full claim
to be established before a proportionate benefit can be claimed.
Proportionate benefit (UK)
In the UK, the ABI Statement of Best Practice includes a Guidance Note on
proportionate benefit. Among other things, it is recommended that insurers
should be prepared to adopt a flexible approach to proportionate benefits in
order to reach a financial agreement with the claimant. This recognises that it is
in the insurers’ and policyholders’ long-term interest to facilitate a return to
employment in some form.
The ABI Statement of Best Practice states that insurers who allow inflation
proofing should include in the policy document details of the method and index
used to make the proportionate benefit calculations.
Rehabilitation/partial benefit
This IP benefit is payable when a claimant is no longer totally unable to follow

his or her original occupation and returns to it in a reduced capacity. The
amount of benefit is usually calculated in the same way as that for proportionate
benefit, as described above.
Rehabilitation can also apply to the process of counselling where disability

counsellors assist disabled persons with advice on practical matters to do with
the benefit and their disability, to aid a return to work.
Rehabilitation/partial benefit (UK)
The comments on the ABI Statement of Best Practice recommendations for

proportionate benefit apply equally to rehabilitation benefit.

Replacement ratio (or net replacement ratio)
This refers, in the context of income protection insurance, to the ratio of net (in
benefit) income to net pre-disability income. A value less than one is desirable
from the insurer’s viewpoint, to provide a financial incentive for the claimant’s
return to work, especially given that expenses in disability may be less than
those in normal (working) health.
Reported but not settled (RBNS)
This term relates to claims that have been notified to the insurer, but the sum insured
due has yet to be agreed and paid. The insurer is required to hold reserves against these
claims, when assessing results or submitting accounts for a particular period.
Residence
This clause limits the countries in which the policyholder may be resident to
make a valid claim, to ensure effective claims management.
There are almost as many variations on this clause as there are companies
transacting business.
Retail Price Index (RPI) (UK)
An index published by the Office of National Statistics (ONS) in the UK.
It is an average measure of change in the prices of goods and services bought for the
purpose of consumption by the vast majority of households in the UK. It is compiled
monthly and has been published regularly since 1948.
The RPI includes prices for food and drink, tobacco, housing, household goods and
services, personal goods and services, transport fares, motoring costs, clothing and
leisure goods and services. The data are collected through surveys.
See National Average Earnings Index (NAEI).

Reviewable premiums
A popular form of premium offered by the income protection and critical illness
insurance providers is the “reviewable” premium. This allows the insurer to alter
the premiums if the prospective claims experience (or indeed any aspect of the
premium basis) for the portfolio as a whole is different from that which was
originally expected. Most companies that employ reviewable rates undertake the
reviews every five years, though experience monitoring is done on a regular
basis.
See Guaranteed premium rates.
Rider benefits
These can be described as extra benefits that can be added to a basic policy
either at commencement of the cover or sometimes at defined policy
anniversaries of the contract. These benefits would be underwritten at outset
and would, of course, affect premium rates and possibly initial underwriting
requirements. For marketing reasons, some riders are provided for the
policyholder at no additional charge.
Riders (IP)
A number of additional benefits may be added to standard IP covers, such as:

• hospitalisation benefit
• lump sum TPD benefit
• critical illness benefit
• terminal illness benefit
• unemployment and health waiver of premium benefit
• death benefit
• state benefit option (this pays an additional IP benefit if you do not receive
state benefits)
• fatal accident benefit
• retirement protection option.

Risk equalisation
Risk equalisation applies in some markets where the profits or losses on

specified policies or risks are pooled and reapportioned among participating
insurers so that each shares in the average market experience.
In the Republic of Ireland, a risk equalisation mechanism operates in the PMI market.
Risk premium
The risk premium method of reinsurance is used when a long-term insurer

wishes to reinsure only the risk element (mortality or morbidity) of a policy. The
insurer and reinsurer agree a set of risk premium factors to be applied to benefit
reinsured; these factors will generally vary by age sex and smoker status. Under
CI and other health contracts, these risk premium rates are often used as the
basis for the insurer’s office premium rates.
Secondary care
Secondary care is the term given to such advice and treatment as provided by
hospitals, consultants and other specialists, usually after referral by the patient’s
general practitioner.
See Primary care, Tertiary care.
Smoker/non-smoker rates
Most companies offer different rates for smokers and non-smoker, reflecting the
different morbidity or mortality of smokers and non-smoker for long-term
contracts. Smoker/non-smoker differentials would not apply to the pricing of
larger group schemes which are fully experience-rated.
Smoking status is defined by each insurer, eg not used smoking materials of any kind
for the last three years.
Stand-alone critical Illness plans
These are policies that only provide cover against critical illness and do not
provide (or accelerate in the case of a stand-alone rider) any benefit in the event
of death. Following payment of the critical illness benefit, the policy terminates.
Occasionally such policies may offer a nominal sum in the event of death before
a critical illness is suffered.
See Accelerated critical illness benefit.

Stop Loss
Similar to Cost Plus, Stop Loss is a reinsurance contract whereby an insurer’s

claims exposure will be restricted at some multiple of premium. The Stop Loss
arrangement will stipulate a loss ratio above which the reinsurer becomes
responsible for all or the majority of further claims.
Surplus reinsurance
Under a surplus reinsurance arrangement, the long-term insurer will cede to the
reinsurer all sums that exceed its retention on each individual life.
Switch
In the context of PMI, switch applies to the process whereby an existing PMI
policyholder, individual or group, changes insurer on renewal, without further
underwriting.
Telemarketing
The marketing of products via the telephone. Usually enquiries are generated by
direct marketing (see above) with the customer telephoning the advertiser
(usually the insurance company). The aim is to complete all application
procedures over the telephone. The policy will then be despatched together with
a direct debit instruction for completion and a copy of the completed application
for signature by the applicant confirming the answers given to the underwriting
questions.
See Direct marketing.
Terminal illness
A condition that in the opinion of a medical specialist or consultant means that the
insured expectation of life is twelve months or less.
Tertiary care
Specialized care, usually on referral from secondary medical care personnel, by

specialists working in a centre that has personnel and facilities for special investigation
and treatment (eg treatment in a specialist neurological unit).
See Primary care, Secondary care.

Tied agents
Also known as appointed representatives. These are sales people who act more
independently than a member of a direct sales force (see above), but sell only
the products of one insurance company, ie they are “tied” to one company.
They enjoy more freedom in how they operate and may employ sales people
themselves to sell the products of the selected company.
See Direct sales force.
Total permanent disablement (TPD)
Often introduced as a “catch all” insured condition on a CI or personal accident policy.

It might be specified in terms of a test based on ADLs, subject to an over-riding
condition of mental impairment.
Treaty
A treaty is a formal agreement between an insurer and a reinsurer setting out the
terms of a reinsurance arrangement. A treaty imposes an obligation on the
reinsurer to accept automatically business ceded within the scope of the treaty.
It also usually imposes a similar obligation on the insurer to pass business to
the reinsurer which falls within that scope and other terms of the treaty
Unemployment benefit
Where cover for unemployment is provided under an IP policy, it is usually for a

reduced benefit. The level is usually identical to that offered under the
Housepersons benefit.
Some companies provide cover during unemployment but change to a definition

of incapacity that requires confinement to the house (this may be extended to
include a medical institution) or being unable to go outdoors without assistance.
The student should note that this is not unemployment insurance – payment if
insured becomes unemployed.
Unit rate
See bulk rate.
Voluntary Group
This describes a collection of policyholders for whom membership of a PMI

scheme is voluntary. It may include affinity groups or employment groups.
See Affinity group.

Waiting period
This is a feature adopted by friendly societies under which sickness benefits will
not be paid for a specific period after the member first joins the society. This
waiting period may also be applied to any additional benefit from the date that
the member buys the additional units of cover. It might also be called a no-claim
period.
See Deferred period.
Waiver of premiums
This refers to the practice whereby the premium for an IP or CI policy is covered
in addition to the main benefit provided by the policy in the event of disability.
Waiver of premiums (UK)
The ABI Statement of Best Practice on IP includes a Guidance Note on waiver of

premium, which states that the definition of incapacity for waiver should be no
stricter than that applying to the main benefit.
Waiver of premium is automatically included in the basic premium rates by the

majority of IP providers in the UK. Practice is split between companies that
refund premiums proportionately for the period during which a claim is paid and
those that waive premium payments which fall due whilst the benefit is being
paid.
WHO (World Health Organisation)
An autonomous health organisation set up in 1948, with the aim of assisting the
population in the attainment of the highest possible level of health. WHO
proposes conventions, agreements, regulations and makes recommendations
about international nomenclature of diseases, causes of death and public health
practices. It also develops, establishes, and promotes international standards
concerning foods and biological, pharmaceutical and similar substances
Written premiums
In the case of regular premium business, written premiums are defined as the
annualised amount of premiums for all policies commencing or renewing in a
given period. Single premiums are deemed wholly written.

ST1: Q&A Bank Part 1 – Questions Page 1
Part 1 – Questions
Introduction
The Question and Answer Bank is divided into seven parts. The first six parts include a
range of short and long questions to test your understanding of the corresponding part of
the Course Notes, whilst the last part contains a set of exam-style questions covering the
whole course.
We strongly recommend that you use these questions to practise the thinking necessary
to pass the exam. Do not use them as a set of material to learn but attempt the questions
for yourself under strict exam style conditions, before looking at the solutions provided.
This distinction represents the difference between active studying and passive studying.
Given that the examiners will be aiming to set questions to make you think (and in
doing so they will be devising questions you have not seen before) it is much better if
you practise the skills that they will be testing.
It may also be useful to you if you group a number of the questions together to attempt
under exam time conditions. Ideally three hours would be set aside, but anything from
one hour (ie 35 marks) upwards will help your time management.
Part 7 of the Question and Answer Bank consists of 100 marks of exam-style questions.
You may wish to use this part as part of your revision closer to the examinations (for
example by using it as a mock examination).

Page 2 ST1: Q&A Bank Part 1 – Questions
Question 1.1
Define the following terms and phrases used in private medical insurance:
(i) Moratorium. [1]
(ii) Coinsurance. [1]
(iii) Age at entry pricing. [1]
(iv) Community rating. [1]
(v) Elective surgery. [1]
(vi) Investigative surgery. [1]
[Total 6]
Question 1.2
Describe the following individual policies and the consumer needs met by each one:
(a) income protection insurance
(b) critical illness insurance
(c) long-term care insurance. [5]
Question 1.3
Comment briefly on the following piece of advice:
“Buying an immediate needs long-term care annuity to provide an income to cover the
cost of care for the rest of your life is foolish. These contracts will be backed with
fixed-interest securities and so you would do better to buy these directly and cut out the
insurer’s expenses and profit.”
“Also, when you die there will be the added advantage that you can bequeath the money
left over to your relatives and friends, rather than to the insurance company.” [4]
Question 1.4
(i) Describe the employer’s interests as a stakeholder in the design of a group

income protection insurance product. [5]
(ii) Explain why employers have a stakeholder interest in the design of a group PMI
product, but rarely in the design of group LTCI and CI products. [6]
[Total 11]

Question 1.5
A health and care insurance company is considering entering the market for pre-funded
long-term care insurance contracts that cover the costs for an elderly person of home or
nursing-home care.
Describe a possible design for this new contract, so that it meets the needs of all the
stakeholders involved. You should consider both the structure of the benefits and
premiums, as well as the wording and definitions for eligible claims. [16]
Question 1.6
A health and care insurance company writes:

(a) critical illness policies secured by level premiums throughout the term of the
policy
(b) immediate needs long-term care insurance policies secured by a single premium
paid at the start of the contract.
Describe how new business strain is likely to arise in each case. [4]
Question 1.7
State the four risk factors that are important for IP business, and explain how each
affects the risk. [4]
Question 1.8
(i) State the four main distribution channels used by health and care insurance
companies. Explain briefly how each distribution channel operates. [8]
(ii) State what is meant by worksite marketing. [1]

[Total 9]

Question 1.9
(i) Discuss the reasons why an actuarial association might issue professional
guidance to actuaries advising health and care insurance companies. [3]
(ii) Describe the broad areas that this guidance might cover. [2]
[Total 5]
Question 1.10
State the most common types of regulatory restriction that are imposed on health and
care insurance companies. [6]
Question 1.11
A health and care insurance company writes a significant volume of critical illness
insurance business. New business volumes have fallen by 30% over the past three
months.
Describe possible reasons for the fall in new business. [11]
Question 1.12
A large bank currently has a defined-benefit occupational pension scheme.
The scheme provides a variety of benefits to the bank’s employees, in return for
contributions paid by the employer and the employee.
One of the benefits is an ill-health retirement pension. This is paid to members of the
scheme who are judged as being permanently unable to work again as a result of illness
or injury. The amount of the pension is related to the member’s salary at the date on
which they were granted ill-health retirement. The pension is 1 60 th of salary at the date
of ill-health retirement, for each year between the date of joining the pension scheme
and the expected date of normal retirement at the age of 65.
Describe the factors that may affect the design of a group IP insurance scheme that
would be suitable for the employees of this company, giving examples of the benefits
that may be offered. [8]

Question 1.13
(i) Explain how regulations specifying minimum levels of supervisory reserves may
limit the volumes of new long-term business that a health and care insurance
company can write. [3]
(ii) Briefly explain, and give examples of, how such regulations might influence
product design. [6]
[Total 9]
Question 1.14
You are the actuary for a health and care insurance company. The governors of a
private school have approached your company about the possibility of offering a group
CI scheme to the parents of pupils at the school.
The benefit would be the payment (direct to the school) of all fees on a termly basis
from the date on which either parent satisfied one of a standard list of conditions until
the child left school following their 16th birthday. Premiums would be collected by the
school with the fees due each term, and would increase in line with the level of fees
payable. The policy for any pupil would end when the first qualifying critical illness
event occurred, or when the child left the school, if earlier. Pupils enter the school in
the year in which they have their 11th birthday.
(i) Describe, giving reasons, the underwriting procedures you would put in place.[6]
(ii) Discuss whether it would be satisfactory to charge the same premium to all
parents. [2]
[Total 8]

Question 1.15
In discussing LTCI the Core Reading states:
“Few insurers, if any, will fund for care, ie will promise to indemnify the policyholder’s
residential and medical costs from incapacity in the future for the balance of lifetime.
This is deemed to be too uncertain a liability to entertain. The insurer will generally
take a longevity (annuity) risk and may additionally promise to increase benefit levels in
line with a suitable objective index of costs – but this is far short of indemnification.”
(i) What characteristics of the long-term care risk make it “too uncertain a liability
to entertain”? [3]
(ii) Explain how insurers who offered an indemnity policy could limit their
indemnity, yet still provide a product that appealed to consumers. [3]
[Total 6]
Question 1.16
A friend of yours who is aged 30 has obtained quotations for an individual IP policy
with a term of 30 years.
The benefit is £10,000 pa with a deferred period of 52 weeks.
Two premiums have been quoted:

● A fixed premium of £35 per month for the duration of the policy.
● A premium of £25 per month for the duration of the policy, guaranteed for the
first five years. On every fifth policy anniversary the premium will be reviewed,
and guaranteed for each subsequent period of five years.
Your friend sees this as merely a cynical ploy by the insurer. If he opts for the
reviewable premiums, the insurer may increase the premium to £40 or more at the first
opportunity. Where’s the insurance in this, he asks?
Explain how you would respond to your friend’s comments. [7]

Question 1.17
Describe the advantages and disadvantages for a PMI insurer of controlling claim costs
in each of the following ways:
● A co-insurance arrangement, whereby the insurer pays 75% of each and every
claim.
● A no claims discount (NCD) scheme with a 10% discount after one claim-free
year and 25% discount after two claim-free years. After a claim the discount
level reverts to 0%.
● A maximum claims payment of £10,000 in any policy year.
● An excess of £1,000 applied to each and every claim. [8]
Question 1.18
In the context of PMI insurance, explain what is meant by each of the following terms,
and describe how they help the health and care insurer to manage claims:
(i) pre-authorisation of claims
(ii) restricting treatment to listed hospitals and clinics. [5]
Question 1.19
A health and care insurance company writes the majority of its business through
insurance intermediaries. 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.
Discuss:
(i) The reasons why the company might offer some intermediaries a higher multiple
than others. [5]
(ii) The risks it accepts from this approach. [2]
(iii) How it can reduce these risks. [2]

[Total 9]

Question 1.20
In a certain country the only tax levied on healthcare insurance companies or healthcare
insurance policies is a premium tax. A percentage of each premium received by the
insurance company is paid to the government.
State the advantages and disadvantages of this method of taxation from the perspective
of the insurance company and the government. [5]

ST1: Q&A Bank Part 1 – Solutions Page 1
Part 1 – Solutions
Solution 1.1
(i) Moratorium
Certain PMI products, in place of medical underwriting, do not cover medical

conditions that existed during a pre-specified period (pre-existing conditions), usually
between two and five years, but will then extend cover if no treatment, symptoms or
advice takes place for a period of, typically, two years. The policyholder is however on
immediate risk for all other conditions. [1]
(ii) Coinsurance
The general term given to a PMI policy condition whereby the policyholder is required
to pay, at least in part, for medical expenses incurred. [½]
The insured and the insurer share the cost of the claim in fixed proportions (eg the
insured pays 20% of the claim). [½]
In other contexts, coinsurance also refers to the situation where two insurers share the
contract with the policyholder and also may refer to reinsurance on an original terms
basis.
(iii) Age-at-entry pricing
This phrase relates to the practice in some PMI markets of calculating premiums with
due allowance for the increasing age of the policyholder over the prospective period of
cover (often to age 65). [½]
Provided the insured renews his or her policy each year, premiums will not increase
because of the policyholder’s increasing age. [½]
The insurer usually retains the right to increase premiums subsequently to allow for
medical inflation or medical inflation in excess of levels assumed in the original
calculation.

Page 2 ST1: Q&A Bank Part 1 – Solutions
(iv) Community rating
Community rating most often refers to the practice of charging all policyholders or a
significant subset of the persons insured the same premium rate irrespective of rating
factors such as age, sex and medical history. [½]
Community rating sometimes refers to the process of applying tabular rates to

applicants irrespective of claims history. [½]
(v) Elective surgery
Surgery that is not deemed necessary or even advisable, but that the patient chooses to
undergo, is deemed elective and is seldom covered by standard PMI plans. [½]
For example the cure of an acute condition is generally covered by PMI plans but
cosmetic surgery is not. [½]
(vi) Investigative surgery
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 MME products.) [1]
Solution 1.2
(a) Income protection
This is a protection product that provides an income to the insured while they are unable
to follow their normal occupation because of illness or injury during the term of the
policy. [1]
Its function is to replace (part of) the income lost as a result of the incapacity. [½]

(b) Critical illness
This protection product provides a sum insured (cash sum) on the diagnosis of a
“critical” illness, as defined in the policy. [1]
The cash sum could be used to pay for medical treatment, to pay for nursing and other
care, to pay off family debts, to help support dependants in future, or even to pay for a
world cruise! [1]
(c) Long-term care
This protection product can be used to cover, or help to cover, the cost of care in old age
when individuals are no longer able to look after themselves. [1]
This might be home-based care or care in a nursing or residential home. It might also
pay for the costs of extra equipment or alterations to the insured’s home to help to deal
with their incapacity. [1]
[Maximum 5]
Solution 1.3
The principal objection to this comment concerns the absence of insurance if someone
were to take this advice. [½]
An annuity may be thought of as insurance against the financial consequences of living

too long (ie beyond the point at which your money runs out). Without an annuity, the
individual is taking the risk of living too long (longevity risk) himself or herself. [1]
Someone needing long-term care will not be in a position to supplement their income
when their savings run out. [½]
In fact, rather than leaving money to your relatives and friends, you may need to rely on
them to help pay for your care. [½]
Running out of money may mean that you have to change your lifestyle (eg move to a
cheaper care home) at a time when you are least able to adapt to change. [½]
Other points that might be mentioned:
The expenses of buying fixed-interest investments directly may be higher for the
individual. [½]

But it is true that the insurer’s administrative expenses and profit would be cut out
(assuming that the insurer is making a profit). [½]
The individual might not know which are the best securities to buy. [½]
The contract might not be backed entirely with fixed-interest securities. For example, if
the company has sufficient investment freedom to invest a proportion of the funds in
equities, index-linked gilts or corporate bonds, it may be able to offer better rates to
policyholders. [½]
[Maximum 4]
Solution 1.4
(i) Stakeholder interest in income protection
An employer is motivated by:

● The desire to provide a valuable benefit in kind for employees that will enhance
the employee’s total reward package, perhaps making it more attractive to
employees than those offered by other employers. [1]
● The desire for efficient management (in terms of cost and time) of the sickness
absence of employees. [1]
The employer will want:

● Benefits that complement any ill-health retirement benefits available from an
occupational pension scheme. [½]
● Benefits that enable the employer to cover the risks of paying statutory sickness
benefits. [½]
● A high free (of underwriting) cover limit. [½]
● Benefits that look attractive to employees and match their needs for income
while they are unable to work as a result of sickness or injury. [½]
● Efficient claims processing with the minimum of paperwork. [½]
● Counselling and rehabilitation services so that periods of sickness absence are
minimised. The availability of this service without cost during any deferred
period before benefits are payable would be an added advantage. [1]
● Advice on the employer’s statutory liabilities. [½]
● Competitive premiums, perhaps with rating related to the employer’s own
experience. [½]
[Maximum 5]

(ii) Stakeholder interest in other health and care products
PMI
Employers have an interest in PMI because it can be offered to employees as a benefit

in kind. [½]
The evidence is that PMI is usually valued by the employees and so enhances the total
reward package. [½]
PMI will also help manage the workforce by ensuring that employees’ acute medical
conditions are treated promptly at a time suited to both the employee and the employer.
[1]
PMI will help to minimise the time the employees are absent from work. [½]
PMI may improve the quality of treatment, making employees more happy and
productive in the long run. [½]
Employers may therefore have a keen interest in finding a group PMI policy that meets
their needs. [½]
The need for long-term care in old age does not have a direct impact on an employer’s
business. [½]
LTC does not have a high profile with the public in general, and so a LTCI benefit is
not likely to be valued as much by employees as IP or PMI benefits. [1]
One exception is where group LTCI is offered to employees with cover that extends to
their family, including their parents (and spouse’s parents). This reduces the risk to the
employer of employees retiring early from employment in order to provide care for their
ageing parents. Those doing this tend to be older, and so it results in the loss of
well-trained and experienced employees. [1]
Examples of this benefit are found in North America, where early retirement for this
reason has been a problem for some employers.

Critical illness insurance
The risks posed by many of the critical illnesses that are of concern to employers are
more effectively managed by a group PMI policy, that provides indemnity rather than
cash cover. Employers are therefore less interested in CI policies. [1]
In effect CI provides cover for some events that are “unnecessary” in the employer’s
eyes, and therefore could be more expensive than PMI.
CI provides payments for some illnesses from which employees are unlikely to recover
so that they can work again. Employers will not see a direct benefit from these
payments, and so are less interested in CI insurance. [½]
Many employees may already have critical illness insurance (eg connected with
mortgages and other loans) and so would not value such a benefit as highly as IP or PMI
insurance. [½]
[Maximum 6]
Solution 1.5
The following solution gives one suggestion. Alternative, well-justified designs would
also be acceptable.
Benefit structures
To meet the consumers’ needs the product must provide an income when a person needs
home or nursing-home care, and provide (potentially) sufficient benefits to cover the
cost of that care when it arises. [½]
The above needs could be met by a stand-alone conventional pre-funded LTCI

product. [½]
However, additional consumer needs could be met by alternative solutions, such as:
● a unit-linked LTCI investment product with fund protection (to provide a
savings vehicle) [½]
● LTCI as a rider to another protection product, such as CI (to provide further
financial protection). [½]
Additional benefits may also be considered, such as benefits to cover the cost of any
assistive devices or the provision of independent care advice. [½]

A benefit that provides a regular income for life (subject to ongoing disability) is likely
to be appropriate for the main benefit. [½]
However, alternatives could be considered, such as a single lump sum or restricting

benefit payments for a maximum period. [½]
A deferred period would apply – the length of which might be chosen by the
policyholder at outset (eg 3 or 12 months). [½]
Benefits might be limited to the actual cost of care, which would fully indemnify
claimants for their losses and allay fears associated with increasing future care costs. [½]
However, indemnity-based benefit levels should be subject to specified limits, in order

to control the potential total claim cost. The claim amount would be the lower of the
actual cost of care and this maximum amount. [½]
Alternatively, cash benefits could be provided, to protect the insurer from increasing
care cost. This would provide the claimant with flexibility, but increases the risk of
needs not being met. [1]
The LTCI product should have at least two levels of cash benefit because, for example,
the cost of nursing-home care can be considerably higher than that of care in one’s own
home. [½]
Further benefit levels may be considered – eg based on the level of the policyholder’s
disability – if this will increase the attractiveness of the product without
over-complicating it or making it too expensive. [1]
The maximum benefit (or cash benefit) might be linked to an inflation index. [½]
Benefits could be guaranteed, but this might significantly increase:

● the risk of not meeting the profitability requirement
● the amount of the supervisory reserves required
● the cost of capital (due to the higher reserves)
● the level of the premium or charges required to cover both the higher risk and
the higher cost of capital, which might in turn affect its marketability. [2]
Other things being equal, guarantees are often an attractive feature of a contract and
hence can enhance marketability. A compromise between marketability and cost might
be reached (eg by guaranteeing benefits from an advanced age, such as 70). [1]

Premiums
We must ensure that the premium (or charges) under the contract will be sufficient to
cover the expenses and benefits, and to produce a margin for profit in most foreseeable
circumstances. [1]
Premiums would usually be regular, but single premiums or retrospective premiums

(from the sale of a house) may be permitted. [½]
Premiums should be waived when benefits are payable. [½]
It might be practical to have a limited premium payment period, eg premiums cease at

age 85. This may also appeal to consumers, who might be wary of the obligation to pay
premiums for a long period with “no prospect of benefits”. [1]
Premiums may be guaranteed (in line with benefits, see points made above), but
reviewable premiums or charges will be most likely in the light of future uncertain
claims experience. [½]
In order to minimise the inflation risk, premiums (or charges) might be linked to an
inflation index (similar to benefits). [½]
Claims definitions
Clear, unambiguous criteria for claiming under the various benefit levels should be
imposed. For example, claim entitlement might be based on the claimant’s ability to
carry out certain activities of normal living (eg washing, dressing). [1]
The onerousness of the conditions to be set will be a balance between having:

● many conditions, which will reduce costs but may result in claims not being paid
when customers think they should be
● few conditions, so that claims may be paid that were not intended. [1]
The chosen criteria should be such as to achieve the required reduction in risk without
excessively reducing the attractiveness, and hence marketability, of the product. This
would be helped by ensuring that the case for any individual claim is judged
independently of the company, so that policyholders should feel that their claim
assessment will not be prejudiced by the interests of the company. [1]

General points
The benefit structure, premiums and claims conditions will need to be attractive in the
market in which it is intended to operate and the distribution channels open to the
company. [½]
Hence, the experience of competitors and the results of market research will be
considered in the final product design. [½]
[Maximum 16]
Solution 1.6
New business strain occurs when the initial asset share (premiums received less initial
expenses) is less than the sum of the supervisory reserves and the required minimum
solvency margin. Any such strain has to be made good from the company’s free assets
(ie those assets not earmarked for any particular purpose). [1]
(a) Critical illness
For regular premium contracts the asset share is normally negative in the early years.
This is because there is a high level of expenses incurred at the start of the contract, in
particular from commission, sales & marketing, underwriting and policy
documentation; and these costs are unlikely to exceed the amount of the first premium
received. [1]
The reserves will be at least zero because of the supervisory restrictions, plus any
solvency margin that may be required. Thus the value of the liabilities exceeds the
value of the assets, and we have new business strain. [1]
(b) Immediate needs LTCI
New business strain often arises due to the valuation basis being stronger than the
premium basis. For this reason it is common to have new business strain, despite the
large positive net cash inflow at time zero. [1]
[Total 4]

Solution 1.7
Any factor that may influence the probability of a claim or influence the amount of the
claim is a risk factor.
The four most important factors are:

● Age – older lives have a greater number of sickness periods that tend to last
longer than those for younger lives. [1]
● Sex – females have higher sickness rates than males. [1]
● Occupation – occupations involving a greater proportion of heavy manual work
tend to have higher claim rates than those involving no manual work. The stress
associated with an occupation can influence claim rates. [1]
● Area of residence – climate, presence or absence of tropical diseases and ease of
access to good medical services can influence claim rates. [1]
Also important are:

● Smoking status – those who smoke have higher mortality and morbidity. [½]
● Sales channel – business from independent intermediaries tends to have lighter
mortality and morbidity than that from direct sales, for example. In part, sales
channel is a proxy for social class. [½]
[Maximum 4]
Solution 1.8
(i) Distribution channels
The four main distribution channels used by health and care insurance companies are:
● Insurance intermediaries
● Tied agents
● Own sales force
● Direct marketing [1]
Insurance intermediaries
These are independent of any particular health and care insurance company. They can
advise their clients on the best contracts for their needs from among all the contracts
available. [1]
They may be remunerated by commission from the insurance companies whose

products they sell or by fees from their clients. [1]

Tied agents
These are insurance intermediaries who offer the products of only one or a limited
number of insurance companies. If the tie is to more than one company then usually the
product ranges of the companies are mutually exclusive. [1]
Typically, tied agents are financial institutions such as banks or building societies. Tied
agents are paid commission by the companies whose products they sell. [1]
Own sales force
These are usually employees of a health and care insurance company and so only sell
the products of that company. They may be paid by salary or commission or a mixture
of the two. [1]
Direct marketing
The main forms of direct marketing are telephone selling, press advertising and mail
shots. Internet sales are also possible. [1]
Telephone selling might involve “cold-calling” by the company or might be in response
to an advertisement (in which case press advertising and telephone selling are part of the
same process). [1]
Press advertising might include an application form or invite requests for further
information. Mail shots will definitely include application forms. [½]
Internet selling may be linked to advertising, and is essentially web-based application

processing. [½]
[Maximum 8]
(ii) Worksite marketing
Either insurance intermediaries or the company’s own sales force (or perhaps particular
employees of the company) will carry this out. [½]
An employer agrees to allow access to the work force (through meetings or literature)
for the purpose of marketing products to the employees on an individual basis. [1]
[Maximum 1]

Solution 1.9
(i) Reasons for issuing professional guidance
An actuarial association is a stakeholder in the healthcare insurance market. Guidance

notes provide a way of insuring that its interests are protected. [½]
The main aim is to give actuaries a framework for issues that they need to consider in
carrying out their professional responsibilities. [½]
This helps to ensure consistency (eg in approaches to pricing and reporting) and to
maintain professional standards (eg by providing a standard on the strength of which
disciplinary actions against members can be taken). [1]
This is essential to protecting the public interest, and to maintain a high degree of trust
between the public and the health and care insurance companies. [½]
This should encourage individuals to take out the insurance that they need. [½]
The guidance can also add weight to the actuary’s arguments if he or she needs to resist
pressure from proprietors in order to protect the best interests of policyholders. [½]
[Maximum 3]
(ii) Areas typically covered
These include:
● the design and pricing of new health and care insurance contracts [½]
● determining reserves [½]
● profit distribution. [½]
Actuarial associations may also issue guidance on the interpretation of government

regulations. [½]
In fact, the legislation may be framed in a general way, with the expectation that the
actuarial association will set out an appropriate specific interpretation. [½]
[Maximum 2]

Solution 1.10
The following are common regulatory restrictions.
● Restrictions on the type of contract that a health and care insurance company can
offer. [½]
● Restrictions on the premium rates or charges that can be used for some types of
contract. [½]
● Requirements relating to the terms and conditions of the contracts offered, for
example specifying the terms for claim payment or how paid-up policy and
surrender values (if any) are to be calculated. [½]
● Restrictions on the channels through which contracts may be sold, … [½]

…or specified procedures which must be followed, … [½]
…or information which must be given as part of the selling process. [½]
● Restrictions on the ability to underwrite, for example a prohibition on the use of

the results of genetic testing. [½]
● An indirect constraint on the amount of business that may be written. [½]

This arises from minimum requirements for reserves and solvency margin,
which decrease available capital and increase the capital needed to fund new
business. [1]
● Restrictions on the types of asset that can be held … [½]

…or the amount of any particular asset in which the insurer may invest, … [½]
…or which it can include in its asset value for the purpose of demonstrating
solvency. [½]
[Maximum 6]

Solution 1.11
Loss of business means that some aspect of the company’s marketing is inadequate.
The aspects of marketing that might be important are:
● the premium rates (price of the product)
● the characteristics of the product
● how the product is sold
● how the product is promoted.
Premium rates
As critical illness insurance is generally a price-sensitive product, if premium rate have

been increased, this might make the company uncompetitive in the critical illness
insurance market. [1]
Premium rates of other companies have been reduced. This may be as a result of
changes in morbidity experience or changes in the companies’ profit criteria. It is
possible that margins in the premium basis for future claim volatility may have been
high until recently, and companies are now shedding some of these margins as
experience develops and future rates can be predicted more reliably. [1]
One or more companies, who are able to offer more competitively-priced products may
have entered the market, eg because they have lower expenses or because they are using
less stringent profit criteria such as selling at lower profits (or even losses) to establish
themselves in the market. [1]
Also, new entrants or other competitors may have been “cherry picking”, (ie using
stricter underwriting in order to offer lower premium rates to healthy lives), leaving this
company with rates that only look reasonable to the less healthy lives. [1]
[Give similar credit for alternative relevant points]
Product characteristics
Business may have been lost because the product design is out-dated (eg the list of
conditions covered does not match those offered by competitors). [1]
Other aspects of the environment (eg tax, legislation) may have changed resulting in the
current structure of the product becoming less attractive to customers. [1]
Some other aspect of the competition’s products may have improved, (eg commission
rates, options available to policyholders). [1]

How the product is sold
The underwriting criteria used by the company may have become more stringent. So it
may be accepting a smaller proportion of applications on standard terms. When new
underwriting criteria become apparent to intermediaries, they often send business
elsewhere unless there are other reasons to stay put. [1]
If the company sells though independent intermediaries, it may have fallen out of
favour, eg commission rates out of line with those of other companies or poor
administration resulting in delays in processing sales. [1]
The company may sell exclusively or primarily through a distribution channel that has
declined in importance over this period, eg using their own sales force rather than
selling through IFAs. [1]
The company may have experienced problems in distributing its products, (eg loss of an
independent intermediary, problems with its own sales force). [1]
How the product is promoted
The product may be have been poorly promoted. This embraces all aspects of how the
product and the company appear to those who are interested in buying a CI policy. [½]
Some issues are:

● The company may have received bad publicity – eg from adopting over-strict
claims management procedures, or in relation to another product, or just
generally. [1]
● There may have been falls in critical illness insurance sales generally, (ie a
decline in the market as a whole rather than anything specific to this company).
This may be a result of, for example, a decline in customer confidence in the
insurance industry or bad publicity following mis-selling of products. [1]
[Maximum 11]

Solution 1.12
The design of the group IP scheme needs to complement the benefits available from the
occupational pension scheme. [½]
The ill-health retirement benefits will cover the risk of an employee being unable to
follow their normal occupation as a result of sickness or injury in the long term, so the
group scheme will need to cover short-term sickness absence, say up to one year. [1]
The benefits should be calculated using a simple fixed formula so that they are related
to the income received immediately prior to the claim period. [½]
The total benefit should be limited, so that the income replacement ratio does not
exceed 60-70%. [½]
If the scheme benefits are to be paid to the employer then we can ignore statutory sick
pay, otherwise it should be deducted from the benefit payable. [½]
If membership of the scheme is required as a condition of employment, then

underwriting could be restricted to a simple criterion (eg continuously at work in the
two months prior to joining). [1]
If membership is voluntary, then a similar underwriting criterion could be used for those
who join at the first opportunity, otherwise a more detailed medical questionnaire would
be needed. [1]
If the benefit formula was fixed and the same for all members, then we should not need
to impose any restrictions on the cover available for individual members. [½]
Otherwise we would need to impose a free cover limit above which strict underwriting
criteria would be applied. [½]
If the employer is paying the premiums then a simple percentage of the total salary bill
paid each month would be satisfactory. If individual members are paying their own
premiums then a simple premium scale based on a percentage of gross salary and
varying by age at entry would be satisfactory. [1]
If the scheme has a very short deferred period for benefits (eg 4 weeks), perhaps
because the employer is using the scheme to cover the cost of statutory sickness
benefits, then claims underwriting will need to be more stringent than if the deferred
period was longer (eg 26 weeks). [1]

In the latter case we should require any absence lasting longer than, say, 4 weeks to be
notified so that suitable support and counselling can be provided to reduce the
likelihood of an eventual claim. This service is often seen as a positive aspect of the
scheme by employers anxious to maximise the productivity of their workforce. [1]
[Maximum 8]
Solution 1.13
(i) How reserving regulations restrict new business volumes
The restrictions are indirect and involve two related factors.
First, available capital for writing new business is in essence assets minus {liabilities
plus solvency capital}, on the supervisory basis. [½]
The prudence we expect in supervisory requirements means that the value of the
liabilities plus solvency capital for existing business, are larger than would otherwise be
required. [½]
This is significant for most health and care insurance contracts due to the amount of
uncertainty involved with regard to the future claim experience, and this will result in
higher contingency margins. [½]
This reduces the free assets available as capital for writing new business. [½]
Secondly, the amount of capital required for writing a new contract is increased by such
regulations. [½]
This is because the reserve plus any additional required solvency capital for each new
contract, is larger than that which would be calculated on the contract’s premium basis.
[½]
So each policy issued “uses” some of the company’s supply of capital. There is
therefore a limit to how much new business a company can actually write in a certain
period of time. [½]
[Maximum 3]

(ii) The influence on product design
The main influence is that companies may have to design products that are capital
efficient. [½]
For example:
● Issue contracts that have unit-linked rather than conventional structures, which
can be designed to operate in capital-efficient ways (such as by having low
allocation rates at the start of the contract). [1]
● Try and reduce the extent of any guarantees offered, as guarantees will require
larger reserves. This will usually take the form of offering contracts with
reviewable premiums and/or charging rates. [1]
● Limit the availability of policyholder options, as their presence would require

additional reserves because of the additional contingency. [½]
● Try and improve the matching of expense charges and expense outgo, … [½]
… for example by using level commission for regular premium contracts, by
issuing short-term or single premium contracts, or directly using a unit-linked
structure. [½]
● Limit the extent of benefit uncertainty by choosing appropriate benefit terms and
restrictions, … [½]
… for example, putting a ceiling on the periodic benefits payable under LTCI or
IP contracts, or by having strict definitions of diseases covered under CI
policies. [½]
Try and ensure that the best possible data are used for determining the assumptions in
the pricing models and the reserving basis. This will reduce the parameter uncertainty
and hence reduce the need for margins in the reserves. [1]
Try and avoid issuing novel and innovative products, which regulators might regard as
particularly high-risk, and on which stringent reserving requirements might be imposed.
[1]
[Maximum 6]

Solution 1.14
(i) Underwriting procedures
The aim of the underwriting procedures should be to prevent selection against the
insurer. [½]
The opportunity for underwriting is limited because the insurer will have little direct
contact with the parents – the school is to collect and remit the premiums. This means
that the procedures must be very simple. [1]
The benefits are determined using a fixed formula and are earmarked for a specific
purpose (the insured lives will not receive any cash payments). There is therefore no
need for financial underwriting. (In effect financial underwriting was completed when
the school decided that the parents were capable of paying the fees.) [½]
Because the benefit level will be similar for all individuals (per child), there may be no
need for a free cover limit. [½]
However, the risk to the insurer could be considerably higher from parents who have
more than one child at the school, so free cover could be offered for those with only one
child (say) but not for those paying for several children. [½]
If a large proportion of all those eligible joined, or if membership was compulsory, this
would reduce the chance of anti-selection and reduce the need for extensive
underwriting. [1]
If membership was voluntary, cover could be offered with no underwriting to those who
opted to join at the first opportunity. Those who wished to join subsequently would be
subject to detailed underwriting, perhaps using the same procedures as those used for
the company’s individual business. [1]
We are assuming that underwriting at the claims stage would be sufficient to prevent
those who fall on hard times and are unable to pay the fees from making a fraudulent
claim. [½]
If membership was in effect voluntary with no minimum take up required, then some
limited underwriting is essential. This could take the form of a simple form asking for
date of birth, smoking status etc, and confirmation that each parent had been
continuously at work during the past three months or, for those not gainfully employed,
unrestricted in their day-to-day activities during this period. [1]

Asking for a declaration of any medical treatment currently being received would
provide an additional safeguard. This would allow the insurer to restrict cover for
pre-existing conditions. [½]
If the school collects this information the costs of the exercise would be minimised. [½]
An alternative would be to impose a moratorium, and so exclude claims relating to

pre-existing conditions during the, say, first year of membership. [½]
[Maximum 6]
(ii) Would the same premium for all parents be satisfactory?
Parental ages are likely to range from, say, about 30 to 50. Expected critical illness
incidence rates increase with age over this range, particularly towards the end.
However, with a large membership a fixed premium might be acceptable to the insurer.
[1]
The alternative is to use age-banded premiums that vary according to the age of the
parents, but this would be more administratively complicated and possibly less
attractive to parents. [1]
Costs of premium collection would be reduced if the policy was offered as a “free”
benefit (to parents) with premiums (paid by the school) being determined as a fixed
percentage of the total fee income each term. So in effect the premium rate (% of fee
payable) would be the same for all parents. [½]
The risk for two parent families will be greater than that for families with only one
parent. So you may consider offering a simple discount on premiums for one-parent
families. [½]
[Maximum 2]
Solution 1.15
(i) “Too uncertain to entertain”
The uncertainties surround the probability of a claim and the cost of the claim. [½]
The probability of a claim will be influenced by the type of accidents and illnesses that
result in a need for care in the future, rather than those that result in a need for care now.
[½]

New methods of treatment (eg a cure for Alzheimer’s disease) would dramatically
reduce the probability of a claim, but other as yet unknown conditions may increase the
probability of a claim. Similar advances in care technology may increase or decrease
the probability of a claim. [½]
Advances in medical treatment may not prevent a condition occurring but may prolong
the insured’s life when they need care. There will be additional uncertainty about the
expected duration of claims. [½]
The cost of a claim will be influenced by the costs of care (eg salaries of care workers)
and how care is provided (eg more high-tech care may be more expensive). [½]
Changes in the supply and demand for care services can also significantly affect claim
costs in a very unpredictable way. [½]
It is difficult if not impossible to forecast these changes, hence the conclusion that they
are too uncertain to entertain. [½]
[Maximum 3]
(ii) How to limit indemnity
All the suggestions involve some sharing of the risk between the insured and the
insurer. [½]
The major contributor to claims costs is the very long periods of high-intensity care that
are needed for a few individuals (ie the right hand tail of the claim cost distribution). [½]
Some suggestions are:
Have a deferred period during which no benefits are provided (the insured might be
happy to fund an initial care period out of their own resources), then provide care for,
say, three years and no benefits after this. The insured might view the probability of
needing care after 3+ years as very small and be happy to rely on State care if this was
necessary. [1]
Have a maximum total care benefit (eg five years of complete care), and allow the
insured to claim different amounts of benefit (eg 25% of the maximum for care in the
home provided by friends and relatives) until the total benefit was used. [1]
Impose an index-linked monetary amount on the maximum amount of benefits that will
be paid. [½]
Introduce reviewable premiums. [½]

[Maximum 3]

Solution 1.16
In both cases, the premium is calculated to produce a level premium over the 30-year
term. It is not the insurer’s intention for it to increase (eg with age), or even decrease,
over the term, even in the case of reviewable premiums.
The insurer’s estimate of the expected claims cost for the next 30 years will be subject
to considerable uncertainty. As a result of this uncertainty the insurer will need to
include a contingency loading in the premium. [1]
This loading may be substantial for a policy with guaranteed premiums for a term of 30
years. [½]
However, if the insurer is able to reassess the expected cost of claims every five years
then the contingency loading required will be much smaller. [½]
At the end of the first five years, the insurer will reassess the risks faced for the
remainder of the 30-year term with the help of the additional statistical knowledge
gained about the portfolio of policies during the previous five years. [½]
Premiums are reassessed for the whole portfolio of policies and not on a policy-by-
policy basis. All those policyholders having the same combination of rating
factors (eg age, sex, occupational class etc) will be charged the same premium. [1]
The reassessment is of the future risks and the insurer should not attempt to make up for
past mistakes by adjusting the future premium. However, a poor claims experience in
the past may result in the insurer estimating that the expected cost of claims in the future
will increase. [1]
The size of the adjustment that the insurer can make to the premium will be constrained
by market forces. [½]
Each policyholder has the option to accept or reject the new terms. If the new
premiums are much higher than the current market rates, healthy policyholders will seek
cheaper insurance elsewhere and allow their current policies to lapse. [½]
The insurer will therefore only retain the less healthy lives who, because of
underwriting, cannot obtain new policies elsewhere, and so the claim experience of the
will be higher, leading to reduced profits. The insurer is therefore unlikely to impose
excessive increases to premiums. [1]
The element of “risk sharing” with the policyholder is likely to lead to lower total
premium payments over the term of the policy under reviewable premiums compared to
guaranteed premiums. [½]

However, there is a chance that there will be a general deterioration in the claims
experience for all policies (and which might extend to all insurers), in which case the
reviewed premiums will reflect this increased risk. [½]
On the other hand, reviewable premiums may be reduced on review, as a result of the
experience of the portfolio of policies being better than expected. This would not be the
case is the premium was fixed. [½]
[Maximum 7]
Solution 1.17
Co-insurance
+ There is an element of claims control because the cost of each claim is shared
with the insured. The insured is less likely to make false claims or to exaggerate
the size of a claim. [1]
+ Premiums will be more competitive than for a policy without co-insurance,

resulting in higher sales. [½]
+ If the feature is novel in the market, it may result in higher sales. [½]
– The insurer will be involved in all claims, so claims administration costs will be
high. [½]
– There is a no limit to the amount that the insured may have to pay. This
represents a risk for the insured. If the insured is unable to afford to contribute
to very large claims, this may lead to bad publicity that may harm the insurer’s
reputation. [1]
– There is no limit to the amount that the insurer may have to pay. [½]

NCD scheme
+ It will encourage the insured to pay for small claims, thus reducing the number
of claims and keeping down claims administration costs. [1]
– It may be viewed as immoral by the industry because it discourages people from

claiming when they need treatment. [½]
– It will increase other administration costs. We need to ensure that our systems
can deal with the ratings imposed. [½]
+ It may encourage the insured to renew his or her policy, particularly if the
discount is not transferable between insurers. [½]
Maximum claims payment in any policy year
+ It will limit the insurer’s liability, resulting in lower claims overall. Premiums
can be reduced to more competitive levels, and this should lead to more sales. [1]
– If the insured is seriously ill (eg needs an organ transplant), the insurance cover
may run out before the treatment is complete. There is a risk of bad publicity
harming the insurer’s reputation. [½]
– This would have most effect at older ages, where claims are more frequent. The
insured may feel that he or she has paid for many years without claiming, and so
any restriction may appear to be unfair (in spite of the policy wording). [½]
– The insurer will still have to pay all claims, so the claims administration
expenses will be high. [½]
+/– The overall impact is likely to be small because most cases where expensive or
lengthy treatment is required will be for chronic conditions, which are excluded
from most PMI policies. [½]

An excess of £1,000 on each claim
+ This would act to reduce the number of claims, so reducing the cost of claims
administration. [½]
+ Overall claims costs will reduce, allowing premiums to be more competitive

compared to those with “normal” excess levels (eg £50). [½]
– It may look bad if the excess is seen to discourage people from seeking the
treatment they need. [½]
[Maximum 8]
Solution 1.18
Pre-authorisation
Some PMI insurers require (others recommend) that they approve intended courses of
treatment or surgery for policy coverage before costs are incurred. [½]
This process can often provide opportunity for the insurer to manage care provision or
at least avoid the complications arising from inadmissible events. [½]
A secondary purpose is to control the quality of treatment that is provided. [½]
Pre-authorisation will also minimise the number of claims that are refused. [½]
Treatment in listed hospitals
A PMI policy may restrict cover to such treatment as is carried out in certain medical
establishments (with whom it has special arrangements, often financial) or may limit the
scale of reimbursement outside these establishments. [½]
The premium for such policies where treatment must take place in such a preferred
provider organisation (PPO) will usually be cheaper than if the claimant had the choice
of any provider. [½]
If the insurer is able to enter into contracts with the selected providers, treatment and
aftercare can be provided at an agreed, fixed price, irrespective of any complications
involved in a particular case. [1]
Bulk purchase from these hospitals will also ensure competitive prices. [½]
Contracts can also ensure that minimum quality standards are met. [½]

Contractual arrangements (eg monthly bulk billing) may ensure simpler and cheaper
[Maximum 5]
Solution 1.19
(i) Why offer some intermediaries a higher multiple than others?
The company is interested is maximising total profit, which is achieved by finding a

suitable blend of quality of business and volume of business. [½]
Higher quality business should lead to higher profits, through having better experience
(eg morbidity, persistency). If some of this extra anticipated profit is passed to those
intermediaries who produce the better quality business, through increased initial
commission, new business volumes from these intermediaries should increase thereby
improving overall profit. [1½]
Similarly, a higher average case size should lead to higher profits (if not already
reflected fully in the standard scale). So, if more business can be encouraged from
intermediaries writing larger cases, overall profit should improve. [1]
For intermediaries requiring less support (eg help with administrative tasks), expenses
will be lower, so some of the benefit from this might be passed back to the intermediary
via increased commission. [1]
Increased commission might also be offered for competitive reasons. [½]
Large IFAs and IFA networks are likely to be very important for this insurance
company, since it could be depending on them to write sufficient volumes of business to
recoup development and fixed costs. Unless the company keeps up with competitors, it
might lose this business. [1]
It might be better to accept less profit per policy if this generates sufficient sales to
spread fixed costs. [½]
Offering higher commission might also help the company sell business to new
intermediaries. [½]
[Maximum 5]

(ii) The risks
There is a risk of upsetting some IFAs and losing their business if they perceive their
terms to be unfair compared with other intermediaries. [½]
If future experience from policies written via a particular intermediary is not as good as
assumed, then the higher profits won’t materialise. Therefore, there is a risk that overall
profit is reduced, because the intermediary has not produced the business that it was
assumed would generate the funds for the extra commission. [1]
There might be ongoing pressure for increased commission from other intermediaries,
gradually eroding the value of the better experience, until the company is no better off
than before. [½]
(iii) How to reduce these risks
The company could try to keep individual commission agreements secret, but this might
only serve to increase suspicion. [½]
A better approach might be to explain the process clearly so that intermediaries will
understand that the terms are fair. (This assumes that there is a clearly thought out
process, not some ad hoc approach.) [½]
The company should also ensure that all commission offered is still as competitive as is
necessary. [½]
While maintaining the proposal to pay multiples of initial commission, it could alter the
overall split between initial and renewal commission. [½]
The company will need to monitor experience, if it is to be able to put any controls in
place. The company could introduce a clawback provision, whereby some of the initial
commission is returned if experience is worse than assumed. However, this might be
unpopular and would be hard to enforce. It would be easier just to change the
commission offered in future to intermediaries not continuing to meet the experience
requirements. [1]
[Maximum 2]

Solution 1.20
Part of this solution does not appear in the Subject ST1 Core Reading. Examiners often
expect you to apply general principles to areas that are not, perhaps, covered in full
detail in the course, as in this question. So, while this initially appears to be a pure
bookwork question, it does require you to think rather than simply regurgitate
bookwork knowledge.
Insurance company’s perspective
+ The method is simple and any change in tax rates will be simple to administer as
a simple change to premium rates. [½]
± The tax paid is not dependent on profits. This seems penal if the business is
loss-making and, conversely, generous if the business is making large profits.[½]
- The method does not distinguish between type of product (eg short-term or
long-term, income or lump-sum benefits, conventional or unit-linked). [½]
This may distort the premium rates charged and hence the buying habits of
customers. [½]
+ It does not alter the relative price-competitiveness of the product in the market,
(ie the ratios between the prices of different products are unchanged), so will not
influence relative sales. [½]
- Method by which tax is collected is explicit, and this may make products less
attractive to customers. (A less obvious method, having an equivalent effect on
premiums, may create fewer disincentives for customers.) [½]
- The tax paid is not dependent on expenses and other factors that would normally
be considered to be allowable against profits. [½]
Government’s perspective
+ The method is simple and cannot be manipulated. [½]
+ Taxation revenue will be easy to plan for, depending on market conditions and
stability. [½]
- The tax paid is not dependent on profits. This will seem unfair to loss-making
companies who will effectively be subsidising profit-making companies. [½]
- There may be conflicts with other government objectives, such as the

encouragement of healthcare insurance provision. [½]
[Maximum 5]

Question 2.1
(i) Discuss the principal requirements that should be met by an actuarial model used
to assist in the financial management of a healthcare insurance company. [6]
(ii) Describe the steps that should be followed when using a model to set the charges
under a new unit-linked income protection product. [9]
[Total 15]
Question 2.2
Describe the social and economic influences on private medical insurance (PMI). [3]
Question 2.3
State the principles that should be taken into account when setting the demographic
assumptions in the pricing basis for a new healthcare insurance product. [5]
Question 2.4
(i) State what is meant by the “net present value” of a contract, and how it would be
calculated. [2]
(ii) Explain the various ways in which healthcare insurance companies can make use
of net present value calculations. [6]
(iii) Describe why a healthcare insurance company might choose to use the net
present value as a profit criterion, rather than the internal rate of return or the
discounted payback period. [6]
(iv) Describe the drawbacks of using the net present value as a profit criterion. [5]
[Total 19]

Question 2.5
Describe all the steps involved in re-pricing an existing private medical insurance
product. [28]
Question 2.6
Explain how future developments in medicine may be expected to affect claim costs
under the following healthcare insurance contracts:
(a) critical illness [3]
(b) income protection [2]
(c) private medical insurance. [2]
[Total 7]
Question 2.7
Explain why stochastic modelling might be useful for healthcare insurance purposes.
State any disadvantages that stochastic modelling may have compared to the use of
deterministic models. [5]
Question 2.8
Write down a suitable formula for calculating the claim incidence rates under an
accelerated critical illness policy. [2]
Question 2.9
A healthcare insurance company sells a large volume of non-linked individual income

protection policies, on guaranteed terms, through insurance intermediaries.
List the items that would be used in a cashflow profit test to price this product. Identify
the items on your list that would not be used in a formula approach. [7]

Question 2.10
A State has in the past funded its healthcare system on a pay as you go (PAYG) basis.
It is proposing to move to a forward funding basis.
Describe the difficulties it might face in making this change. [8]
Question 2.11
Explain how the pay as you go (PAYG) system of funding State healthcare and welfare
operates and depends on the trust between successive generations in the community. [5]
Question 2.12
In Country A all healthcare is free at the point of use.
A fundamental principle of healthcare funding in Country B is the element of personal

contribution. The level of cover provided by the State is a fixed percentage of the
published tariff for the care received. However, providers are free to charge consumers
more than the tariff price.
Some examples of the percentages of the costs of care met by the State are:
Treatment Rate of reimbursement

Major Surgery 95%
Minor Surgery 80%
Pregnancy & Childbirth 95% to 100%
Prescribed Medicines 35% to 65%
X Rays 70%
GP/Specialist Visits 70%
(i) Describe the advantages and disadvantages to the State of each system. [12]
(ii) Describe how each system might influence the market for PMI in that State. [5]
[Total 17]

Question 2.13
The premium for a five year combined sickness and death benefit policy is to be
calculated using a multiple state model with the three states H (healthy), S (sick) and D
(dead).
The policy pays £2,500 at the end of each year if the policyholder is sick at that time.
If the policyholder dies during the term, an income benefit of £5,000 pa is payable for the
remainder of the five years, the first payment being made on the policy anniversary
following death, and the final payment being made at the end of the fifth policy year.
No benefits are paid to healthy lives.
A level premium is payable at the start of each policy year provided the life is in good
health at the time the payment is due.
The transition probabilities (which operate independently in each year) are as follows:
P ( state = D at time t + 1| state = H at time t ) = 0.01
P ( state = S at time t + 1| state = H at time t ) = 0.05
P ( state = D at time t + 1| state = S at time t ) = 0.05
P ( state = H at time t + 1| state = S at time t ) = 0.80
(i) Calculate the probabilities that the life is in each of the states at the end of policy
year t, t = 1, 2, … , 5 . [6]
(ii) Calculate the net premium for a policy issued to a healthy life, assuming an
interest rate of 6% pa and ignoring expenses. [4]
[Total 10]

Question 2.14
A long-term care insurance policy provides the following whole of life benefits:
● on irreversibly requiring assistance in the insured’s own home, an income of
£5,000 pa
● on irreversibly requiring care in a residential home, an income of £15,000 pa
● on death while healthy, a return of all premiums paid, without interest
● on death while receiving a benefit for care in the insured’s own home, a lump
sum of £20,000.
No payment is made on death while receiving benefits for care in a residential home.
Healthy policyholders pay a premium of £1,000 pa until age 70 or until earlier death.
All premiums and care benefits are assumed to be payable continuously, and death
benefits are payable immediately on death.
The following multiple state model is used by the company for pricing and reserving:
σx S ρx R
H Care in Care in a
Healthy insured's residential
own home home
νx
µx λx
D
Dead
The forces of transition (shown in the diagram) are assumed to be a function of age x.
You can also assume that you have probabilities of the form:
t pijx = probability that a policyholder aged x and in state i is in state j at age x+t,
where i, j = H, S, R, D.

Write down a formula for the expected present value of the future loss from this
contract for a new policyholder aged 50 at entry, assuming the following expenses:
● initial: £200
● regular: £25 pa incurred continuously from the start of the policy and for as long
as the policy is in force
● claim: £30 pa incurred continuously for the duration of any assistance benefits,
and £60 on any death claim. [9]
Question 2.15
A healthcare insurer offers a waiver of premium benefit on a whole of life assurance

policy while the policyholder is sick, but not within the first year of sickness. Premiums
under the assurance are paid weekly until age 65. By what percentage should the
premium for a normal whole of life policy for a man aged exactly 50 be increased in
order to provide the waiver benefit?
Basis: Mortality ELT15(Males)

Sickness S(ID) claim inception and annuity basis table
Interest 6% pa
Expenses 5% of gross premiums (including waived premiums). [5]

Question 2.16
A healthcare insurance company issues an income protection insurance contract to a

healthy life aged exactly 30. Under the contract, a benefit of £20,000 pa is payable
weekly in the event of disability. The benefit continues to be payable during disability,
until the policyholder recovers or reaches age 65. The benefit increases continuously in
payment at the rate of 3% pa compound.
There is no waiting period or deferred period. Premiums continue to be payable during

periods of disability.
Disability benefit payments are valued using rates of claim inception and termination.
Describe the method of valuing disability benefit payments under this contract, setting
out the data required. [7]

Question 2.17
A healthcare insurer prices sickness insurance contracts using the following three state
model in which the forces of transition depend on age:
σx
H S
healthy sick
ρx
µx νx
D
dead
Level premiums are payable continuously. Benefits are payable continuously during
periods of sickness. There is no death benefit, and the contracts have a deferred period
of three months and include a waiver of premiums during periods of benefit payment.
State briefly, with reasons, what effect (certain increase, certain decrease, not certain)
the following changes will have on the premium, if the same net present value of profit
is to be achieved:
(a) an increase in the death rate from the sick state, together with an increase in the
rate of transition from the healthy state to the sick state
(b) a fall in the death rate from the sick state, together with a fall in the rate of
transition from the sick state to the healthy state. [4]

Question 2.18
A one-year accident and sickness insurance policy pays a benefit of £10,000 pa for two
years following the inception of sickness or disability. Sickness benefits cease
immediately on recovery, death, or on the second anniversary of disability inception,
whichever event occurs first. There is no deferred period. People who recover from
one (or several) bouts of sickness are allowed to claim again under the policy provided
the policy term has not expired. Sickness benefits are assumed to be payable
continuously.
Calculate the single premium for this contract according to the following:
● age at entry 30
● mortality ELT 15 (Males)
● morbidity S(ID)
● interest 6% pa
● expenses 7.5% of the premium, plus 1% of each benefit payment. [7]
Question 2.19
You work for a life insurance company that currently issues conventional term
assurance contracts, under which the sum assured is payable on the death of the
policyholder during the specified policy term. The company now proposes to issue term
assurance products with accelerated critical illness benefits, such that the sum assured
will be payable on the earlier event of critical illness diagnosis or death during the
policy term. Both products have, or will have, fully guaranteed benefits and premium
rates. The company has never issued critical illness contracts before.
Locally-based industry standard tables for mortality and critical illness rates both exist,
and currently the company bases its term assurance premiums on 75% of the current
standard mortality table rates.
Towards the end of a recent office party (which was very good), an actuarial colleague
suggested using the following basis for pricing the new product:
● mortality: 75% of existing standard term assurance mortality rates
● critical illness: 75% of existing standard critical illness rates.
Suggest what you might have said to your colleague, and the (sometimes heated)
arguments that you might have made to support your points. [8]

Question 2.20
A healthcare insurance company requires an approximate price for the following

income protection policy:
● benefits: zero for sickness durations up to 12 months
£800 per month for sickness durations exceeding 12 months and
up to 24 months
£1,200 per month for sickness durations exceeding 24 months
● entry age: 50
● expiry age: 65
● premiums: payable monthly in advance until age 65 or until earlier death
● waiver: premiums are waived when sickness benefits are being paid.
(i) Find an approximate value for the monthly premium using the following basis:
● mortality: ELT 15 (Males)
● morbidity: S(ID)
● interest: 6% pa
● expenses: initial: £200
regular: £25 pa while not receiving benefit
£100 pa while receiving benefit.
Do not attempt to adjust your calculations to take account of the difference

between the actual monthly payment frequencies and the continuous payment
frequencies assumed in the Tables. [5]
(ii) You have been asked to test the profitability of the policy you have priced in
Part (i). Describe how you would do this (detailed formulae are not required).
[8]
[Total 13]

Solution 2.1
(i) Requirements of a model
The model must be valid, rigorous and adequately documented. However, some
approximations may be made for reasons of practicality. [1]
The model points chosen must adequately reflect the distribution of the business being
modelled. This may or may not include model points for new business. [1]
The parameters used must allow for all those features of the business being modelled
that could affect the advice being given. Examples of such parameters include inflation,
withdrawals and morbidity experience. [1]
The parameters must be set appropriately taking account of the features of the company
and the business environment in which it operates. [1]
reasonableness. [½]
The output should also be communicable to those to whom advice will be given. This
will include the output being in a suitable format. [1]
The model should not be so complex that the results become difficult to interpret, or the
model takes too long or costs too much to run. [1]
[Maximum 6]
(ii) Setting charges
The company will need to decide on the methods of charging to use, eg bid offer spread,
reduced allocation, policy fee, management charge. [½]
It may choose a charging structure that is consistent with other unit-linked policies that
it sells, or one that it thinks will give a marketing advantage. [½]
It may decide to fix the values of some of these charges. The other charges can be
refined using the modelling process. [½]
It needs to build a model and project the development of the unit fund and non-unit
cashflows. [½]

A profit criterion must be decided upon. This is likely to be in the form of a net present
value possibly expressed as a percentage of the initial premium or commission. [1]
The positive cashflows include premiums received, charges from the unit fund, interest
on non-unit reserves and reductions in reserves. [1]
The negative cashflows include allocations to the unit fund, expenses, claims and
increases in reserves. [1]
Assumptions will be needed for all the relevant parameters. [½]
The assumptions used will probably be close to best estimates. The level of uncertainty
can be allowed for in the risk discount rate. [½]
Model points must be chosen that reflect the expected mix of new business. [½]
For each model point, the non-unit reserves would be assessed by first projecting the
non-unit cashflows using prudent assumptions, then choosing reserves which would
eliminate any negative profit flows. [1]
Then the non-unit cashflows would be projected, probably at monthly intervals,

allowing for reserving requirements and any required solvency margin. [½]
The net cashflows will be discounted at a risk discount rate that reflects the return
required by the company and the level of statistical risk attaching to the cashflows. [½]
A deterministic approach is likely to be used unless there are investment guarantees or

options under the contracts. A stochastic approach would then be required in order to
value such guarantees and options. [½]
The charges can then be varied and the above procedure repeated to produce the
required profit. [½]
Sensitivity testing should be carried out by varying the key parameters in the model. [½]
Consideration should also be given to marketability. [½]
The cashflows from the model points can be scaled up to match expected new business
volumes, and incorporated into a model of the whole company to check the adequacy of
the available capital, and the impact on the tax position of the company. [1]
[Maximum 9]

Solution 2.2
Economic pessimism and high unemployment will encourage some employees to claim
for particular treatments under group PMI policies, in case they lose their jobs and are
then no longer able to benefit from the insurance. So this will increase claim costs. [½]
Lower unemployment may mean tighter labour markets, resulting in an increased

demand for group PMI schemes as employers seek to hire and retain key employees. [½]
High inflation will result in increasing claims costs, which will cause premiums to
increase significantly. This could reduce policy renewal rates and the demand for new
business. [1]
Greater general health awareness (eg government campaigns) may increase demand for
PMI. [½]
Improvements in State medical provision will reduce the demand for PMI. [½]
Increasing prosperity will increase disposable income, resulting in an increased demand

for PMI. [½]
[Maximum 3]

Solution 2.3
The values assigned to the parameters should reflect the expected future experience of
the lives who will take out the contract. [½]
In particular consideration should be given to:

● the target market and distribution channel [½]
● the territory in which the product will be sold [½]
● the underwriting controls [½]
● the expected changes in morbidity between the time of the last experience
investigation and the average point in time at which the demographic
assumptions will apply. [½]
The assumptions will be based on an adjustment to rates from a standard table, if an

appropriate table is available. [½]
The adjustment could be derived by analysing the company’s experience for a similar
class of business, if there is one. [½]
The period of the investigation should be long enough so that the volume of data
(exposed to risk) is large enough, but not so long as to introduce excessive
heterogeneity into the data, due to trends in experience over time. [½]
Split the data into homogeneous groups to reflect the rating factors, subject to a credible
level of data in each cell. [½]
If insufficient data are available from the company’s experience, then industry,
reinsurers’ or population data should be used instead. [1]
Further adjustments may be required to allow for changing or differing target markets,
policy wordings or underwriting procedures. [½]
If there is great uncertainty surrounding the correct rates to use then significant margins
will be needed and a prudent assumption used, or alternatively may use a higher risk
discount rate for valuing the profit flows. [½]
[Maximum 5]

Solution 2.4
(i) Net present value
The net present value first requires the calculation of the profit signature for a given
model point. The profit signature is the expected (usually annual) future profit stream
that would be generated by a single (long-term) policy. [½]
The first step is the projection of future cashflows, these being the difference between
income (premiums or charges, and investment returns) and outgo (expenses, claim costs
and tax). [½]
The annual cashflows will be reduced by the expected cost of increasing the supervisory
reserve each year, and increased by the investment returns earned on the reserves. [½]
The future profit flows are then adjusted to allow for future survival and withdrawal, to
produce the profit signature. [½]
The net present value is the discounted value of the profit signature at the risk discount
rate. [½]
[Maximum 2]
(ii) Using net present values
The net present value is an example of a profit criterion: a single figure that tries to
summarise the relative efficiency of contracts with different profit signatures. [½]
By applying a profit criterion to different contracts with different profit signatures, and
by ranking the results in order, it may be possible to say with confidence which contract
makes most efficient use of a company’s capital. [½]
Such a criterion can also be used to price a long-term healthcare insurance contract, by
finding the premium (or charges) that satisfies the required profit criterion, based on a
given set of future experience assumptions. [½]
Given a choice between the future cashflows from two different investments, economic
theory states that an investor should choose the one with the higher net present value.
This choice is optimal, and cannot be bettered. [½]
Another way to put this is that the first priority for the managers of any company is to
maximise the net present worth of the company. [½]

Also, the net present value can be usefully expressed either as:
● a percentage of the commission payable under the contract, or [½]
● a percentage of the expected present value of the premiums payable under the
contract. [½]
If we use the first measure as the profit criterion, ie:
Net present value

c= ¥ 100
Initial commission
then c shows the net present value relative to the effort expended in selling the policy.
[½]
Assuming that sales effort is geared towards maximising the commission paid to
intermediaries, then pricing using this criterion will ensure that the sales process will
also maximise the company’s profits, regardless of which products are actually sold.
[1]
If we use the second criterion, ie:
Net present value

c¢ = ¥ 100
Expected present value of future premiums
then the company will be sure that its profitability will increase in proportion to any
increase in market share that it can achieve for any product. [½]
The company would choose which of these to adopt on the basis of which factor was
most influential in driving sales: increasing commission payments or increasing market
share. [½]
The use of net present values is not confined to measuring the worth of new healthcare
insurance policies. An insurer has other possible uses for its capital, such as the
improvement of its administration systems for the support of existing business, or the
development of a new sales channel. The company can use net present value to
compare all kinds of capital investment projects, regardless of their nature. [1]
[Maximum 6]
(iii) Why net present value in preference to other criteria?
In part (ii) it was stated that, according to economic theory, the net present value cannot
be bettered, and so if any other criterion disagrees with it then the company should go
with the net present value. [½]

This is defined as the rate of return at which the discounted value of the cashflows is
zero. [½]
All other things being equal, a company should prefer a contract that has a higher
internal rate of return. However, the internal rate of return does not always agree with
the net present value. [½]
Calculating an internal rate of return requires an iterative approach, whereas a net

present value does not, and so the latter is simpler. [½]
Net present value may be more reliable in some cases, for example:
● If there is more than one change of sign in the stream of profits in the profit
signature, the internal rate of return will not usually be unique. [½]
● The net present value can be related to useful indicators of the policy’s worth to
the company, in terms of sales effort or market share. There is no way to do this
with the internal rate of return. [1]
● If a policy makes profits from the outset then the internal rate of return may not
even exist. The net present value always exists, however. [½]
The net present value can allow for the risks of the project by adjusting the risk discount
rate and/or by including specific margins in the individual assumptions. Only the
second of these methods is possible using the internal rate of return. [½]
The discounted payback period is the policy duration at which the profits which have
emerged so far have present value zero, ie it is the time it takes for the company to
recover its initial investment with interest at the risk discount rate. [1]
A company with limited capital might prefer to sell contracts with as short a payback
period as possible. [½]
The discounted payback period will not usually agree with the net present value as it
ignores completely all the cashflows after the discounted payback period. [½]
Only the net present value provides any information about the size of the profit flow.
This means that neither of the other two methods can be used without considering the
net present value as well. [½]
[Maximum 6]

(iv) Drawbacks of net present value
Comparisons based on the net present value will only be valid if:
● there is a perfectly free and efficient capital market, which is never exactly true
[½]
● the risk discount rates used to discount two (or more) risky investments
appropriately reflect their riskiness, which may be very difficult to assess. [½]
The net present value is subject to the law of diminishing returns. If it were not, then a
company that could sell one policy with positive net present value, could sell an
unlimited number of policies and increase the value of the firm without limit. [1]
So even a marketable and competitive product would run out of customers once the
market is saturated, and the cost of making more sales becomes increasingly prohibitive.
[½]
It says nothing about competition at all. There is no point in designing a contract with a
high net present value if it cannot be sold. [½]
However, these last two (related) problems can be effectively dealt with by comparing
total net present values for whole projects, based on realistic assumptions of future new
business sales. [½]
If the expected cost of overheads is included in the net present value, this will also give
a distorted comparison if the assumed volume upon which the fixed expenses are based
is incorrect. [½]
This can be avoided by including only marginal profit in the net present value
calculation. [½]
The net present value does not distinguish between policies that have very different
initial capital requirements, and hence may have very different discounted payback
periods. [½]
[Total 5]

Solution 2.5
Claim incidence rates
We will need to analyse the past experience. [½]
The data will be subdivided by benefit/procedure class, age, sex, smoker status,
occupation, distribution source, territory, region. [1½]
Several years of recent experience may be combined in order to produce credible data.
[½]
But we must avoid introducing too much heterogeneity by keeping the period as short as
is compatible with adequate data for credible estimates. [½]
Numbers of claims would be divided by the number of observed policy years, to obtain
the historical claim incidence rate (for each grouping). [½]
Trends in experience may be identified by analysing the data over time. [½]
Data from reinsurers, and industry or market data may be used to support the internal
investigation… [1]
…though differences in applicability and relevance of the data must be taken into
account. [½]
Such data may also be useful for identifying trends. [½]
The historical incidence rates should then be projected over the next year… [½]
…(or number of years, if any guarantee is being offered on keeping rates unchanged on
renewal or if the company is hoping to keep its rates constant over a period, eg for
marketing reasons). [½]
Changes in economic conditions, policy benefits provided, mix of business, policy

conditions, types of treatments covered, etc need to be taken into account when
projecting the rates. [1½]
Additionally, future rates may be adjusted to allow for higher incidence rates among
policyholders who have claimed at least once before under their policies. [½]
The extent of any adjustment would be estimated from the past experience in this
regard. [½]

Claim amounts
Using past data subdivided as above, calculate average claim cost per claim… [½]
…by dividing the total claim costs by the number of claims involved. [½]
Claim amounts will then be projected to the period for which the new rates will apply…
[½]
…allowing for the impact of changes in:

● medical treatments
● costs of treatments
● medical protocols
● hospital charging structures
● inflation of medical costs
● the mix of business (eg age, sex, distribution channel, occupation, policy size)
where these are not fully allowed for in the pricing structure.
[½ mark for each, maximum 2½]
Calculate the risk premium
The premium to cover the expected cost of claims is found by summing over all the
different benefit classes covered by the policy (for, say, a given age and sex): [½]
RP = Â ik ACk [1]
k
where ik = assumed incidence rate for benefit class k [½]
ACk = expected average cost of claims, per claim, for benefit class k. [½]
Rates of renewal
Numbers of renewals will be divided by the numbers of policies coming up for renewal,
in the past experience data, as a starting point for estimating future renewal rates. [1]
Rates may be analysed separately by distribution channel, occupation, territory, and

duration since the policy was first sold (ie by the number of previous renewals). [1]
Any special conditions (eg economic circumstances) affecting the past experience
should be taken into account before using the historical data to estimate the future
experience. [½]

The projected rates would also take account of:

● changes in the (perceived) service delivery from State-provided alternatives [½]
● changes in premium rates due to inflation (eg a large increase in premium rates
would discourage renewals) [½]
● changes in the economic outlook [½]
● the effect of the proposed change in premium rates, compared to the
competition. [½]
Expenses
The company will need to analyse its recent expenses due to:
● initial expenses of acquiring a new policy (selling, underwriting, admin) [½]
● expenses of renewing a policy [½]
● expenses of policy termination (ie of non-renewal) [½]
● claims management expenses. [½]
Data may need to be divided into homogenous groups, if necessary to reflect unequal
shares of costs, eg between distribution channels, sex, occupation. [½]
The expenses will be analysed relative to appropriate measures, eg:

● selling expenses as a percentage of premium [½]
● claim and underwriting expenses as a percentage of average claim amounts [½]
● the remaining expenses as per-policy. [½]
Dividing by the appropriate measures will give the historical expense loadings for the
contract. [½]
The loadings will then need to be increased for inflation to the middle of the period for
which they are expected to be appropriate. [½]
The past expenses (and loading) will need to be split according to whether they were
direct or overhead (fixed). [½]
In order to estimate its expense inflation rate, the company would compare its historical
expense increases against past changes in prices and earnings indices; expectations of
the relevant index-inflation rates will then help determine the rate to use. [½]
An allowance will be made for spreading the initial expenses over the expected number
of renewals of the contract – using the appropriate renewal rate assumptions. [½]

Commission would be allowed at the rate(s) that the company intends to pay. The
additional cost of initial commission would be spread over the expected renewals in the
same way as for other initial expenses. [1]
The appropriate per-policy expense assumptions would be obtained by considering total

expected future new business volumes, including both new business and renewals, to
work out each policy’s expected contribution. [½]
Calculating the office premium
The office premium is obtained by adding the expense loadings to the appropriate risk
premium for each risk group. [½]
The overall price may then need to be adjusted in relation to competitors’ prices and the
expected marketability of the product. [½]
The aim will be to maximise:
{Individual profit per policy} ¥ {number of new sales and renewals} [½]
with both components of this quantity likely to be sensitive to the price charged. [½]
Margins will need to be included in excess of best estimate assumptions, in order to

introduce some risk protection and to generate an expected profit. [½]
Any regulatory constraints on the way the contract should be priced should be taken into
account (eg these may prevent different premiums being charged for different sexes).
[½]
The effect of any existing or anticipated reinsurance should be taken into account in the
pricing. [½]
Reinsurance has an expected cost, and so this may cause the price to rise. [½]
On the other hand, the reinsurance should reduce risk, reducing the need for margins
and so reducing the price. [½]
Some reinsurance can benefit both parties (eg through tax arbitrage), again reducing the
price. [½]
If the reinsurance is to a high quota share (for example), then the reinsurers may
effectively be dictating (or at least strongly influencing) the pricing terms anyway. [½]
[Maximum 28]

Solution 2.6
(a) Critical illness
Medical developments can increase the rate of disease diagnosis. [½]
This can make claims occur sooner; or it can make claims occur in the policy term,
which would previously have occurred only after the end of the contract with no cost.
[1]
Both cases will increase the cost of claims, especially the second case. [½]
Some diseases will be diagnosed that would never have otherwise been recognised. [½]
Medical advances may prevent some diseases from occurring, thereby reducing claim
costs. [½]
Some critical illness claims relate to the need for specific expensive treatments (like
heart bypass surgery). Medical advances can mean that some of these treatments no
longer occur, so reducing claim costs. [½]
Alternatively, medical advances can enable many more people to receive the treatment,
thereby increasing claim costs. [½]
[Maximum 3]
(b) Income protection
The effect depends on the type of disease or disability involved with the claim. If the
disease is chronic, so that the claimant is unlikely ever to return to work, medical
advances may prolong life and hence increase the duration over which the claim
payments are made. [1]
If the disease is normally only temporary, then medical advances should hasten
recovery and so reduce total claim costs. [½]
In some cases, recovery may now occur during the deferred period, thus eliminating
these claim costs altogether. [½]
Medical advances that reduce the incidence of disease will reduce claim costs. [½]
[Maximum 2]

(c) Private medical insurance
If medical advances make more expensive treatments available, then this will increase
claim costs. [½]
Previously expensive treatments may become more routine and so less expensive, thus
reducing claim costs. [½]
Treatments may become more effective, reducing the duration of treatment and the
associated costs, such as the cost of hospital stays. [½]
Some advances may remove the need for treatment altogether, again reducing claim
costs. [½]
[Total 2]
Solution 2.7
Why might stochastic modelling be useful?
With health and care products, the future incidence experience is very difficult to
predict. [½]
The particular difficulty lies in the potential benefit amount, which may vary by policy-
specified inflation (LTCI, IP), by medical inflation (PMI), by changes in accepted
medical protocols (PMI) or other factors. [1]
With such uncertainty and hence volatility of cashflows, it is important to be able

project the distribution of possible future outcomes, and this is what stochastic
modelling enables us to do. [½]
It achieves this by:

● allowing some of the variables in the model (eg number of claims or claim
amounts) to vary and have their own probability distribution [½]
● simulating random drawings from the probability distribution many times, and
hence producing simulated random outcomes from the model. [½]
The set of simulated outcomes from the model can then be used to form an estimate of
the probability distribution of the outcome. [½]
Stochastic models and simulation also enable us, where appropriate, to assess the impact
of financial guarantees. [½]

Disadvantages compared with deterministic modelling
There may be time and computing constraints – so stochastic modelling work might
have to be done with a very simplified version of the model. [½]
The outputs from the model are sometimes very sensitive to the (deterministically
chosen!) assumed values of the parameter(s) involved. [½]
We may have little confidence about the probability distribution (and its parameters)
chosen for the stochastic variables. [½]
The preceding two points can therefore lead to spurious accuracy, and hence render the
results of the modelling of very little practical use. [½]
[Maximum 5]
Solution 2.8
A suitable formula might be:
ix + (1 - k x ) qx [½]
where:
ix is the critical illness inception rate [½]

kx is proportion of deaths due to critical illness [½]
qx is the mortality rate [½]
all relating to a life aged x exactly. [Deduct ½ if omitted]

[Total 2]

Solution 2.9
The items in a cashflow profit test would be:

● investment return
● premiums
● benefit payments
● inflation rates
● claim incidence rates
● disability annuity values (alternatively claim termination rates so that annuity
values can be calculated)
● mortality rates
● expenses
● expense inflation
● commission scale
● tax
● mix of new business where there are cross-subsidies (eg by policy size)
● new business volumes (for determining the expense loading)
● lapse rates
● profit criterion
● risk discount rate
● reserving basis
● required solvency margin.
[½ for each, maximum 5½]
The last five items would not be used in a formula approach. [1½]
(Lose ½ for each of these included in the previous list that have not been included in
this list.) [Total 7]
Solution 2.10
The PAYG method of funding depends on trust between successive generations. [½]
The current generation pays for the costs of the preceding and the next generation, and
trusts that other generations will do the same. So the financial burden of the healthcare
and welfare system will depend of the benefits provided and the relative sizes of
successive generations. [1]

The forward funding method looks at the expected costs over several generations. [½]
These costs are then smoothed, so that the burden on each generation is roughly the
same. So some generations may contribute more than the costs of their own care, and
some may contribute less. [1]
If the current generation is small relative to the adjacent generations then PAYG
contributions will be high. Changing to forward funding would reduce these
contributions. [1]
The relative size of generations is mainly influenced by past birth rates (eg the post-war
baby boom in the late 1940s created a large generation), and to a lesser extent by
improvements in mortality rates, particularly at older ages.
However, the State still has to pay the current costs, so there will be an immediate
shortfall in funding. [½]
If this is raised through general taxation, then in effect we have PAYG in disguise.
Only if the current deficit can be transferred to future generations, through a loan
arrangement, will we have moved to forward funding. [1]
The alternative is to correct the deficit created by the change in the funding method by
reducing benefits. [½]
This may cause difficulties because senior citizens have paid their contributions in the
past under PAYG, and consequently are relying on inter-generational trust. This trust
will have been broken. [1]
If the current generation is large relative to the adjacent generations then PAYG
contributions will be low. [½]
Changing to forward funding would increase these contributions. [½]
The current generation was expecting to pay PAYG contribution rates. They may resent
this increase, which results not from an increase in benefits, but because the
Government is “fiddling the books”. They will see the increase in contributions as one
for which there are no immediate benefits. [1]
If the State gives in to these pressures, then in effect we will not have moved to forward
funding. [½]
[Maximum 8]

Solution 2.11
The current generation of working age pays for the cost of healthcare and welfare
benefits for:
● their children
● their parents and grandparents
● themselves. [1]
However, the major costs arise from benefits for children and senior citizens. [½]
Costs for children arise mainly from welfare benefits (eg child allowances paid to
parents) and primary healthcare. Costs for senior citizens arise mainly from welfare
benefits (eg old-age pensions) and from secondary and tertiary healthcare.
The payment is made through:

● earmarked taxation
● general taxation revenues (eg income tax, sales tax), when there is a shortfall
from earmarked revenues. [1]
So contributions from each individual of working age will rise when the current
generation is small compared to the preceding and the next generation. [1]
The smoothing provided by general tax revenues does not alter the fact that the current
generation pays all the costs, except insofar as the government runs a budget deficit and
effectively funds the shortfall by borrowing. [1]
Each generation effectively covenants to pay the costs incurred by their grandparents,
parents and children. [½]
The current generation trusts that the succeeding generation will not abuse the
system (eg by cutting benefits, rather than increasing contributions or borrowing more).
[1]
If this trust is well founded, then future support for the current generation will match the
support that they provided for other generations. [½]
[Maximum 5]

Solution 2.12
(i) Advantages and disadvantages to the State: Country A
+ Ensures that all those who need medical treatment receive it according to their
clinical need, and not their ability to pay. [½]
– May encourage inappropriate use of healthcare because it is free to the user,

eg seeking healthcare advice for what are personal and social difficulties rather
than genuine medical problems. [1]
+ All resources can be devoted to providing treatment, rather than collecting fees
from patients. [½]
– Causes consumers to under-value healthcare because they have no idea of the

costs involved (eg missing appointments, not taking prescribed medicines). [1]
– Controls on the costs of the service may only be possible through third-party
providers. [½]
+ PMI is not essential, and so regulation of insurers (although essential to protect

consumers) will not be a major task. [1]
+ popular with consumers, if it works well. [½]
– May generate excess demand and result in waiting lists for operations and
perhaps the need to ration expensive treatments. [1]
– No profit motive, and so there will be little effort to control costs and little
incentive for staff to be efficient and give good customer service. [½]
– Because there are no costs involved in ill health, people are not encouraged to
look after themselves. [½]
– Does nothing to encourage commerce and competition for healthcare provision.

[½]

Advantages and disadvantages to the State: Country B
+ Consumers will appreciate the costs of healthcare. This may encourage them to
look after themselves and only seek treatment when it is necessary. This
exercises (limited) control on the demand for services. [1]
+ Those who pay are less likely to abuse the system (eg always keeping
appointments, or cancelling them if they are not needed). [½]
+ Providers are allowed to charge above tariff prices. This may make consumers
more aware of the quality of care and the expertise of those providing it. This
greater appreciation will help the State when it needs to explain healthcare
choices to consumers. [1]
+ The published price tariff is a mechanism whereby the State can exercise some
control over the costs of the service. [½]
+ By varying the percentages of the costs met by the State, the Government will be
able to vary the impact of health costs. (For example, consumers make a greater
contribution to primary care – this is illustrated in the example given in the
question.) [1]
– There will need to be a PMI market (basic policies to pay the patient
contribution needed for tariff prices, and superior cover to pay the higher
contribution needed for treatment by providers charging non-tariff prices). All
consumers will need insurance and so there will need to be comprehensive
regulation of insurers to protect consumers. [1]
– If prices for basic PMI cover are too high for the poorest consumers, it may
create an “underclass” who do not receive adequate treatment. This
consequence may be unpopular with many voters (not just the poorest who are
affected in this way). [1]
+ Medical expense insurers will have an interest in the costs of all care because
basic PMI will pay a proportion of the costs of every treatment. So the insurers
will be another force acting to control prices. [½]
+ Competition will encourage innovation in treatments and the ways in which they
are provided. [½]
[+1 for each valid point that includes an explanation or example, + ½ otherwise]
[Maximum 12]

(ii) Influence of system on market for PMI: Country A
PMI is optional. [½]
The market will be confined to those with higher incomes (and better health). Because
cover is optional, premium levels are unlikely to be regulated. [1]
Insurers will need to design products that offer benefits that are superior to the free
service that is available for everyone (eg treatment when and where the consumer wants
it, superior non-medical care). [1]
The market will be influenced by economic prosperity (buoyant in good times and
sluggish in bad), and by the success of the free service (eg long waiting lists for
treatment or lack of treatment choice will increase the demand for insurance). [1]
Influence of system on market for PMI: Country B
Some PMI cover is essential, and so there will be a large market for basic policies. This
will help to pool risks and spread overhead expenses, but will mean that policy
servicing costs will be a large proportion of the premium. [1]
The large market will mean more competition between insurers, and may lead to a more
efficient PMI market. [½]
Because basic cover will be purchased by nearly everybody, some price control will be
likely. This may mean that community rating is imposed. This will make it harder for
insurers to charge premiums that match each risk. [1]
There will be a market for policies that meet the costs of care at non-tariff rates. This
market will be confined to those with higher incomes. [½]
Insurers will need to design products that provide extra benefits that consumers want to
buy. This might be easier than in Country A, because all consumers already have some
experience of using PMI. [½]
[Maximum 5]

Solution 2.13
(i) Calculating probabilities
The probabilities for each possible “transition” are:
P( H → H ) = 0.94 P( H → S ) = 0.05 P( H → D) = 0.01 P( S → H ) = 0.80

P( S → S ) = 015
. P( S → D) = 0.05 P ( D → D) = 1 [1]
Working through year by year gives the following probabilities for being in each state:
Time Healthy Sick Dead

0 1 – –
1 0.94 0.05 0.01
2 0.8836 + 0.04 0.047 + 0.0075 0.0094 + 0.0025 + 0.01
= 0.9236 = 0.0545 = 0.0219
3 0.8682 + 0.0436 0.0462 + 0.0082 0.0092 + 0.0027 + 0.0219
= 0.9118 = 0.0544 = 0.0338
4 0.8571 + 0.0435 0.0456 + 0.0082 0.0091 + 0.0027 + 0.0338
= 0.9006 = 0.0538 = 0.0456
5 0.8466 + 0.0430 0.0450 + 0.0081 0.0090 + 0.0027 + 0.0456
= 0.8896 = 0.0531 = 0.0573
We have calculated the probabilities for the dead state from first principles, to provide
a check on the calculations. If you are confident that your calculations for the first two
columns are correct, you can calculate the probabilities for the dead state more quickly
by subtracting from 1. [1 mark for each correct row in the table (times 1-5), total 5]
[Total 6]
(ii) Calculating the net premium
Applying these probabilities to the benefit amounts and discounting, we find that:
PV premium payments = P(1 + 0.94v + " + 0.9006v 4 ) = 4.1877 P [1]

PV sickness payments = 2,500(0.05v + 0.0545v 2 + " + 0.0531v5 ) = 559 [1]
PV death payments = 5, 000(0.01v + 0.0219v 2 + " + 0.0573v5 ) = 681 [1]
(noting that a death benefit is paid at the end of each year to anyone then in the “dead”
state). So the premium equation is:
4.1877 P = 559 + 681 which gives P = £296 [1]

[Total 4]

Solution 2.14
The expected present value (EPV) of the premiums is:
20 t
1, 000 Ú HH
v t p50 dt [1]
0
The EPV of the benefits and expenses payable for own home assistance is:
•
5, 030 Ú vt t p50
HS
dt [1]
0
and for residential home assistance is:
•
15, 030 Ú vt t p50
HR
dt [½]
0
The EPV of the death benefit from healthy is:
20 •
1, 000 Ú t vt t p50
HH
m50+t dt + 20, 000Ú vt t p50
HH
m50+t dt [2]
0 20
and of the death benefit from own home assistance, including expenses, is:
•
20, 060 Ú vt t p50
HS
n 50+t dt [1]
0
The EPV of the expenses on death from healthy is:
•
60 Ú vt t p50
HH
m50+t dt [1]
0
and the EPV of the initial and renewal expenses is:
200 + 25Ú vt
•
0
( t
HH
p50 HS
+ t p50 HR
+ t p50)dt [1½]
The EPV of the whole future loss is then the EPV of all the benefits and expenses less
the EPV of the premiums. [1]
[Total 9]

Solution 2.15
Let 100k % be the percentage increase in the whole of life premium, and let P be the
normal whole of life annual premium.
Then the value of the extra net premiums must equal the value of the waiver benefit. The
equation of value is therefore:
HS (1 all )
0.95 P k a50:15 = (1 + k ) P a [3]
50:15
(approximating weekly payments by continuous functions).
Using the Tables we get:
0.95 ¥ k ¥ 9.516 = (1 + k ) ¥ 0.247810 [1]
So: 9.0402k = 0.247810 (1 + k ) ie: k = 0.02818 [½]
Thus the normal whole of life premium has to be increased by 2.82%. [½]
[Total 5]

Solution 2.16
The method is based on two double decrement tables. The first table relates to healthy
lives, and has decrements of death and claim inception. [½]
The table includes future recoveries as increments and hence all future claim inceptions
(not just the first) relating to a currently healthy life are included in the decrements. [½]
We will need a table that specifically relates to persons all of whom are healthy at age
30. [½]
The elements of the table are:
(al )30+t = expected number of surviving healthy lives at age 30 + t out of (al )30
healthy lives aged 30 (including all lives who have been sick between
age 30 and 30 + t but who are now healthy at age 30 + t ). [1]
d
(ad )30 +t = expected number of healthy lives dying during the year of age
[30 + t , 30 + t + 1] , out of (al )30 healthy lives aged 30. [½]
s
(ad )30 +t = expected number of healthy lives becoming sick during the year of age
[30 + t , 30 + t + 1] , out of (al )30 healthy lives aged 30. [½]
The second table relates to sick lives. It has decrements of death and recovery from
sickness (or, alternatively, can be considered to be a single decrement table with
decrement of claim termination, which implicitly includes both causes). [½]
This double decrement table is used to calculate annuity values of the form:
s
a x¢ :65 -x
= The expected present value of a sickness benefit of £1 pa, assumed
payable continuously to a sick life now aged x, until age 65 or until
earlier death or recovery. [½]
The rate of interest used would be at net rate (i - 0.03) /1.03 , in order to
allow for the increase in benefit during payment. [½]

The EPV can then be approximately obtained using:
EPV =
(al )30{
20, 000 ½ s
v (ad )30 ¢s
a30½:34½ + v1½ (ad )31
s
¢s
a31½:33½ +"
[2]
+v 34½ s
(ad )64 ¢s
a64½:½ }
[Total 7]
Solution 2.17
(a) Increase in sick-to-dead rate and increase in healthy-to-sick rate
An increase in death rates from sick will reduce the length of time that sickness benefits
are paid, which would, on its own, reduce the cost of the benefits and thereby the
premium required. [½]
For those lives who are sick but within the deferred period, an increase in the death rate
would reduce the number of these cases which would ultimately give rise to benefits
being started, which would again reduce the premium required. [½]
A statutory profit is also made at the point of death, as the positive reserves are released
as free assets after each death, reducing the cost of capital and hence again reducing the
premium required. [½]
Increasing the rates of transition from healthy to sick will increase the expected
numbers of claim inceptions, which, on its own, will increase the cost of the benefits
and thereby the premiums required. [½]
The company’s reserves will also rise (as reserves for sick lives are higher than those
for healthy lives), increasing the cost of capital and again requiring a greater premium to
achieve the same present value of profits. [½]
The overall effect is not certain, as it will depend on the relative magnitudes of the two
changes, which affect the premium in opposite directions. [½]
(b) Fall in sick-to-dead rate and fall in sick-to-healthy state
Both of these changes have the same effect on the cost of the benefits – they result in
fewer terminations of benefit payments at each age, and a greater proportion of
individuals remaining sick through their deferred periods in order to start claiming
benefit. So more benefits would be paid and for longer periods of time, thereby
increasing the cost and the premium required. [1]

The overall increases, both in the number of policies in force and in the proportion of
those policyholders who are sick at any one time, will increase the reserves held by the
company and hence the cost of capital. [½]
Hence the premium will definitely increase. [½]

[Maximum 4]
Solution 2.18
The expected present value (EPV) of the benefit is:
{
10, 000 v½ ½ p30 (ia)30,0 a30½:34½
i
, d =0
- v 2½ i
2½ p30 (ia )32, 2 a32½:32½ , d = 2 } [2]
where:
½ (l30 + l31 ) ½ (97, 645 + 97,556 )

½ p30 ª = = 0.999544 [½]
l30 97, 645
½ (l32 + l33 ) ½ (97, 465 + 97,370)

2½ p30 ª = = 0.997670 [½]
l30 97, 645
i
a30½:34½ , d =0
ª 12 È a30:35
Î
i
, d =0
i
+ a31:34 ˘=
, d =0 ˚
1
2 [0.0333 + 0.0350] = 0.03415 [1]
i
a32½:32½ , d =2
ª 12 È a32:33
Î
i
, d =2
i
+ a33:32 ˘=
, d =2 ˚
1
2 [5.5915 + 5.6769] = 5.6342 [½]
(ia)30,0 = 0.322744
(ia )32, 2 = 0.000294 [½]
So the EPV of the benefit is:
{
10, 000 ¥ 1.06-½ ¥ 0.999544 ¥ 0.322744 ¥ 0.03415
-1.06-2½ ¥ 0.997670 ¥ 0.000294 ¥ 5.6342 }

= £92.72 [1]

To find the premium P we must allow also for the expenses. So we find P from the
equation of value:
P = 0.075 P + 1.01 ¥ 92.72
fi P = £101.24 [1]
[Total 7]
Solution 2.19
You might have said “you’re drunk”. Alternatively (or in addition) you might have
brought up some of the following arguments.
The suitability of the basis will depend on whether our critical illness experience rates
will relate to the industry average in the same way that our term assurance mortality
rates do. [½]
It might be appropriate to assume the same proportions because: [½]

● both types of experience relate specifically to temporary protection contracts,
and so we would expect the contracts to attract a similar class of lives [½]
● our company may anticipate using similar underwriting criteria for the new
product, and these criteria should relate to the industry average criteria in the
same way as for our current product [½]
● in the absence of any experience of our own, it would seem to be the most
logical assumption to make. [½]
But:
● our new product may attract a different class of lives from the one we have
attracted hitherto – this might also make the mortality assumption incorrect [½]
● the critical illness table may be based on a very different mix of contributing
companies from the term assurance mortality table, with a very different balance
of underwriting practice represented, a different mix by territory, distribution
channel, etc [1]
● the critical illness tables may relate to stand-alone contracts as well as, or instead
of, accelerated CI contracts – this may make the standard table less relevant [½]
● the experience underlying the critical illness standard table may relate to a
different time period from that of the mortality table (the former is likely to be
more recent, if the CI market is not so well established as term assurance), and
so the required time adjustments from the tables to the present day will be
different [1]

● critical illness rates and mortality rates are likely to change differently over time
anyway, so that the adjustment would be different even if the investigation
periods were the same [½]
● our new product applies to a different time period from the old one, so we would
have expected all our assumptions to have changed relative to our current basis
[½]
● our company might adopt a quite different stance on underwriting the new
product given the greater uncertainty over the future critical illness experience
[½]
● underwriting practice might affect critical illness rates quite differently from
term assurance mortality rates, and so we cannot argue for the same adjustments
even if underwriting practices are consistent [1]
● our company has no experience of handling critical illness claims and might end
up paying out many fewer – or greater – claims than other companies in the
market, even for equivalent underlying morbidity experience [½]
● our policy conditions may be quite different from the industry average (eg the
allowable diseases for a critical illness claim may be different), whereas for our
term assurance policies our conditions are likely to be very similar to the norm
(eg the claim condition “are you dead or not?” would apply) [½]
● we are likely to put much greater margins in our basis, reflecting the much
greater uncertainty about the future critical illness rates: at least some of this
margin might be put into the critical illness assumption itself (depending on the
approach for dealing with risk) [½]
…and so on … (but your colleague would have been asleep, anyway).

[Maximum 8]
Solution 2.20
(i) Calculating the approximate premium
The expected present value (EPV) of the benefits is:
12 ¥ 800 ¥ a HS (1/ all ) + 12 ¥ 400 ¥ a HS (2 / all ) [1]

50:15 50:15
The EPV of the expenses is:
200 + 25 a50:15 + 75 a HS (1/ all ) [1]

50:15

The EPV of the premiums is:
12 P È a50:15 - a HS (1/ all ) ˘ [1]

ÍÎ 50:15 ˙˚
where P is the required monthly premium.
Setting the EPV of the income equal to the EPV of the outgo we get:
(9, 600 + 75) a HS (1/ all ) + 4,800 a HS (2 / all ) + 200 + 25 a50:15

50:15 50:15
P= [1]
12 È a50:15 - a HS (1/ all ) ˘
ÍÎ 50:15 ˙˚
From the Tables:
a50:15 = 9.516
a HS (1/ all ) = 0.247810

50:15
a HS (2 / all ) = 0.184025
50:15
giving:
3, 718.782
P= = £33.44 per month. [1]
111.218
[Total 5]
(ii) Testing the profitability of the policy
This would be done using a cashflow model. This would involve projecting the
expected future net profit flows from the policy in each future policy year. [½]
Each year’s profit would be calculated as:
{premiums} - {expenses} + {interest} - {cost of claims} - {increase in reserves}

[1]
The cost of claims would be calculated as the EPV of all claims payable (until death,
recovery, or age 65) on policies where claim payments commence during the year. [½]
This could be calculated by multiplying a yearly inception rate by a disability annuity.

[½]

The two levels of payment would require two inception rate/annuity calculations: one
for inceptions after deferred period one year for £800 a month, the other for inceptions
after deferred period 2 years for £400 a month. [1]
The end-year reserves would use similar formulae but based on prudent assumptions.
[½]
The preceding 2 marks (ie three points) could alternatively be earned by describing a
multiple-state method.
The end year reserves will include any additional solvency margins required by the
legislation. [½]
The future profit flows would then be multiplied by the probabilities of initial
policyholders remaining in force to the start of each year, allowing for both deaths and
lapses, to produce the profit signature. [½]
The assumptions used in the projection would be best estimates. [½]
The profit signature gives the pattern of profit emerging over time. [½]
Discounting at the risk discount rate (RDR) and summing the present values gives the
net present value (NPV) for the policy. [½]
The RDR should reflect the shareholders’ required return on capital and allow for the
relative riskiness of the product. [½]
Alternatively, the projection assumptions could include individual risk margins and the
RDR would be lower.
A non-negative NPV indicates that the shareholders will obtain their required return on
capital. [½]
The NPV can also be calculated as a proportion of some standardising value (eg amount
of initial commission or the EPV of future premiums), so that its relative size can be
seen. [½]
We can calculate the earliest time at which the sum of the discounted profits to that
point first becomes positive (the discounted payback period). This gives an indication
of how quickly the shareholders’ capital is repaid. [½]
We can also calculate the internal rate of return. This will indicate what the profitability
means in terms of the return obtained on the shareholders’ capital. [½]

These profit measures should be recalculated on a range of different possible

assumptions for the future experience, in order that the robustness of the profit can be
ascertained (ie perform sensitivity testing). [½]
It is not appropriate to talk about full model office testing in this question as the
question is talking about a specific policy, rather than the product as a whole.
[Maximum 8]

Question 3.1
A healthcare insurance company is setting the pricing bases for some of its products.
Discuss the importance of the assumptions made about the investment return, the
expenses and the withdrawal rates, when setting the pricing bases for the following
products:
(i) A without-profits critical illness insurance. [5]
(ii) A without-profits immediate needs long-term care annuity. [5]
(iii) A large unit-linked group income protection insurance. A monthly charge is

deducted to pay for the cost of sickness claims commencing during the month.
A level percentage of the unit fund is also deducted each month to cover
expenses. The employer pays all contributions and is entitled to the residual unit
fund value on discontinuance of the scheme. (In this context, withdrawal refers
to the ending of the whole group scheme by an employer, rather than to
individual members leaving the scheme.) [7]
[Total 17]
Question 3.2
A proprietary healthcare insurance company issues a wide range of conventional and

unit-linked products.
(i) State the requirements that should be met by an actuarial model, which will be
used for calculating the value of the profits from the company’s existing
business. [4]
(ii) Describe briefly the main items that would be included in the calculations
performed within the model, and explain how the model would be used to enable
you to make a report on the value of the existing business to the company. [6]
(iii) List the principal assumptions that will be required as inputs to the model. [5]
[Total 15]

Question 3.3
A life insurance company issues conventional single premium accelerated critical illness
insurance policies.
The premium is to be calculated for a special 3-year insurance policy for lives aged
exactly 40, where the basic sum assured is £100,000, payable at the end of the year of
claim.
This special policy carries a guaranteed insurability option (GIO) that may be selected
at the outset of the 3-year policy in return for the payment of an additional single
premium.
This option provides a guarantee to the policyholder that an additional sum assured of
£100,000 may be purchased, at a subsequent policy anniversary, on normal premium
rates and without further evidence of health.
The additional sum assured purchased will not itself carry any GIO, and will have a
term that lasts until the end of the term of the original policy.
A policyholder who has paid the additional single premium at the outset can
subsequently decide whether or not to take up the option. The option can only be
exercised once.
The company uses the “North American experience” method for pricing the option.
Calculate the additional single premium payable at outset for a policyholder who
chooses to buy the option.
Basis: Claim incidence rate:

five times the AM92 Select mortality rate, except in the case of
policyholders who decide to exercise their option to increase the
sum assured. For these policyholders, the incidence rate basis
assumed to apply, from the point of increase in sum assured, is
750% of the AM92 Ultimate mortality rates.
Interest: 5.5% per annum
Proportion of eligible policyholders at the first anniversary who decide to
increase their sum assured at that point: 20%
Proportion of eligible policyholders at the second anniversary who decide to
increase their sum assured at that point: 20%
Expenses: none [11]

Question 3.4
A life insurance company offers an option on its 10-year without-profits term assurance
policies to effect a whole of life accelerated critical illness policy, at the expiry of the
10-year term, for the then existing sum assured, without further evidence of health.
Premiums under the whole of life policy are payable annually in advance for the whole
of life, or until earlier claim. All benefits are payable at the end of the year of claim.
(i) Describe the conventional method of pricing the critical illness option, stating
clearly the information and assumptions required. Formulae are not required. [4]
(ii) A policyholder aged exactly 30 wishes to effect a 10-year without-profits term

assurance policy, for a sum assured of £100,000.
Calculate the additional single premium, payable at the outset, for the option,
using the conventional method.
The following basis is used to calculate the company’s standard premiums:
Mortality: AM92 Select

Accelerated critical illness inception rates: as AM92 Select mortality for
lives aged 20 years older then
the actual age
Interest: 6% per annum
Expenses: none [3]
(iii) Describe how you would calculate the single premium for the option described
in part (ii) above using the North American method, stating clearly what
additional information you would require and what assumptions you would
make. [4]
(iv) Discuss whether it would be preferable to use the conventional method or the
North American method for pricing the option under the policy described in part
(ii) above. [3]
[Total 14]

Question 3.5
An existing group healthcare insurance scheme, which provides IP benefits, operates

under the following conditions:
● membership is compulsory for all employees who are actively at work on the
first anniversary of starting work with their employer
● membership ceases immediately if the employee leaves employment for any
reason
● a level of free cover is granted to all new members
● premiums are experience rated with a credibility factor of 0.2.
Discuss the expected effects of the following on the claim experience under the scheme.
You can assume that each occurs without any of the others occurring at the same time.
(a) a raising of the free cover to 150% of the current level

(b) an increase in the number of voluntary withdrawals from the scheme, through
members resigning from their employment
(c) changing from compulsory to voluntary membership
(d) an increase in unemployment in the industry in which the employer operates
(e) increasing the credibility factor to 0.5. [6]
Question 3.6
A healthcare insurance company is currently in the process of re-pricing its group

income protection product. The company uses experience rating for policies that have
more than 1,000 person-years of past experience data.
(i) Describe the investigations the company will carry out in order to determine
assumptions for use in the re-pricing of these contracts, including an explanation
of how the assumptions will be determined.
(A detailed description of an expense investigation is not required.) [21]
(ii) Outline the additional factors that the company should consider before using the
new premium rates. [3]
[Total 24]

Question 3.7
Describe the various ways in which reinsurance can affect product pricing. [6]
Question 3.8
Describe how the principle of consistency would influence the reserving basis that you
would assume when pricing a product using a cashflow model. [4]
Question 3.9
You are reviewing the adequacy of premium rates for a range of contracts. Discuss the
extent to which margins against adverse contingencies are required in the following
cases. Where you think margins are required, state with reasons how and where in the
basis the margins might be applied.
(a) Twenty-year critical illness insurance.
(b) Immediate needs long-term care annuity.
(c) Private medical insurance. [18]
Question 3.10
A healthcare insurance company is launching a conventional pre-funded long-term care

insurance product on guaranteed terms. You have already determined an appropriate set
of premium rates according to the pricing basis.
Describe the sensitivity tests you would perform before going ahead with the launch,
and suggest any amendments that you might have to make to the product as a result of
your investigations. [18]




using the course.

Solution 3.1
(i) A without-profits critical illness insurance
Investment return
The reserves that build up under this product are comparatively small, therefore the
investment return is not a key assumption. [½]
The price is relatively insensitive to this assumption, and so it won’t be too serious if the
assumption turns out to be wrong. [½]
Expenses
Competition for this business is often on price, therefore there will be fairly small
margins in the premium rates. [½]
This is the second most important assumption for this class of contract after morbidity.
The typically small premium size makes the expenses more significant. [½]
As the market is likely to be price-sensitive, the expense assumption is likely to be

critical in determining the volume of sales and hence in maximising the total
contribution to overheads and profit. [½]
However, if the assumption used is too low, the company may write far more new
business than expected, but at a loss; if the assumption used is too high, new business
volumes may be much lower than expected, with the result that contributions towards
fixed costs are insufficient. [1]
Withdrawal rates
There is usually no benefit payable on withdrawal, but there will still be lapses. These
are likely to be from among the healthier lives, and so the expected future morbidity
experience of the remaining portfolio will be heavier. [½]
The company will make a loss on a particular policy if it lapses when its asset share is
negative. Otherwise there will be a profit. So, the importance of this assumption is
different for early and late withdrawals. [1]
[Total 5]

(ii) A without-profits immediate needs long-term care annuity
Investment return
Investment return, mortality and (in those cases where the annuity payments vary with
the degree of incapacity) morbidity, are the key assumptions for this product. [½]
The single premium, less initial expenses, must be invested at outset to provide a future,
guaranteed income stream. The amount of this income stream will depend crucially on
the investment returns available at the outset. [½]
The single premium is likely to be invested in index-linked bonds of appropriate

duration, assuming that the benefits are inflation linked. A highly matched strategy
should secure a relatively certain real yield. If such a strategy is used, it is essential that
the annuity pricing assumption is not higher than this yield, as this would lock the
company into a guaranteed loss. [1]
The pricing assumption will need to be reduced in any case – both as a result of the
uncertainty of the liability duration due to variable mortality, and to the extent that
appropriate matching assets may be unavailable. [½]
This assumption must be reviewed regularly in the light of changing investment

conditions. [½]
Expenses
The expense assumptions are important because terms are guaranteed, but less so than
investment return because the relative impact of expenses on profit is lower. [1]
The majority of expenses will occur at the outset (eg underwriting, contract issue) and
their amounts will be better known. [½]
Withdrawal rates
There is very unlikely to be any withdrawal benefit and no further premiums are
payable, and so there is no reason for anyone to withdraw from this product. Therefore
this assumption is not at all important. [½]
However, if there were a withdrawal benefit, the assumption could become very
important, depending on the size of the withdrawal benefit payable. [½]
[Maximum 5]

(iii) A unit-linked group income protection insurance
Investment return
The investment risk is largely passed to the policyholder (employer) and there are no
investment guarantees. Therefore, from this perspective, this is not a key assumption.
[½]
However, the only charge received by the company to cover expenses is a percentage of
fund, which makes the unit growth rate very important. [1]
The employer’s contribution rate will reflect the investment return assumption used. It
is important to manage expectations and explain the risks and the uncertainty involved.
The appropriateness of a prudent or optimistic assumption for this purpose will depend
on the employer’s attitude to risk and willingness to increase premiums later, if
necessary. [1]
Expenses
The importance of this assumption depends on whether the company can vary the
monthly charge. [½]
If “no”, then the assumption is very important. If “yes”, then not so important, but the
company will need to consider PRE. [1]
Also, there would still be a delay before the charge increase could be implemented, and
so there would be a continuing loss in the meantime. [½]
Withdrawal rates
Consider how the discontinuance benefit (the value of the unit fund) compares with the
asset share. [½]
An important factor is the incidence of charges relative to expenses. The charges will
start off very low (fund starts at zero) and slowly increase over time, although the level
may well be volatile. In contrast, the initial expenses will be substantial, with ongoing
expenses much lower, but steadily increasing. [1]
This will mean that the unit fund value will be much in excess of asset share at early
durations; at later durations the asset share will catch up with, and ultimately overtake,
the unit fund. [½]
Therefore, there will be a large loss on early discontinuance, as no early termination

penalty applies. [½]

So, in the absence of such a penalty, the withdrawal assumption will be very important.
[½]
If a surrender penalty was applied, then the withdrawal assumption would be much less
important.
[Maximum 7]
Solution 3.2
(i) Requirements of an actuarial model
The model must be valid, rigorous and adequately documented. [½]
The model points chosen must be such as to reflect adequately the distribution of the
business being modelled. [½]
Alternatively, the company’s actual policy data file could be used, provided the software
was able to handle the computations effectively.
The parameters used must allow for all those features in the business being modelled
that could significantly affect the advice being given. [½]
The parameter values chosen should be appropriate to the business being modelled …
[½]
…and take account of the special features of the company and the economic and
business environment in which it is operating. [½]
reasonableness … [½]
…and should be communicable to those to whom advice will be given. [½]
The model should not be overly complex so that either the results become difficult to
interpret and communicate or the model takes too long or becomes too expensive to run.
[½]
[Total 4]

(ii) Main items to be included in the model
All future cashflows from the existing business would be projected by the model… [½]
…allowing for cashflows arising from supervisory reserves… [½]
…and from discretionary benefits, such as non-guaranteed surrender values. [½]
Cashflow calculations need to allow for any interactions between assets and liabilities.
[½]
Cashflows arising from the exercise of policy options would need to be included. [½]
Use of the model
To calculate the value of the profit from the existing business:

● model points would need to be chosen to represent the existing business [½]
● project the future cashflows from each model point, allowing for the impact of
supervisory reserves in order to assess the profit that can be transferred to
shareholders in each future year [½]
● discount the expected profit at an appropriate risk discount rate [½]
● scale up the results of each model point and sum over all model points, to give
the expected present value of the total profit from the existing business [½]
● combine with the current assessment of the free assets attributable to
shareholders in order to get the total value of the profit. [½]
Sensitivity of the calculation would be assessed by recalculating using different values

for all the relevant assumptions required by the model (eg interest, mortality rates). [1]
When making these variations, the parameters would be changed in a way that reflects
the expected relationship between them. [½]
The effect of departures from the base assumptions used in the model can then be
described in the report to the company. [½]
[Maximum 6]

(iii) Principal assumptions

● Investment returns: unit growth rates and returns on non-unit assets. [½]
● Future tax rates. [½]
● Mortality and morbidity rates. [½]
● Rates of discontinuance (eg of lapse, surrender, paid-up). [½]
● Future supervisory valuation bases. [½]
● Rates at which existing policy options are taken up by policyholders. [½]
● Future discontinuance terms (eg surrender values), where these are discretionary.
[½]
● Future expenses (regular, claim) attributable to the existing business, split by
policy type. [½]
● Future inflation rate for expenses and for any inflation-linked benefits. [½]
● Risk discount rate. [½]
[Total 5]
Solution 3.3
Note that those that take the option exhibit the special mortality only from the point at
which they take the option. Up to the option date, they are assumed to experience the
normal select claim incidence rate assumption. Those that take the option are subject
to the higher claim rate for all their policy benefits (ie for £200,000), not just for the
additional benefit.
So it is the act of choosing to take up the option that tells us that the insured morbidity
rates are likely to be much higher. Prior to this event we assume that the morbidity is
that of the insured population in general.
One way of tackling this question is to construct a combined claim incidence and
withdrawal decrement-increment table for the population taking out the policy at age
40 (where “withdrawal” refers to people who choose the option). Create two tables,
the first subject to normal claim rates and withdrawal, the second subject to the special
claim rates and which takes as increments the withdrawals from the “normal” table.
First we need to create the combined decrement table in which those lives choosing the
option experience the special claim rates of 750% of AM92 Ultimate. We choose a
radix of 100,000 for normal lives at age 40.

Normal lives
t ¢ +t
l[40] ¢ +t
q[40] ¢ +t
d[40] w[40]+t
0 100,000 0.003940 394.00 19,921.20
1 79,684.80 0.004810 383.28 15,860.30
2 63,441.22 0.005520 350.20 –
[2]
Lives choosing the option
t ¢¢ +t
l40 ¢¢ +t
q40 ¢¢ +t
d 40
1 19,921.20 0.007605 151.50
2 35,630.00 0.008280 295.02
[1½]
¢ +t = 5 ¥ q[40]+t ]
Where q[40]
¢ +t = l[40]
d[40] ¢ +t × q[40]
¢ +t
(
¢ +t - d[40]
w[40]+t = l[40] )
¢ +t ¥ 0.2
¢¢ +t = l40
d 40 ¢¢ +t × q40
¢¢ +t
¢¢ +1 = w[40]
l40
¢¢ + 2 = l40
l40 ¢¢ +1 – d 40
¢¢ +1 + w[40]+1
The premiums charged for the additional sums will be:
● for the option at the end of year 1:
= 100, 000 ¥ È q[41]

Î ¢ (
v + 1 - q[41] )
¢ +1v 2 ˘˚
¢ q[41]
È 0.004255 0.005245 ˘
= 100, 000 ¥ Í + 0.995745 ¥ ˙ = 872.55 [1½]
Î 1.055 1.0552 ˚

● for the option at the end of year 2:
100, 000 ¥ 0.004610

= 100, 000 q[42]
¢ v= = 436.97 [1]
1.055
The premium for the normal policy is:
= 100, 000 ¥ È q[40]

Î ¢ ( )
v + 1 - q[40] ( )(
¢ +1v 2 + 1 - q[40]
¢ q[40] ¢ 1 - q[40]) ¢ v3 ˘˚
¢ +1 q42
Ê 0.003940 0.004810 0.005520 ˆ

= 100, 000 ¥ Á + 0.996060 ¥ + 0.991269 ¥ ˜
Ë 1.055 1.0552
1.0553 ¯
= 1, 269.90 [1½]
The expected present value of the premiums:
19,921.20 ¥ 872.55v + 15,860.30 ¥ 436.97v 2

= 1, 269.90 +
100, 000
= 1, 496.93 [1]
The expected present value of the claims:
Ê 394.00v + (383.28 + 2 ¥ 151.50)v 2 + (350.20 + 2 ¥ 295.02)v3 ˆ

= 100, 000 ¥ Á ˜
Ë 100, 000 ¯
= 1, 790.77 [2]
Therefore the option premium is:
1, 790.77 - 1, 496.93 = £293.84 [½]

[Total 11]

Solution 3.4
(i) Conventional method
The premium for the policy taken out under the option is calculated assuming a select
claim experience (usually the same experience basis as that used for a current new
policyholder). [½]
It is assumed that persons taking the option are actually subject to the corresponding
ultimate claim experience (but otherwise the same experience as in the current premium
basis), and that all persons eligible to take the option do so. [1]
Where a policy provides a choice of option dates, then it is assumed that policyholders
choose to take the option on the date that leads to greatest cost to the company. In order
to assess this, calculations of the expected cost of the option as if it were taken on each
alternative date will be needed. [1]
The option cost is obtained as the expected present value of the future loss from the
option (benefits and expenses less premiums for the policy taken out under the option).
This option cost will then usually be spread and charged as a level additional premium
for the policy to which the option attaches. [1]
We need: the current premium basis assumptions for select and ultimate claim
experience rates. [½]
[Total 4]
(ii) Calculating the option single premium
The ages in the factors shown in the solution below include (where appropriate) the 20
years assumed addition to the age stated in the question.
The assumed premium from age 40 for the policy taken out under the option (the
“option policy”) is:
A[60] 0.32533
100, 000 = 100, 000 ¥ = 2, 729.51 [1]
a[60] 11.919

The expected present value at age 30 of the cost of the option is:
l
(100, 000 A60 - 2, 729.51 a60 ) v10 l 40 (*)
[30]
1 9,856.2863
= (100, 000 ¥ 0.32692 - 2, 729.51 ¥ 11.891) ¥ ¥ = £130.55 [2]
1.0610 9,923.7497
[Total 3]
(iii) North American method
The premium for the option policy would be calculated using select mortality and
morbidity assumptions, as for the conventional method. [1]
However, the method assumes that only a proportion of all eligible policyholders
exercise the option, and that the claim experience of these “option-takers” is
significantly higher than the corresponding ultimate experience. [1]
So in (*) above we would need to calculate the A and a functions using a much heavier
mortality basis; the resulting value for (*) would then need to be multiplied by the
assumed proportion of policyholders who choose to exercise the option at the expiry
date of the term assurance policy. [1]
Data will be needed to assess the expected proportion of policyholders taking the
option, and to assess the worse (post-option) mortality and morbidity of this group.
Historical experience of this type of policy (or of a similar one) would be analysed. We
would also need the current premium basis assumptions for the select and ultimate
claim experience, as before. [1]
[Total 4]
(iv) Which method?
The conventional method relies on fewer assumptions, and so there is less risk of
getting the wrong answer. Because the conventional method covers the cost of every
possible impaired life exercising the option, then it should be a conservative method
leading, if anything, to an overstatement of the expected option cost. [1]
The problem with the North American method is that its results are very sensitive to the
assumptions made. Unless there are very good data backing the assumptions, there will
be a higher risk of undercharging for the option using this method. [1]

On the other hand, if there are reliable data to inform the company that not every
impaired life actually exercises the option in practice, then the conventional method
may result in an unnecessarily uncompetitive premium, and this is likely to be an
important consideration for a conventional protection insurance policy. In these
circumstances the North American method will be more realistic and may then be
preferable. [1]
[Total 3]
Solution 3.5
(a) Raising the free cover level
This will increase the cost of claims from members who present higher than standard
risks. [½]
However, because membership is compulsory and new employees (one year before
membership) are likely to be healthy, the financial impact of this is likely to be limited
and, with adequate data, predictable. [½]
(b) Increase in voluntary withdrawals
It is likely that the healthiest lives will leave, which will increase the expected claim
experience amongst the remaining members. [1]
(c) Changing from compulsory to voluntary membership
This increases the chance of anti-selection – with a greater proportion of the higher-risk
individuals electing to join the scheme compared to those of lower risk. [½]
The existence of the free cover level makes this prospect more serious, as cases below
the free cover level are accepted on standard terms regardless of their state of health.
[½]
The result could be a worsening of the claim experience amongst those who do choose
to take out the cover… [½]
…although it is mitigated by the fact that decisions on joining still have to made only a
year after starting work, and so relatively few employees will be able to recognise a
marked increase in their risk by this time… [½]
…and it will be further reduced if the membership take-up rate turns out to be high. [½]

(d) Increase in unemployment
If the employer is laying off some of the workforce, it would be unlikely for the
healthiest lives to be those who were made redundant. So there is unlikely to be any
adverse selection effect here. [½]
However, the employment conditions may lead to higher claim costs amongst those still
in employment… [½]
…for example, the employer may attempt to reduce the cost of unproductive labour by
encouraging existing claimants to claim benefits for longer, or it may actively use it as a
redundancy vehicle. [1]
(e) Increasing the credibility factor
The premiums will become more responsive to the company’s ongoing experience. [½]
Elements of moral hazard (such as the examples given in (d) above) are likely to be
more controlled by the employer, wherever possible, thus improving the claims
experience. [½]
[Maximum 6]
Solution 3.6
(i) Investigations required and setting assumptions
The company will need to analyse the experience of its portfolio of policies as a whole,
so that it can work out a table of book rates for the product. [½]
It will also need to analyse separately the relevant past experience for each policy
(scheme) that satisfies the conditions for experience rating. [½]
It will need to analyse:

● claim inception rates [½]
● claim termination rates [½]
● expenses [½]
● renewal rates. [½]
It will also require assumptions for future investment returns and inflation. [½]

Claim inception and termination rates
Book rates will differ on account of the following scheme-related factors:

● free cover levels [½]
● type of industry [½]
● geographical region or territory [½]
● deferred period and other contractual differences. [½]
To estimate the book rates we will use the data for all schemes combined, analysed
according to the above scheme-related factors. [½]
An appropriate investigation period will be chosen: as long as possible in order to

maximise the volume of data (exposed to risk), but not so long as to introduce
significant heterogeneity into the experience. [1]
Claim inception rates will be analysed by comparing actual numbers of inceptions with
those expected according to the current book rate assumptions. Alternatively a standard
table could be used for this (if available). [½]
The data will be further subdivided into homogeneous groups, according to age,
duration in employment (or since joining the scheme), sex, and smoker status.
Subdivision by category of employer (eg manual, non-manual), if appropriate, might
also be done. [1]
A similar analysis would be done for claim termination rates. An additional key factor
for subdivision will be duration of sickness or claim payments. [½]
Historical experience rates would be adjusted, if necessary. [½]
This would be in order to take account of known or expected changes in:

● free cover levels [½]
● underwriting standards for cases in excess of the free cover limits [½]
● trends in experience (reinsurers’ and industry data may be additionally referred
to for this) [1]
● changes in distribution channel or target market [½]
● past, current and future expected economic conditions (which could influence
the employees’ propensity to claim either individually or as a result of their
employer’s encouragement). [½]
Any expected reduction in termination rates would be included in the assumptions used
for valuing the claim annuities. [½]

The experience rates, for each scheme entitled to experience rating, would be
determined by a similar analysis, using the data for that company only. [½]
For a particular experience-rated scheme, the individual risk premium rates would then
be obtained by combining the book rates and the rates based on its own past experience,
using the appropriate credibility factors for the scheme. [½]
Renewal rates
Recent historical rates of renewal would be analysed, broken down by occupation,

territory, sales channel, and duration since the company acquired the scheme. [½]
The ratios of numbers of policies (schemes) renewing over the numbers coming up for
renewal would be measured. [½]
Future renewal rates would then be projected. [½]
The projection would take into account:

● past, present and future economic conditions [½]
● the relative competitiveness of the proposed rates being charged, and whether
this is likely to change. [½]
Expenses
The company will need to analyse its recent expenses due to:
● initial acquisition expenses [½]
● renewal expenses [½]
● claim management expenses. [½]
The recent experience will be analysed in relation to appropriate measures, such as:
● number of members in the scheme [½]
● as a percentage of premium [½]
● as a percentage of benefit level [½]
● per policy (scheme). [½]
Dividing by the appropriate measures gives the expense loadings for the contract. [½]
The above outline of the expense investigation is sufficient given the comment in the
question, but we do still need to describe in detail how the results of the investigation
will be used, as follows below.

The loadings will then need to be increased for inflation to the middle of the period for
which they are expected to be appropriate. [½]
The past expenses (and loading) will need to be split according to whether they were
direct or overhead. [½]
In order to estimate its expense inflation rate, the company would compare its historical
expense increases against past changes in prices and earnings indices; expectations of
the relevant index-inflation rates will then help to determine the rate to use. [½]
An allowance will be made for spreading the initial expenses over the expected number
of renewals of the contract – using the appropriate renewal rate assumptions. [½]
Commission would be allowed at the rate(s) that the company intends to pay. The
additional cost of initial commission would be spread over the expected renewals
identically to the other initial expenses. [1]
The proper per-policy (scheme) expense assumptions would be obtained by considering

total expected future new business volumes, including both new business and renewals,
to work out each policy’s expected contribution. [½]
An investment return assumption will be needed for discounting the claim annuity
payments. This will be based on the real yields from secure index-linked investments
(or fixed interest if the benefits are not inflating) of matching durations. [½]
Margins
Finally margins will need to be added, but because the business is annually renewable
the company is able to review its premiums every year, and so the level of margins may
not need to be large, provided the company does review its experience continually. [1]
The margins are taken, either explicitly on the individual assumptions themselves, or
incorporated into the risk discount rate. [½]
[Maximum 21]
(ii) Additional factors
This may be a price-competitive market. Premium rates of competing companies may

constrain the rates the company charges or affect options or guarantees that it needs to
give. [1]
The assumptions of new business volumes and renewal rates will also be affected by
this. [½]

The morbidity assumptions will be affected by the extent of any guarantees given on
premium rates, for future renewals. [½]
Availability of reinsurance on favourable terms may reduce any margins needed in the
premiums. High reinsurance costs may lead to higher premiums. [1]
If the office issues associated group pension schemes to the same clients it could reduce
the expense loadings in its group IP rates. [½]
[Maximum 3]
Solution 3.7
Reinsurance will usually have a net cost to the insurer, reducing the expected
profitability of the contract. The product price may therefore need to be increased to
reflect this cost. [1]
Due to arbitrage possibilities (eg tax), it may be that reinsurance can lead to increased
profit for the insurer. This could result in a reduction in product price. [1]
Reinsurance generally reduces risk. This means that the product can be priced with
more certainty and so the margins in the basis to cover risk (eg in the risk discount rate)
do not need to be so large. This will reduce the product price. [1½]
Reinsurance can help reduce the company’s financing requirement. This will reduce the
cost of capital, and should also reduce the product price. It may also allow more
business to be written. [1]
Reducing the price may also have the effect of increasing sales, so resulting in higher
total profits. [½]
The reinsurance agreement may specify the price that the insurer has to charge for a
product (eg when a high quota share is used). [1]
Any profit-sharing agreements may affect the expected profit and hence the price that
can be charged. [½]
[Maximum 6]

Solution 3.8
Consistency is the principle whereby assumptions used in an actuarial model should

relate to each other in a realistic way. [½]
So any observed correlations or interdependencies between the different variables

should be incorporated into the model. [½]
A cashflow pricing model generally uses a best-estimate basis. [½]
The reserves assumed at the end of each future projection year should be consistent with
this approach. [½]
We therefore need to work out the best estimates of the supervisory reserves that the
company is likely to hold at those times. [½]
The assumed reserving basis must be appropriately prudent in relation to the best
estimate of the conditions that are projected to exist at each future reserving date. [1]
When performing sensitivity tests, it would be necessary to vary the reserving

assumptions in line with the changed future experience assumptions, again keeping
appropriate margins for prudence. [½]
[Total 4]
Solution 3.9
General
Some or all of the margins suggested below could alternatively be incorporated into the
risk discount rate, if used, by making it higher. [1]
In practice, the scope for margins will be limited by competition. [½]
(a) Twenty-year critical illness insurance
The extent of margins will depend on the degree to which premiums might be
reviewable during the policy term. [½]
The more frequently they can be reviewed, the lower the margins need to be, provided
there is no restriction on the amount to which premiums can be increased. [½]

Such a restriction may result from marketing requirements, as an increase in premiums

in excess of what policyholders are prepared to pay will lead to selective lapsing and
even worse experience following the review. [½]
Margins are needed to cover poor claim experience because of: [½]
● poor assumption-setting as a result of scanty or inappropriate experience data
[½]
● disease-diagnosis rates accelerating more quickly than expected, due to
unforeseen medical advances [½]
● new diseases occurring which, perhaps due to loose claim definitions in the
policy wording, lead to more claims being made [½]
● a higher rate of disease incidence in the population than expected [½]
● a greater extent of selective withdrawal than expected [½]
● a different mix of business sold than expected, where cross-subsidies in the
claim experience have been allowed for – eg by distribution channel, policy size.
[½]
The margin would take the form of an increase to the assumed claim incidence rate in
the basis. [½]
Maybe also assume a high lapse rate early on when the earned asset share is negative,
possibly lower lapse rates later in the term when a profit would be made on lapse. [1]
There is little point in assuming a margin in the interest rate assumption for regular
premium critical illness insurance. It would make little difference to the premium rate,
because the reserves are relatively small and the investment contribution to profit is
small. [1]
If the contract were single premium (unlikely) a low interest rate would guard against
reinvestment risk (although even here there will normally be little, if any, reinvestment.)
[½]
Expenses could be higher than expected, due to:

● the policy administration requiring more work than expected (this is particularly
likely in the area of claims management) [½]
● fewer policies being issued than expected causing a greater per-policy cost of
fixed expenses [½]
● inflation of expenses being higher than expected. [½]

It would be sensible to include margins by increasing the expense assumption, and

increasing inflation rate assumption. [1]
(b) Immediate needs long-term care annuity
There is likely to be much uncertainty over:

● the length of time the policyholder will live [½]
● the rate at which claimants will move into higher care categories (if this leads to
increased annuity payments under the contract). [½]
Assumed mortality rates therefore need to be reduced. [½]
Transition rates to higher care categories, where these exist, need to be increased. [½]
Depending on how the benefits are defined under the policy, it may be that these will be
affected by increases in long-term care costs (eg nursing home fees), and may turn out
higher than expected. [½]
A higher inflation rate for benefit levels should then be assumed. [½]
If policies are well matched by assets, then there will be a reduced need for a margin in
the interest rate assumption. [½]
However, the uncertainty over the duration (and possibly amount) of future claim
payments means that assets and liabilities may end up being significantly mis-matched.
[½]
Also, investment return is a significant component of future cashflow and so it would

then be necessary to have a margin in this assumption. A reduction in the assumed
investment return would be made. [1]
Future expenses could be higher than expected, as in (a). This is especially true if
changes in benefit levels are allowed under the contract when care needs change. [½]
Higher expenses, and expense inflation, should again be assumed. [½]

(c) Private medical insurance
These are one-year contracts so they are effectively yearly renewable. Margins are
therefore needed less than in the other contracts as the renewal premiums can be revised
in the event of worsening claim and expense experience. [1]
Margins will still be necessary, in order to make a profit. Higher than expected claim
incidence rates, expenses and average claim amounts could be used, or an explicit
overall margin could be added. [1]
A particular explicit margin might be needed for the rate of renewals assumed when
spreading the initial expenses. A lower than expected rate of renewal would be used. [1]
Some claims (particularly the more expensive ones) may result in payments that
continue for several years. In such cases, medical inflation will be an important
influence on claims costs. We should assume a higher rate than expected in order to
provide the margin. [½]
Reserves will be small, and so the investment return will not be a significant factor.
Therefore little loading will be needed for this. [½]
[Maximum 18]
Solution 3.10
Sensitivity testing
We will need to project the future profitability of the product, including return on
capital, under a wide range of different possible future conditions but assuming that the
product is issued at the calculated price. [1½]
The main variables that might be used to reflect these future conditions are:
● claim incidence rates and other transition rates between benefit categories [1]
● lapse rates [½]
● investment returns [½]
● expenses and expense inflation [½]
● benefit inflation [½]
● mortality rates [½]
● volume and mix of new business. [½]

Deterministic testing
Deterministic sensitivity tests will be carried out on some or all of the variables. [½]
Each parameter would generally be varied on its own, within the range of feasible long-
term possible outcomes for the variable, to see what effect such parameter shifts would
have on profitability over the long term. [1]
However, the values chosen should reflect the known correlations and dependencies
between the parameters. [½]
For example, changes in lapse rates will be expected to affect claim rates due to their
selective effect, and so the appropriate changes in the claim experience must be
included when lapse rates are being varied. [Similar examples should be given credit.]
[½]
Stochastic testing
Stochastic sensitivity testing could be carried out on some of the key variables. [½]
For this product, we would most likely use stochastic analysis for either or both of:
● the transition rate variables
● the financial variables (investment returns and inflation). [1]
A multiple-state structure would be required for the transition rate model. [½]
First, stochastic projections would be made using a basis that is consistent with the
pricing basis… [½]
…eg using best estimate assumptions for the parameters that define the assumed
probability distributions for the variables. [½]
Projected outcomes would be calculated by computer, making random drawings from

the assumed probability distributions, and many simulations would be performed to
produce an adequate picture of the distribution of outcomes occurring. [1]
This will give an idea of the extent of the variation in profitability likely as a result of
purely random fluctuations. [½]
The volume and mix of business will influence the magnitude of the random variation
predicted by the stochastic transition rate model (the law-of-large-numbers effect), and
so sensitivity of the results to different assumptions for mix and volume of new business
will have to be looked at. [1]

The stochastic projections would be repeated, using different assumed probability

distributions for the stochastic variables, including different parameter values. [½]
Other volume and mix investigations
Further analysis will be necessary to estimate the effects of variation in new business
volume and mix on the company’s capital position. [½]
Model offices will be needed for this, in which supervisory balance sheet values will be
projected for each future year for the whole company. [½]
Also investigate:
● the significant possibility of high sales volumes of this business causing the
company unacceptable capital strain [½]
● the effect of low volume on overall profitability, including the effect of reducing
the cover of the fixed expenses. [½]
Possible amendments
Amendments are generally possible to the product design, or the price, or to both. [½]
If the product’s profitability is particularly at risk from particular future outcomes, then
steps must be taken to reduce this risk. [½]
Introducing a reviewable premium and/or benefit structure is one of the most significant
ways in which we can reduce sensitivity to most variables. [½]
This could also reduce capital requirements, thus reducing the level of sensitivity to new
business volumes. [½]
If the product profitability is sensitive to the new business mix, then any pricing cross-
subsidies may need to be reduced. [½]
The possibility of structuring the product on a unit-linked basis could be explored, as

this would make it easier to match income and outgo and so reduce the need for large
reserves. [1]
Benefit levels may be capped so as to reduce the most severe outcomes that might arise
from, say, high claim inflation and worsening claim rate experience. [½]
Margins may be increased in the pricing basis (eg increase the risk discount rate) to
reflect the level of sensitivity. [½]

The ability to do this successfully will be limited by competitive considerations. [½]

Incorporating reinsurance can help reduce sensitivity (and could reduce the financing
requirements)… [½]
…though this will also tend to reduce profitability. [½]

[Maximum 18]




using the course.

Question 4.1
An established health insurer has been writing only private medical insurance for many
years, in the country in which it is based. The insurer specialises in providing cover for
pioneering treatments into cancer, the target market being heavy smokers and those with
a strong family history of the disease.
The insurer’s total assets are worth £500m, yet the technical liabilities (including the
required minimum margin), amount to only £300m.
Describe, with reasons, a suitable investment philosophy for the company. You should
also give an indication of a possible split of assets. [12]
Question 4.2
A medium-sized health insurer writes only long-term care insurance policies. Regular
or single premiums are paid into the policy during the working life of the policyholder,
and, from age 65, long-term care benefits are available if needed. Surrender benefits are
available prior to age 65. The benefits payable in the event of a claim or surrender on
any particular date are linked to the performance of a published price inflation index,
subject to a fixed minimum benefit amount.
Discuss the suitability of equities as an asset for this insurer. [8]
Question 4.3
A small health insurance company sells only critical illness policies, and has done so for
many years. The finance director has suggested that given the recent drop in the market
values of the company’s equity holding, these assets should be moved immediately into
direct property.
Discuss the suitability of the director’s proposal. [10]
Question 4.4
A health insurer sells only income protection contracts. List the information needed to
accurately calculate its reserves for reported claims. [5]

Question 4.5
A health insurer that sells only private medical insurance (PMI), is considering
calculating its incurred but not reported (IBNR) claims reserves for statutory purposes
using one of the following methods:
(a) Investigate the historic development of claim numbers in order to estimate the
proportion of claims expected to be unreported as at a certain date for a
particular cohort of policies in force. Multiply this by the past average PMI
claim size to get the IBNR reserve.
(b) Use a standard triangulation technique to project total claims reserves and deduct
the reserves for outstanding reported claims.
(c) Take IBNR to be a fixed proportion of the reserve for outstanding claims
reported in the previous accounting year.
Discuss the appropriateness of each of these methods. [14]
Question 4.6
A health insurer sells only annual premium private medical insurance business.
(i) Define the term unexpired risks. [1]
(ii) Discuss the factors the insurer should consider when calculating its reserves for
unexpired risks. [10]
[Total 11]
Question 4.7
A stand-alone critical illness insurance policy includes an option to extend the term
without further medical evidence.
Describe the factors you would consider when allowing for this option in the calculation
of reserves. [15]

Question 4.8
A long-term insurer sells only individual non-linked annual premium critical illness
policies.
List and define the types of reserve held to meet the claims liabilities of the insurer and,
with reasons, give indications of their sizes. [6]
Question 4.9
Describe briefly how cashflow stochastic modelling might be used to determine

strategic investment guidelines for health insurance company investment managers. [6]
Question 4.10
A mutual long-term health insurer transacts all types of without-profits, non-linked

health insurance business. Discuss the extent to which assets and liabilities should be
matched. [5]
Question 4.11
Explain the importance of policyholders’ reasonable expectations as far as investment

returns are concerned, for health and care insurance. [2]
Question 4.12
Explain the principal concerns that the marketing manager and the valuation actuary
will wish to consider when assessing the proposed design and pricing of a new health
and care insurance product. [8]
Question 4.13
List the factors that a claims assessor would consider when estimating the ultimate
claims cost for an individual private medical insurance claim. [3]

Question 4.14
An insurance company is considering the launch of a conventional regular premium

income protection insurance product, having inflation-linked benefits and premiums.
You can assume that the policy has no deferred period. Premiums are waived whenever
sickness benefits are being paid. Each policy will terminate at a specified date, which in
no case can exceed age 70.
The company’s systems manager has asked you about the systems requirements for
calculating the supervisory reserves for the product.
(i) Assuming you are going to use a multiple-state methodology for this purpose,
and that you will be able to estimate all the transition probabilities you need:
(a) list the policy data you would ideally require the system to hold, for the
purpose of calculating the supervisory values of both benefits and
premiums
(b) using formulae, or otherwise, set out the calculation routines that you
would require the system to perform in order to calculate the supervisory
values of the policy benefits.
Ignore the calculation of any IBNR reserves. [10]
(ii) Describe any problems you might encounter in practice if you were to use the
approach described in Part (i)(b) for calculating the company’s supervisory
reserves, and the main implications of these problems for the company. [5]
(iii) Suggest ways in which the company could attempt to overcome the problems
you have described in Part (ii) above. [3]
(iv) State the advantages of multiple-state methodology, compared with alternative

methods of valuing income protection insurance benefits, for the purpose of
calculating the supervisory reserves. [2]
[Total 20]

Solution 4.1
The primary aim will be to maximise investment return. [½]
This will be subject to meeting the liabilities due, whilst taking into account the
uncertainty involved. [½]
For the known liabilities of £300m, it will be desirable to maintain a matched position,
in terms of nature, term and currency. [1]
For private medical insurance, the vast majority of the claims liabilities depend on the
costs incurred in receiving treatment covered by the policy. [½]
Normally, we would expect the liabilities to be short tailed, with little scope for
significant investment return. [½]
If this is the case, a mixture of cash and short-term fixed-interest bonds would be a
suitable match. [½]
However, for some prolonged treatments, in particular the cancer treatment that the
company specialises in, the claims amounts payable will be unknown and subject to
medical inflation prior to final settlement. [1]
This increase could be substantial and so assets expected to give a real return would be
more appropriate, such as equities and property. [1]
Index-linked bonds may be a suitable alternative too, even though there may not be a
direct relationship between the index and likely inflation of medical costs. [½]
The company has significant free assets. [½]
These are best matched in higher-yielding assets such as equities and property. [½]
The high free assets also means that the company can afford to mismatch its technical
reserves to a considerable extent in the hope of higher returns. [½]
Therefore, an even higher proportion of equities and property may be desired. [½]
However, we will need to consider any regulatory constraints on our investment

philosophy. [½]

In particular, with a considerable amount of mismatching, there may be a requirement to

hold significantly higher reserves, reducing the available free assets. [½]
In addition, as the claim amounts are uncertain, the required minimum margin may be
higher, depending on how it is calculated. This reduces investment freedom. [1]
Expenses also form part of the company’s liabilities. [½]
Expense liabilities tend to increase over time in line with an index (probably an earnings
index due to wages being a large part of expenses). [½]
A suitable match would be securities linked to the same index (if available), such as
index-linked bonds. If these are not available, other suitable assets that provide a real
return might include equities and property. [1]
The liabilities are denominated only in the country concerned and so the company will
wish to have its assets in the same currency to avoid a currency mismatch. [½]
In summary, up to £200m free assets can be in a mixture of equities, property and

index-linked bonds, and the other £300m in a mixture of equities, property, cash and
short-term securities such as government bonds and corporate bonds.
A possible split is therefore:

£m
Domestic equities 250
Domestic property 50
Cash 100
Government bonds 50
Domestic bonds 50 [2]
[Maximum 12]
Solution 4.2
Equities are, in part, a reasonable asset. [½]
The time between premium receipt and claim payment could be substantial. In this
case, equities should provide a long-term real return, designed to provide significant
growth in order to provide the future benefits. [1]
For older policyholders however, the time to benefit payment is short and equities may
prove to be too volatile. [½]

The benefits are index-linked. Therefore the ideal asset would be one that gave a return
linked to that index. If that is not available, equities may be a reasonable alternative,
although their return is not a guaranteed match in either absolute or index-linked terms.
[1]
If the equity approach is taken, it will be important to ensure a diverse range of equities,
to avoid concentration of risk and to reduce default risk. [1]
There is a mismatching risk if the index turns out to increase substantially. [1]
On the other hand, the guaranteed minimum benefit gives an extra risk if equity returns
are poor (even temporarily). [1]
Surrender benefits are also index-linked, and this will be a risk in times of poor market
performance, since policyholders could surrender and are more likely to do so when
markets are depressed. However, the extent of the risk depends on the size of any
surrender penalties. [1]
The size of the insurer’s free reserves will also have a bearing on the suitability of
equities as an investment. [½]
For instance, if free reserves are large, then equities are more suitable because any
volatility will be cushioned. However, if free reserves are small, then a large equity
holding would not be prudent because this could imperil solvency if market values fell.
[1]
Overseas equities may also be suitable if the insurer has liabilities in other currencies or
territories. They would also add diversification albeit with an extra risk. They may also
be considered if the insurer had significant free reserves. [1]
[Maximum 8]

Solution 4.3
To a certain extent, the decision is not a particularly important one. [½]
This is because for critical illness policies, reserves are small and the investment returns
made on the few funds available for investment will not be crucial to the financial
health of the insurer. [1]
The importance of the decision will depend on the proportion of the total assets that is
held in equities. [½]
However, to the extent that there are funds available for investment, it will still be the
general aim to maximise returns, subject to an acceptable level of risk. [1]
We should first question the current holding of equities. They are long-term, volatile,
real assets and do not provide a suitable asset for short-term cashflow concerns, which
will be the main concern for a small company writing critical illness policies. [1]
However, they may be a suitable match for expenses and free assets. [½]
Normally we would expect such a company (small, selling only critical illness) to be
very aware of its day to day cashflow situation, and hence invested in readily-realised
short term assets such as cash and short-dated bonds. [1]
If solvency has been threatened by the fall in market values, moving into property with
the sale proceeds would be a bad idea. [½]
However, it may be that the company is very solvent, in which case equities might have
been a deliberate mismatch in the hope of higher returns. [½]
To this extent, property should also provide long-term real returns. [½]
However, direct property is unlikely to be suitable for other reasons. It requires

expertise, is dealt with in large units and can be unmarketable. For a small company
this is not practical. [1]
Indirect property would be a more suitable investment if property exposure is

desired. [½]
In any case, moving out of equities may also not be a good idea. The recent drop may
have followed a previous gain, in which case the blip can be ignored. [½]
Transferring all in one go is not likely to be a good idea either. [½]

The drop may not be sustained and a rise could follow, which the company would not
want to miss out on. [½]
If the move out of equities is made, any losses on equities will be crystallised,
preventing any further gains or losses. However, if the transfer was made into property,
it is possible that further losses could be made if that asset sector crashes too. [1]
There may also be tax implications of such a move, which should be considered. [½]
We should also check any regulations on whether the move is allowable. [½]
[Maximum 10]
Solution 4.4
For each claim, we need:

● claim amount [¼]
● date of claim inception [¼]
● frequency of benefit payment (eg weekly) [¼]
● policy termination date [¼]
● details of changes to be made to the benefit over time [¼]
● deferred period [¼]
● age [¼]
● sex [¼]
● smoker status [¼]
● occupation [¼]
● territory [¼]
● linked claims period [¼]
● any limits on payment terms (durations or amounts) [¼]
● other information to assess likely duration of claim, eg:
– type and extent of sickness
– medical reports
– details of any previous claims (amounts and durations) [1]
Also:
● reason for the reserving calculation [¼]
● external data on likely duration of sickness (eg reinsurers’ data) [¼]
● relevant inflationary indices (eg earnings index) [¼]
● details of the reserving basis (eg discount rate) [¼]
● statutory restrictions. [¼]
[Maximum 5]

Solution 4.5
General principles
We would expect IBNR reserves for PMI to be small. This is because most (valid)
claims are notified early on in the course of treatment (and often before treatment) to
obtain authorisation. [1]
We therefore want the method to be relatively simple to avoid excessive costs. All the
methods adhere to this. [1]
As the calculation is for statutory purposes, we want the method to result in a reasonable
but prudent estimate of IBNR reserves. [½]
None of the methods given have an implicit allowance for prudence, and so the methods
and/or assumptions should allow for this explicitly, for example by building in margins
into the assumptions. [1]
The method should be non-manipulable and should allow comparisons to be made

between companies and over time. [½]
None of the methods shown have any restrictions or guidance on usage, so their usage
will need to be monitored carefully by the regulators to avoid manipulation. [½]
The method should take into account any statutory constraints or guidance. [½]
Method (a)
This method is commonly known as a “delay table”.
As long as the past reporting patterns of claims can be expected to be appropriate in the
future, then this method should be reasonable. [½]
However, this assumption may be invalidated by, for example, changes in the claims
handling process or reporting behaviour, the mix of business and variations in the types
of claims over time. [1]
An estimate of the average PMI claim size will be readily available from past data,
although suitability will be affected by how many years are included in the calculation
of the average. [1]
However, again this may not be entirely appropriate for the future, particularly due to
claims inflation. [½]

In any case, the average PMI claim size may not represent the average PMI claim size
for IBNR claims alone. [½]
For example, it may be that minor ailments are reported less quickly than serious ones,
in which case IBNR claims would be smaller than average. [½]
Method (b)
This method will only work if an appropriate claims cohort is used. For example, if
claims are grouped according to when they are reported, irrespective of when they
happened, the method would not project IBNR automatically and would therefore be
inappropriate. [1]
The exercise could be distorted by all the usual factors that can distort triangulation
exercises, for example changes in development patterns, the mix of business or claims
handling procedures. [1]
Changes in past and future inflation are also important. [½]
Care needs to be taken over IBNER. The triangulation may or may not include IBNER
estimates depending on the data tabulated within it. For example, if IBNER is already
shown in the data, then the triangulation will automatically include IBNER in the
projection. If the intention is that IBNER is not included in the reported IBNR, then
this will need adjustment. [1]
Method (c)
This method is the simplest of the three, and can be calculated as soon as the
outstanding reported claims reserves for the prior year have been set. [½]
The method is still reasonably accurate since unreported claims reserves should be some
resemblance to a proportion of reported claims reserves. [½]
Given its simplicity and the small size of IBNR, this method may therefore be the most
appropriate. [½]
The complication is in deciding a suitable “proportion”. This should be based on

historical data, which could be inappropriate. [½]
In particular, claims reported in the previous year may not be directly relevant to
unreported claims in the current year, since they represent a different risk period. [½]
[Maximum 14]

Solution 4.6
(i) Unexpired risks
These are risks in respect of the portion of policies written that lies beyond the reserve
calculation date, for which premiums have already been received. [1]
(ii) Factors to consider
The allowance for unexpired risk will consist of an unearned premium reserve (UPR),
and if necessary, an extra allowance called the additional unexpired risk reserve. [½]
The two will cover the allowance for both future claims and associated expenses on the
unexpired portion of cover. [½]
We first need an assumption as to how business is sold throughout the year. In the
absence of any other information, it would be reasonable to assume that PMI business is
sold evenly throughout the calendar year. [1]
We also need an assumption on the length of cover provided by the policies. As the
premiums are annual, it is again reasonable to assume that cover is one year long. [1]
An alternative, and more accurate approach, would be to use the actual unexpired
period calculated on a policy-by-policy basis, in which case the last two assumptions
would not be required. [1]
Next, we need an assumption on the earnings of the premium, ie how the risk on the
policy is spread over the year. [½]
One option would be to assume that it is even over the year. The UPR in this case
would be a simple proportion of the written premium based on the number of days
cover unexpired (either assumed or actual, as above) as at the calculation date. [1]
However, it is perhaps better argued that there will be more claims over the winter
period (eg for pneumonia), in which case the risk is greater over those months. For
example, in the UK, the months of November to February might give more risk
exposure. [1]
The UPR can be adjusted to allow for this by using a monthly approach to the
calculation, putting more risk weight on the winter months. [½]
There is also an increase of risk with age, as health deteriorates with age and claims are
more likely at the end of the policy year. However, over the space of one year, this
variation in risk is not great and could be taken to be negligible. [½]

We need to consider the purpose of the reserving exercise. [½]
For example, if it is for statutory purposes, we would want a prudent method, whereas
for internal purposes we would want a best estimate basis. [½]
An approximate allowance for prudence could be built in, for example, by taking a
larger premium for the calculation (even the full written premium, so that when we take
the proportion to calculate the UPR, the result would be larger). [½]
For an ongoing company, the UPR should be reduced for the uneven incidence of
expenses over the year. This will lower the reserve, the desirability of which depends
again on the purpose of the calculation. [1]
Finally, the reserve should be increased if necessary to allow for inadequate premiums,
giving the additional unexpired risk reserve. In order to assess this, the adequacy of
past premiums should be analysed. [1]
[Maximum 10]
Solution 4.7
The method and assumptions depend on the purpose of the reserving exercise. [½]
For example, for statutory or solvency purposes a prudent approach will be taken,
whereas for internal purposes a best estimate approach may be more applicable. [½]
The choice as to whether to exercise the option depends heavily on the self-perceived
health of the policyholder. A policyholder who perceives himself to be in poor health or
more susceptible to illness is more likely to exercise the option, thus selecting against
the insurer. [1]
The desirability of the option also depends on the financial needs of the policyholder at
the option date. For example, it may be that the policyholder no longer has a desire for
cover in the event of diagnosis of a critical illness, and so opts not to extend it despite it
being “a good deal”. [1]
To value the option, we can use either the conventional method or the North American
experience method. [½]

North American experience method
● Assumptions will be needed on the proportions of policyholders choosing to

extend cover. [½]
● If prudence is required, we would overstate the proportion choosing to extend.

[½]
● Assumptions will also be needed for the morbidity and mortality experience
during the original term, and of those policyholders who choose to extend cover
thereafter. [1]
● We would then analyse the experience split by age, sex, etc, and allow for any
trends and margins when projecting future morbidity/mortality. [1]
● To reflect the anti-selection opportunity, we would make a much higher claim

incidence rate assumption for post-option experience. [½]
● The assumptions would ideally be based on post-option past data, if available.

[½]
● This will be needed for a variety of model points, eg sample terms and ages. [½]
● We also need to know details about the premium rates of the policies taken up
under the option. [½]
● Insurability will usually be guaranteed at the company's standard premium rates

at the time of extension. [½]
Conventional method
● This assumes that all lives take up the option. [½]
● We then need an assumption for the morbidity experience of the whole group as
at the end of the existing term. This would also be based on past experience. [½]
● We would again analyse the experience split by age, sex, etc, and allow for any
trends and margins when projecting future morbidity/mortality. [½]
● Calculate the expected extra cost of claims from the future “option” policies,
over the standard premium rate, and discount at a prudent interest rate. [1]
● In calculating the extra cost of the option, claim incidence rates and mortality
prior to the option date would be assumed to be low, for prudence, and lapses
would be ignored. [1]

Under both methods, if the extension premiums are on guaranteed terms rather than the
standard rates then in force, this poses an extra risk to the insurer since it is bound by
these rates for the extended term. This is particularly important if the profitability of the
current rates is in question. [1]
We need to know the extent of the option. For example, do the policies taken up under
the option also have further options to extend again at the end of the new term? If so,
the risks are compounded and further assumptions are needed as to the second (or
further) extensions. [1]
We also need to allow for the expenses of administering the option. [½]
The assumptions used in the valuation of the option should be consistent with those
used to value the guaranteed benefits and the assets. [1]
The experience on similar options on similar contracts may be useful. [½]
Reinsurers may be able to offer us some assistance in setting assumptions. [½]

[Maximum 15]
Solution 4.8
Reserves in total will be small for this business, since it is a protection contract with
little need to build up a fund. [1]
However, if the benefits are very likely to be paid (ie high claim frequency), and the
contract is more of a savings contract, then reserves could be larger. [½]
Prospective premium reserves – the discounted value of future cash out-flows. [½]
This will be the majority of reserves, since the funds plus premiums are held to meet the
benefits paid out in the future. [½]
Claims reserves – the discounted value of claims in payment including claims that have
arisen but have not yet been settled. [1]
These should be small unless there are substantial benefits paid as regular payments
rather than lump sum, or significant delays in paying claims due to a lengthy claims
verification process in some cases. [1]
However, the part of this reserve for claims that have been diagnosed, but not yet
reported, could be substantial if there are many claims that take time to be reported. [1]

Option reserves – additional costs which need to be set aside for the eventuality that a
particular option becomes more valuable in its exercise than in its discard. [1]
[Maximum 6]
Solution 4.9
For stochastic asset / liability modelling we need to:

● specify solvency measure [½]
● specify profitability measure [½]
● specify acceptable probability of ruin [½]
● model the future behaviour of assets (using a Wilkie model or some other
stochastic model), including investment return assumptions [½]
● model the behaviour of liabilities, including deciding on any links between asset
behaviour and liability valuation (must be dynamic) [1]
● this could include dynamic strategic responses, eg alter investment strategy
mid-projection if solvency becomes threatened
● include the effect of consistent expense inflation [½]
● decide upon allowance for new business [½]
● decide on a period of projection and calculation frequency [½]
● investigate different investment strategies, looking at the effect on ruin
probability and profitability [1]
● interpret the results. [½]
The basic aim is, given actual free assets and a certain acceptable probability of
insolvency, to find the most profitable investment strategy in relation to the company’s
liabilities that leaves the company with not more than its acceptable level of risk. [1]
[Maximum 6]

Solution 4.10
Matching means choosing assets that will have an equal and opposite cashflow to that of
the liabilities concerned. In practice this is often impossible, so we use matching in a
looser sense to mean choosing assets that share the same nature, term and currency as
the liabilities being matched. [1]
Matching reduces the exposure to small interest rate (or equity market value)
movements. However, it removes the possibility of profit as well as loss. [1]
If the free assets are low, you may decide you can write only business that can be
matched in order to protect solvency. If the free assets are larger, you may decide to
mismatch in the hope of making a profit if interest rates or equity market values move
as you expect. [1]
Extensive matching is unlikely to be achievable on health insurance products because of

the uncertainty of benefit outgo on protection products. However, where it is
achievable, by minimising investment risk, contracts can be competitively priced using
close to current yields as the pricing interest assumption. [1]
Exact matching may be impossible for an expanding fund because there are no assets
available with initially negative income and / or which are sufficiently long term. A
lesser protection is immunisation. Even then, liabilities may be so long that there are no
suitable assets. [1]
[Total 5]
Solution 4.11
Policyholders’ reasonable expectations are, in this context, unlikely to be very

important. [½]
For the majority of health and care insurance products, investment returns play a minor
role in the benefits provided, and so policyholders will not normally expect investment
gains. [½]
Exceptions to this may include unit-linked or with-profits health insurance products,

eg a pre-funded long-term care insurance where the unit fund value is used to purchase
care benefits at the start of the claim. [½]
However, expectations may not be met if the insurer relies on investment returns to such
a degree that underperformance may mean premium hikes on reviewable products
(including unit-linked protection policies). [1]
[Maximum 2]

Solution 4.12
The marketing manager will be primarily concerned with the attractiveness of the
proposed contract to the target market and to the salesforce – since it is often the case
that the salesman represents the main hurdle to the acceptability of a health insurance
product. [1]
Thus his concern will extend to issues such as:

● perceived “value for money” of the product in the client’s eyes
● competitive product terms
● how well the product meets the needs of the target market
● possible “Unique Selling Features” – preferably at no extra cost
● absence of overt charges - such as a nil/reduced allocation period for unit-linked
contracts
● attractive commission terms for salesmen and ease of selling
● easily comprehensible and clear design. [½ mark per point]
The valuation actuary will be more concerned with issues such as:
● use of existing pricing and reserving methodologies
● not to be overly risky: for example, are the guarantees (including any options)
too onerous, and are claims definitions watertight?
● does the extent of cross-subsidy lead to acceptable risk (eg from unexpected
changes in the mix of business)?
● to have sufficient premiums or charges to ensure adequate profitability and
return on capital
● profit to be not too sensitive to changes in conditions: eg are charges or
premiums reviewable?
● minimal new business strain (or enough capital to cover possible future new
business volumes)
● speedy return of initial capital
● adequate underwriting standards and claims control
● ease of reporting and record keeping – including supervisory reporting
● effects on other business, both existing (eg lapses) and on sales of new (other)
business
● fully established administrative/computer systems. [½ mark per point]
[Maximum 8]

Solution 4.13
● procedure type [½]

● hospital (medical centre) to be used [½]
● name of surgeon, consultant or other medical principal [½]
● policy coverage (full indemnity, excess, limits, recuperation benefit etc) [½]
● age, sex and past claims history of claimant may have some bearing [½]
● current levels of medical inflation. [½]
[Total 3]
Solution 4.14
(i)(a) Policy data
For each in-force policy the company would need to record the following information:
● claim status (currently claiming or not claiming) [¼]
● sex [¼]
● date of birth [¼]
● smoker status [¼]
● occupational group [¼]
● date of policy entry [¼]
● date of most recent claim inception (if claiming) [¼]
● reason for claim (if claiming) [¼]
● dates of inception and termination of any past completed bouts of claiming [¼]
● policy termination date [¼]
● current benefit level (including full indexation increases from date of policy
entry) [½]
● benefit payment frequency [¼]
● current premium level (including full indexation increases from date of policy
entry) [½]
● premium payment frequency [¼]
● any special rating information (eg health impairment) [¼]
[Maximum 4]

(i)(b) Calculation routines
For an in-force not-claiming policy at the valuation date, the value of the future sickness
benefits could be calculated from:
w- x
BÂ t -½ pxHS
,r v
t -½
(1 + f )t -½ [2½]
t =1
where: w = policy expiry age [¼]
t -½ pxHS
, r = probability of a currently non-claiming policyholder aged x, with
policy duration r, being sick and receiving benefits in exactly t - ½
years time [¾]
B = current annual rate of benefit payment [¼]
f = future annual rate of inflation. [¼]
The probability values would also be a function of sex, occupational class, smoker
status, and (possibly) whether lives have any previous claims history. [½]
For an in-force (claiming) policy at the valuation date, the value of the future sickness
benefits could be calculated from:
w- x
BÂ t -½ pxSS, g vt -½ (1 + f )t -½ [1½]
t =1
where:
t -½ pxSS, g = probability of a currently sick and claiming policyholder aged x,

with current claim duration g years, being sick and receiving
benefits in exactly t - ½ years time. [¾]
In addition to the above mentioned features, the probability values would also be
function of the cause of claim. [¼]
[Maximum 6]
(ii) Problems of using multi-state modelling, and their implications
Accurate valuations using multi-state modelling (MSM) requires a large table of

transition probabilities, subdivided by many factors into a large number of cells. [½]

Examples of such factors include current claim status, future claim status, age, sex,
policy duration, sickness duration, occupation, smoker status, number of previous
claims, cause of sickness. [1]
It is very unlikely that the company will be able to estimate many of these probabilities
with any degree of confidence, … [½]
… given that the company will have no experience data of its own for the product… [½]
… and that it can be very difficult to forecast sickness experience with any degree of
certainty (eg due to economic influences). [½]
Other sources of data are also usually likely to be thin at this level of detail, … [½]
… and are also unlikely to be very relevant. [½]
This is especially the case for the estimation of termination probabilities, where there
are more factors involved but there are much less data. [½]
The margins in the assumptions made are therefore likely to be substantial, … [½]
… causing potential capital problems for the company if it sells a lot of business. [½]
Also the degree of parameter uncertainty may not justify the use of such a complex
model (the model will give spurious accuracy). [½]
[Maximum 5]
(iii) Dealing with the problems
To overcome these difficulties, the company might:

● combine cells into larger and fewer groups, thereby making the methodology
simpler and easier to justify to the supervisory authority [½]
● use alternative, simpler but more approximate, methodologies, such as the claim
inception and disability annuity method [½]
● ensure that the product design includes reviewability of premiums so that it is
not necessary for the margins in the reserving basis to be so large [½]
● use reinsurers to advise on all actuarial aspects of the launch, including pricing,
underwriting and reserving, and heavily reinsure the new product until the
company’s experience develops [1]
(this will reduce the size of the reserves needed by having more confidence in
the assumptions (smaller margins), and by sharing a large part of the risk with
another insurer) [½]

● use additional financial reinsurance, which will help to reduce the capital strain
from the reserves that still need to be set up [½]
● capital strain can also be controlled by restricting the volume of business sold.
[½]
[Maximum 3]
(iv) Advantages of MSM
The method will show, realistically, how sensitive the reserve values are to variations in
the parameter assumptions. [½]
This will be of great assistance when assessing the size of margins the company needs
to include in each assumption to obtain the required degree of prudence in the reserves.
[1]
It will also enable the actuary to decide (by experimentation) which cells can be
combined into larger groups without causing significant loss of accuracy (ie it can test
the robustness of the model). [½]
[Total 2]

Question 5.1
A health and care insurer is reviewing its Service Level Agreement (SLA) with a
third-party supplier of underwriting and claims payment services.
List the areas of the supplier’s activities that the insurer will want to consider as part of
its review. [4]
Question 5.2
(i) Define pre-authorisation, as applied to PMI products. [1]
(ii) Describe the concept of disability counselling, and its advantages for both
policyholders and insurers. [3]
[Total 4]
Question 5.3
Explain the possible consequences of a reinsurer failure for a health and care insurer. [5]
Question 5.4
A health and care insurance company is considering using industry-average sickness

rates collected over a period of three years, ending two years ago, for pricing a new
income protection contract.
Discuss the risks it would face in using these data. [5]

Question 5.5
A life insurance company transacts regular premium deferred annuity contracts for both
individuals and groups of employees. The contracts contain an optional waiver of
premium rider benefit for which an additional premium is charged. Currently, the same
premium rates and underwriting conditions apply to members of groups as to
individuals. Life cover is not available under the contracts.
The marketing manager has suggested that for group policies there should be no
underwriting. He also argues that, in view of the economies of scale available, the rider
benefit should be provided free of charge to groups.
Comment briefly on the marketing manager’s suggestions. [7]
Question 5.6
A life insurance company transacting individual income protection insurance business is

reviewing its reinsurance retention limits.
List the factors you would take into account in setting revised limits. [5]
Question 5.7
A long-term health and care insurer that sells only critical illness policies has been
losing business recently to its competitors.
State ways in which the insurer could remedy its competitive position. [8]
Question 5.8
A long-term insurance company is about to review the premiums for its without-profits
term assurance product (that pays a fixed benefit only on death within a certain term).
At the same time it is going to add a critical illness benefit. It has not previously offered
critical illness cover on any of its contracts, although other companies in the market do
so. The full sum insured will be payable on the first of death, or diagnosis of a specified
critical illness, within the term of ten years.
Explain how policy and other data relating to the mortality and critical illness benefits
may be a source of risk to the insurer in these circumstances. [8]

Question 5.9
(i) A medium-sized short-term insurance company has decided to start writing a

medical benefits policy which will cover payment of hospital fees, surgeons’
fees and convalescence fees. It will be sold on an individual and group basis.
Outline, with reasons, the types of reinsurance arrangement that might be
suitable for the company in respect of this business. [6]
(ii) Describe circumstances in which an insurance company may decide not to use
reinsurance. [6]
[Total 12]
Question 5.10
(i) Describe four ways in which a health and care insurance company can obtain
underwriting information about a person making an application for a health
insurance contract. [5]
(ii) Explain how the information in (i) would be used by the insurance company, and
the purpose that is served by this process. [6]
(iii) Explain why all four sources of information are not necessarily obtained for all
applicants, and how the company may decide upon which of the four to obtain in
any particular case. [3]
[Total 14]
Question 5.11
You are the actuary to a reinsurance company. A direct writing health insurance
company with whom you currently have no involvement has asked for a quote on
reinsuring a new stand-alone guaranteed premium critical illness policy. Outline the
factors you would take into account in proposing suitable risk premium reinsurance
terms. [9]
Question 5.12
An actuary will seek to support a health and care insurance company in achieving its
aims, within the context of the company’s risk profile and its available resources. State
the problems that confront the actuary in doing this. [10]

Question 5.13
A health insurance company currently markets a without-profits, individual long-term

income protection contract. Premiums and benefits are fixed and level for the duration
of the contract. The contract pays an income benefit while the policyholder is unable to
work because of illness or accident, up to an expiry age of 65. No benefit is payable on
expiry, death or withdrawal from the contract. Premiums are not paid by the
policyholder during a claim.
The company has now decided to replace this contract, for new business, with a
unit-linked version. The contract details are as follows:
● benefits as for the existing contract
● premiums payable monthly in advance
● proportion of premiums allocated to purchase units is 0% for the first 12 months
of the contract, 97% thereafter
● monthly administration fee payable by unit cancellation
● fund management charge 1% pa
● monthly unit cancellations to cover the total cost of claims expected to start
during the month
● while a policyholder is claiming, the insurance company will pay the premiums
on behalf of the policyholder
● the full unit fund will be payable on death, withdrawal or at the age of 65
● premiums are reviewed by the company at five-yearly intervals. All charges
except the allocation rates are reviewable at the company’s discretion at any
time.
Premiums are set so that they are expected to remain level until the expiry age unless
there is a deterioration in experience. The unit fund at expiry is expected to be small
compared with the total premiums payable.
(i) Discuss the risks for the insurance company under the two versions of the
contract, highlighting any similarities and differences. [13]
(ii) Comment on the extent to which the unit-linked design better meets the needs of
a consumer seeking income protection during incapacity at low cost. [4]
(iii) Comment briefly on how the capital requirements of the two contract designs are
likely to compare. [3]
[Total 20]

Solution 5.1
For both underwriting and claims payments, the insurer will review the:
● attention paid to customer care and satisfaction
● speed of dealing with customers/salespeople
● accuracy and checks of data passed to insurer
● security checks put on policyholder information.
In addition, for underwriting, the insurer will review the:

● decisions made with regard to how to deal with loadings, exclusions,
declinatures and requests for further medical information
● quality of training of underwriting staff
● frequency and detail of regular inspections.
For claims payment, the insurer will review the:

● verification of claims eligibility, eg diagnosis, sickness
● rehabilitation and recovery process
● speed of payment of benefits. [½ each, maximum 4]
Solution 5.2
(i) Pre-authorisation
Pre-authorisation is the procedure whereby claims are authenticated against the policy
conditions and medical need established and agreed, prior to treatment. [½]
The procedure also directs the claimant to use the most suitable treatment provider, and
authorises the treatment provider to proceed with the treatment. [½]
(ii) Disability counselling
Disability counselling is the process whereby an insurer’s representative visits a new

insurance claimant. [½]
The policyholder can be given advice on how to deal with their disability or illness. [½]

The policyholder can be reminded about the benefits payable (dates, amounts and
conditions). [½]
Details of State welfare payments and local assistance services can also be learnt. [½]
The insurer will be able to establish the severity of the illness and (if applicable) be able
to estimate a likely date for return to work. [½]
The representative can also promote the idea of returning to work as soon as is
practically possible, keeping the insurer’s costs to a minimum. [½]
The advantages to the policyholder, above, should make the product more attractive and
thus give the insurer a marketing benefit. [½]
[Maximum 3]
Solution 5.3
If the insurer does not use the failed reinsurer, there would probably be no
consequences. [½]
However, even then, the availability or cost of reinsurance in the future may suffer. [½]
The rest of this answer assumes that the insurer did use the reinsurer.
The insurer will be liable for the reinsurer’s share of claims that would otherwise have
been recoverable. [½]
This will not only be for future claims on existing business, but may also affect reported
claims in payment, for which recoveries may no longer be able to be made. [½]
This means that it may have to pay a greater share of many claims, in the case of
proportional arrangements, or may now be liable for very large claims in the event of
non-proportional arrangements. [1]
This could have a serious adverse impact on the financial stability of the insurer … [½]
… which may result in premium rate increases. [½]
In addition, the statutory solvency position of the insurer may worsen. [½]
The company should therefore attempt to replace the reinsurance for its in-force
portfolio of policies that are not claiming, to prevent being exposed to large new claims
from that business. [½]

The company would then only be losing, in effect, the unexpired premium for these
policies. [½]
The insurer will also have to review its reinsurance arrangements for new business by
seeking cover elsewhere. [½]
Both of these arrangements may now, however, prove to be expensive. [½]

[Maximum 5]
Solution 5.4
The insurer would presumably seek to adjust the data in forming its assumptions, but
there will be many factors that it will not be able to allow for with certainty. [½]
These include:
● industry experience may have changed in the period since the data were
collected, or be expected to change in future [1]
● the data may be inaccurate, incomplete or otherwise unrepresentative of the
market as a whole [1]
● there may not be sufficient data for credibility, although this is much less likely
with industry data than it is for a single company [½]
● the market data might not be suitable for use by this company, because of such
things as:
– different approach to initial underwriting or claims control
– different definition of sickness
– differences in other policy conditions, such as the maximum proportion
of pre-sickness income payable under the contract
– different distribution channels and target markets
– format of data may be unsuitable, eg insufficient detail
– different contract designs [½ per point]
● the insurer will not have any data of its own with which to check the above
points. [½]
[Maximum 5]

Solution 5.5
In actuarial exam questions, suggestions made by marketing managers are not usually
entirely actuarially sound. However, you should judge each one on its merits and
comment on any truth in the statement as well as error.
There are two different suggestions here:
No underwriting for group policies
Clearly there is a risk of anti-selection because unhealthy lives will be accepted. [½]
The anti-selection risk is lower with a group (due to the “healthy worker” effect), but is
still present, especially as the benefit is optional. [½]
Also the risks are not independent from individual to individual and so there is a
potential “catastrophe” risk (eg from several employees contracting the same disease
from a work-related cause, or simply through increased mutual contact). [1]
Equally, though, there should be greater homogeneity in the group than in a collection
of individual risks. The claims experience should be more predictable as a result. [½]
Costs would be reduced by not underwriting. The key point is whether this is more than
offset by the greater claims cost that would be expected. [1]
Offering the benefit for free
The economies of scale for group deferred annuity business are unlikely to pay for
removing the charge completely, although it might lead to a reduced cost compared with
individual business, especially if free cover limits are introduced. [1]
If offering the free benefit were to boost sales significantly, it might pay for itself, by
reducing the per scheme cost of the fixed expenses. [½]
However, it would be risky to rely on this. Might consider how many schemes
currently have waiver of premium. This gives an indication of its popularity and hence
whether or not it is likely to increase sales. [½]
Would there be pressure from brokers to introduce it for business in force? If we offer
free waiver to business in force then the cost will be much higher. [1]
Anti-selection and heterogeneity are most likely in smaller groups. If combined with no
underwriting, the level of any free cover should be made dependent on group size, and
might be zero for very small groups. [1]
[Maximum 7]

Solution 5.6
The question says “list”. This implies that you should make a number of short punchy
points. However, it does not usually imply a set of one-word answers. You still need to
demonstrate some understanding.
The following is an example of a good, pass-standard answer.
The current retention limits will be the starting point. These will only be changed if
there is evidence that this is necessary. [½]
A key issue will be the amount of fluctuation in its experience that the company finds
acceptable. The size of the company’s free assets is crucial here. The lower the
acceptable fluctuation, the lower the retention limit. [1]
The cost of capital is also important: the higher the cost (of using capital to reduce claim
fluctuations) the lower the reinsurance retention will be. [½]
The level and quality of underwriting affects uncertainty of future experience, and so
this will be a factor. [½]
The level of fluctuation also depends on the mix of business, especially the different
benefit sizes. [½]
Sickness experience is especially volatile. The company may be cautious when setting
limits for this class. [½]
If the reinsurance is being used wholly or partly to reduce new business strain, then the
retention level will be particularly sensitive to product design, expected new business
volume and mix, and on the existing level of free assets. [1]
The results of modelling investigations will be crucial in order to find retention levels
that maximise profits subject to acceptable risk, and / or provide adequate protection of
the company’s free assets against new business strain for minimum cost. [½]
The company might reinsure more than purely financial factors would suggest if it is
looking to obtain reinsurer’s assistance in certain areas, eg underwriting. [½]
The retention limit will also be affected by the cost and types of reinsurance available.
[½]
[Maximum 5]

Solution 5.7
The insurer could reduce its premium rates for new business … [½]
… or for unit-linked policies with reviewable charges, decrease (or don’t increase)
charges. [½]
Alternatively, for the same premium, it could enhance the benefits for new business, for
example by increasing the benefit amount or benefit escalation rate. [½]
The events for which a valid claim may be made could be widened. [½]
The insurer could add options to the policy (at no or minimal cost), eg an option to
renew the policy at the end of the contract period on non-guaranteed terms. [½]
Guarantees could be added, for example, a guarantee that premiums (if reviewable)
would not increase beyond a certain percentage. [½]
The insurer could increase salaries/commissions payable to the sellers of the product to
improve the desire to sell the business ... [½]
… or it could start selling via a new channel, such as the internet. [½]
The insurer could launch a new critical illness product – for example, with guaranteed
terms and premiums where only reviewable products have been sold to date … [½]
… or with simplified benefits at a more attractive price. [½]
Offering alternative products will give potential customers and sellers more choice. [½]
The company might want to increase its, or its product’s, awareness in the market, by
increasing the advertising for the brand or the product. [½]
Incentives such as vouchers, clocks, etc, could be offered to new customers in order to
increase sales. [½]
The policy terms and conditions could be made more favourable, for example by
decreasing the survival period applicable. [½]
The underwriting could be made simpler, for example by requiring less stringent criteria
or by asking fewer questions. (More policyholders will be accepted and this may also
make the product more attractive.) [½]

The service offered to customers could be improved, for example by investing in

customer care at the policy issue stage (eg better documentation) or by improving the
claims process. [1]
[Maximum 8]
Solution 5.8
Policy data
The company has no policy data for the critical illness benefit. [½]
The company may have reasonably good data for the mortality benefit, based on its own
recent experience. [½]
However, using this data would pose risks if:

● the data are inaccurate or incomplete, or
● the volume is insufficient for any calculated rates to be reliable, or
● any key features determining the rates on existing data have changed or are
expected to change, for example underwriting procedures. [1½]
It is also possible that the addition of the critical illness benefit will make the product
appeal to a different market, changing the mortality experience. [½]
It is certainly the case that mortality rates calculated from the policy data would have to
be adjusted to allow for the fact that on some deaths no payment will now be made
(because the contract ended with payment of critical illness benefit). [½]
Other data
The company may have to rely on other data to set its mortality assumptions. [½]
It will certainly need to do so for the critical illness assumptions. [½]
Possible sources would include reinsurers or industry data (if available). [½]
Depending on the market, these data might be unreliable or incomplete, although there
should be a reasonable volume in well-established markets. [1]

Data may be unrepresentative of the insurer’s experience, due to:

● the possible variety in policy conditions for the critical illness benefit, especially
the diseases covered and the definitions of illness [1]
● the different target markets reached by different companies [½]
● the different levels of underwriting and claims management that may be
employed. [½]
The company can try to adjust the data to allow for its own circumstances (perhaps with
advice from reinsurers), … [½]
… but there is still a major risk of getting this wrong (especially for critical illness,
where there is no own-data at all for guidance). [½]
There is also a risk that the data used will not be appropriate for use in the future due to,
for example, the impact of screening programmes on critical illness claims. [½]
[Maximum 8]
Solution 5.9
(i) Health insurer selling medical benefits
Individual business
A quota share arrangement with reciprocity would be useful as a basis for providing
some diversification. [1]
Reciprocity is an arrangement between two insurers who agree to reinsure risks with
each other, in order to diversify the insurers’ overall portfolios. [½]
An individual claim would need to involve a serious operation plus extensive hospital or
nursing home fees before it would cause significant financial difficulties for a medium-
sized insurer. The effect would depend on what limits, if any, the insurer placed on the
total claim or on each category of claim for any one set of treatments. [1]
However, as it’s a new class of business being written (another reason for using quota
share), the company may wish to minimise exposure initially by using excess of loss,
perhaps at quite a low level. [1]

Group business
Initially, the same comments apply as for individual. Depending on the nature of the
group contracts, there may be the possibility of a concentration of risk of many claims
from one event (eg medical treatment following an explosion in a large factory).
Aggregate excess of loss by event would be necessary here. [1]
Aggregate excess of loss may also be necessary for the individual cover in case there
was any concentration again (however, individuals would need to be all affected by one
event, which is unlikely for individually-sold policies). [½]
Stop loss reinsurance could be considered for both individual and group business if it is
felt that claims experience might be volatile in the early years, but may not be available
at a suitable cost. [1]
Technical assistance from the reinsurer might be useful, particularly as this is a new
product. [½]
[Maximum 6]
(ii) Reasons not to use reinsurance
Possible reasons not to take out reinsurance:

● plenty of diversification (by class or by territory)
● no large risks accepted
● massive free reserves
● not listed so stable results not required
● no need for technical and administrative assistance
● financial support available from parent company
● no possible exposure to a catastrophe. [1 mark each, maximum 6]
Note that this last point may be very hard to establish. Catastrophes have a habit of
developing where they aren’t expected (perhaps because they are never expected!).

Solution 5.10
(i) Sources of information
Proposal form [½]
Applicant has to supply information about:

● current health and medical history
● height, weight, sex, age
● contract applied for and size of benefit (if relevant)
● lifestyle, eg smoking habits, alcohol consumption, hazardous pursuits
● family history of disease and of early death
● occupation and income
● country of residence
● whether special terms have been applied (or offered) by other insurers in the
past.
[Maximum 2 marks for at least 6 points]
Primary medical attendant’s report (PMAR) [½]
This is a confidential report written by the applicant’s medical attendant (doctor). It

gives an account of the applicant’s medical history and an opinion about the applicant’s
future health. [½]
Medical examination (ME) [½]
The applicant is required to undergo a medical examination by the company’s medical

officer or some other independent medical practitioner. This may include routine
medical tests, eg blood pressure tests. [½]
Specialist medical tests [½]
This will involve investigations about specific conditions, eg an electrocardiogram,

chest X-ray, etc. [½]
[Maximum 5]

(ii) Use of the information
The information is used to classify the applicant as to whether he or she is insurable at

standard rates, … [½]
… or if special terms apply, … [½]
… and in the case of the latter, what the special terms should be. [½]
Special terms include:

● charging an extra premium [½]
● reducing the benefit payable [½]
● postponing the decision (eg when prognosis uncertain but should become clearer
at a later date) [½]
● issuing a contract with exclusion from particular causes of claim [½]
● declining insurance, if allowed in the country concerned, possibly offering a
different type of policy [½]
● shortening the policy term. [½]
Purpose of underwriting
The aim is to ensure that the policyholder is charged a premium which accurately
reflects the level of risk presented, and that as few applicants as possible are declined
insurance. [1]
Underwriting will help to ensure that the actual experience does not depart too far from
the assumptions of the pricing basis, and hence that the expected profitability will
materialise. [½]
Underwriting will help reduce the financial risk from over-insurance (preventing people
from taking out policies for larger sums assured than they need). [½]
The intended result is to minimise the risk of anti-selection by high-risk applicants

seeking inappropriately cheap rates. [½]
[Maximum 6]

(iii) Why not all information for everyone?
In many cases the risk can be adequately and accurately classified on less than the total
possible information, and this therefore saves on expense. [1]
The majority of applicants can be judged to be a standard risk from the proposal form.
The few high risks that are let through at inadequate premiums can be tolerated by the
company provided their levels of benefit are not too high. [½]
Determining which information to obtain
All applicants will fill in the proposal form. [½]
Adverse information given on the proposal form will automatically trigger either or both
of the PMAR or ME. [½]
Benefit levels higher than the company’s chosen threshold for a particular age and
contract type will automatically lead to PMAR and/or ME even if proposal form is
clear. [½]
As an ME is more expensive the automatic threshold is higher for the ME than for the
PMAR. [½]
Specialist examinations will be triggered when necessary to provide additional

clarification about conditions identified from any of the other sources. [½]
[Maximum 3]
Solution 5.11
The examiners will be aiming to set questions that test your knowledge and
understanding of the course, rather than test your ability to regurgitate. With slightly
strange questions such as these, you need to be aware that the principles are in the
course otherwise the question would not be asked. You need to think through all parts
of the course and consider what is relevant. Here it all depends on reinsurance,
premium rating and underwriting. You just need to think through all of these from the
perspective of the reinsurer.
The rates you offer will depend on your estimate of the expected claims rate. [½]
You would estimate the expected claims rate by looking at experience with this type of
contract ceded to you by other companies. [½]

To what extent does the underlying contract differ from that offered by other
companies, eg are the critical illness definitions the same? [½]
Also look at any industry data available. [½]
Make allowance for expected future trends in critical illness experience and consider
any uncertainty around this. [½]
If particularly unsure about experience, offer rates reviewable every year rather than
guaranteed (the fact that the direct writer’s rates are guaranteed does not mean that your
rates should be guaranteed). [½]
An important thing to check up on is the company’s intended underwriting procedure

for this contract. [½]
Being a stand-alone protection contract, there is a great possibility of selection against

the company. [½]
So you want to be sure that the direct writing company will minimise such selection.
[½]
You need to ask about the intended limits of cover obtainable for the varying degrees of
medical evidence – are they satisfactory given your experience of this contract? [½]
Also consider how the contract is to be marketed and sold. Will this affect the expected
claims experience? [½]
If you are unhappy about any of the underwriting / marketing aspects then you could
make your terms conditional on their being modified. [½]
You could perhaps only offer cover on a proportion of risk above the direct writer’s
retention, eg by offering to accept only 75% of risk above the retention (instead of the
normal 100%) the direct writer will retain a stronger interest in underwriting quality. [½]
Consider a maximum cession / sum assured that you will accept on an “obligatory”
basis – make anything above that “facultative”. [½]
For this contract, mortality rates are also relevant. These should be based on what you
expect, given your experience with similar contracts. [½]
Given your estimate of the pure premium rates appropriate, add allowance for expenses
and profit in order to achieve target profitability on your risk discount rate. [1]

The loading for expenses might take into account the use of any technical assistance.[½]
Compare with the competition (ie other reinsurers) – if you particularly want this
business, or to get in with this company, you might be prepared to lower your rates,
contingent on at least covering the pure risk premium and marginal expenses. [1]
If the direct writer wants any financing, then that could be incorporated into the treaty.
This arrangement might increase your profitability, or could help offset low profits from
the risk cover if the premiums are low for competitive reasons. [1]
[Maximum 9]
Solution 5.12
The problems that confront the actuary are:
● Policy data. Does the company provide data that are complete and accurate?
● Product design. What contracts should the company offer and what benefits and
design features should they have, given the company’s risk profile and the
resources available to it?
● Pricing. What is the expected profit from selling a new contract at particular
premium rates or with particular charges? What is the variance of that profit?
Will the company have the resources to sell the contract on those terms?
● Return on capital. What return will the company expect to make by investing its
capital in the development and issue of a new health and care insurance
contract?
● Profitability. What is the expected profit, and its variance, from the existing
business?
● Supervisory reserves. What assumptions should be used so that the reserves and
level of solvency capital required provide adequate security for policyholders?
● Investment. How should the company invest its assets so as to maximise

expected return within the resources available to it?
● Capital management. Will the company be able to achieve its long-term plans
given the resources available to it?

● Risk management. How can underwriting and reinsurance be used to manage

risk so that the company can increase profits, while keeping its risk profile
within the resources available?
● Claims. Are the claims procedures adequate? Are the claims functions being
properly followed? Are there effective fraud control measures in place?
[1 mark per point, total 10]
Solution 5.13
(i) Risks
Sickness rates
The difficulty of estimating future claim inception and termination rates is similar under
the two contracts and this presents a significant risk. [1]
However, the risk is lower under the unit-linked design because the company has the
right to review its premiums every five years, and to review its charging rates at any
time. [1]
This does not provide complete protection against the risk because of the need to remain
competitive and the risk of triggering selective withdrawals if premiums are increased
significantly. [1]
It is possible to have non-linked designs with reviewable premiums, but this is not the
situation with which you have been presented here.
There is an anti-selection risk, as people in poor health may apply for insurance.
Assuming that the company is not planning to change its underwriting standards the risk
is similar for the two contracts. [1]
There is also a “moral hazard” risk on both contracts associated with both the claim
inception and termination rates. Some policyholders may wish to use the contract as a
way of avoiding work. [1]
Withdrawal risk
There is a risk associated with early withdrawal under both designs. The asset share is
likely to be negative at the start of the contract and so even a zero withdrawal benefit
will leave the company with a loss. [1]

The insurance company may actually make a small profit from the non-linked contract
on (non-selective) withdrawals further into the policy term. With a level premium being
charged for an increasing risk, a small fund will build up. This is released on
withdrawal because no payment is made. [1]
On the unit-linked contract this fund is paid to the policyholder and so no profit is made.
A small loss may result (compared with if the contract had continued) from the loss of
future charges on the contract. [1]
The existence of a payment on withdrawal may itself encourage more withdrawals on

unit-linked contracts. [1]
Expenses
On either design the company may lose money if expenses turn out higher than
expected, for example through unexpectedly high inflation. It has greater protection
against this on the unit-linked design because some of its charges are variable. [1]
However, the scope for increasing charges may be limited by competition, regulation or
policyholder expectations. [½]
Investment return
The contracts are fundamentally providing protection cover and significant funds are
not likely to build up. Investment is therefore only a minor risk. [1]
The risk is greater for the non-linked design than for the unit-linked one. The
policyholder bears the investment risk on the unit-linked contract. [1]
However, there will be a minor effect on the company if investment performance is

poor because of the fund-related management charge. (This is small in absolute size
because only small unit funds are built up.) [½]
Mortality
If claimants experience lighter mortality than expected then termination rates fall,
claims last longer on average and a loss may be made. [1]
This is unlikely to be a significant risk. However, if improved medical treatments

succeeded in extending life rather than curing disease then this could be an issue. [½]
There is a very minor mortality risk from the possibility that more policyholders than
expected die while the asset share is negative. [½]
[Maximum 13]

(ii) Meeting the needs of consumers
Assuming that the policy conditions for the two designs are similar, and will pay out in
similar circumstances, either contract should meet the policyholder’s need for income
protection whilst unable to work due to sickness or accident. This is fundamentally
what both contracts provide. [1]
The existing without-profits contract provides this with greater certainty about the cost.
On the unit-linked version the expense charges, risk benefit charges and premiums can
all be increased. This may discourage some prospective policyholders. [1]
On the other hand, the unit-linked contract may have a lower initial premium because of
less need for margins in assumptions. Provided experience turns out no worse than
expected the policyholder may get the required cover at lower cost than under the
without-profits contract. [1]
It is even conceivable that premiums or charges will fall if experience turns out better
than expected, particularly if competitive pressures give the insurance company an
incentive for such reductions. [½]
There are a number of offsetting factors which might make the unit-linked contract
more expensive. First, a benefit is provided on death, withdrawal or expiry. This is not
likely to be large, but what there is must be paid for. [½]
Secondly, if experience does turn out worse than expected, then charges (and premiums)
may rise. [½]
Thirdly, the unit-linked contract is more complex and so administration costs are likely
to be higher. [½]
[Maximum 4]
(iii) Capital requirements
The initial expenses may be similar (although the unit-linked version might be more
expensive if a unit-linked system is not already in place). However, the company will
have to decide how it will treat the costs of developing the new type of contract. [1]
The unit-linked contract has a design under which all of the first years’ premiums are
available to recoup initial expenses. This keeps initial reserves low and makes the
contract very efficient at repaying the capital invested. [1]
How the without-profits contract compares with this will depend on the particular
supervisory regulations in force, but it is likely to be less capital efficient than the
unit-linked version. [½]

The lower risk for the company under the unit-linked contract may make smaller
margins necessary in calculating reserves. [½]
The lower risk may also lead to a lower statutory capital requirement. [½]
[Maximum 3]

Question 6.1
A private medical insurance company is to investigate the claims experience on its

individual business. Describe how its claims experience data would be analysed. [9]
Question 6.2
A life insurance company is analysing the withdrawal experience of its unit-linked

long-term care insurance product.
(i) List the data required for the analysis and discuss the level of detail to which the
analysis might be performed. [7]
(ii) Describe why the current experience may not be indicative of the future. [8]
(iii) Describe how the results of the analysis might be used. [6]
[Total 21]
Question 6.3
A reinsurer analyses the income protection claims experience of the individual

companies it reinsures. List the reasons why the experience of two of its major clients
might differ significantly. [5]
Question 6.4
A life insurance company writes conventional IP insurance contracts on guaranteed

terms.
(i) State reasons why the company would want to analyse its sickness experience.
[4]
(ii) The state of the economy in the country where the company is based has resulted
in a large rise in the level of unemployment.
Describe what effect this may have on the company’s sickness experience, and
what action the company may take as a result. [6]
[Total 10]

Question 6.5
A life and health insurance company launched a conventional without-profits

stand-alone critical illness insurance contract ten years ago. The volume of new
business sold has risen significantly in the last three years. Under the contract no
benefit is payable on death or lapse. The company is about to review the profitability of
the contract.
(i) Describe how the company might analyse its critical illness claims experience
since launch. [7]
(ii) Describe how the company might use the results of this analysis to set
assumptions for calculating the profitability of the contract. [3]
(iii) Describe why the results of this analysis may not be indicative of future
experience. [7]
[Total 17]
Question 6.6
A proprietary health and care insurer calculates its embedded value at regular intervals.
The company issues a wide range of health and care insurance products.
Explain the effect that each of the following would be likely to have on the embedded
value of the company one year from now. (You can assume that each event occurs on
its own, ie independently of any of the others.)
(i) Lower than expected renewal rates under PMI policies during the year. [3]
(ii) A change in investment conditions, in which bond and other yields have fallen,
and appear likely to remain at the new lower level for the foreseeable future. [4]
(iii) A significant increase in disease diagnosis rates under CI insurance policies, due
to an unexpected medical breakthrough. [3]
(iv) The launch of a new IP insurance product with sales at 75% of target in the first
year. [1]
[Total 11]

Question 6.7
A life insurance company that already has a substantial portfolio of stand-alone critical
illness insurance (CI) business is planning to launch a CI contract with a 25-year term,
under which policyholders will be re-underwritten every five years. At each
underwriting, policyholders may be accepted on normal terms, charged an extra
premium or refused further cover. Premiums are calculated to remain level over the
whole of the 25-year term provided there is no change in the insured person’s
underwriting status.
The company is also considering a suggestion from the marketing manager that if a
policyholder is shown to be acceptable on normal rates when re-underwritten then he or
she should be allowed to increase cover by up to 50% if desired. A suitable increase in
premium for the increased cover would be calculated at that time.
(i) Describe how the relevant expense loadings to be used in pricing this contract
would be determined. (A detailed description of an expense investigation is not
required.) [8]
(ii) Discuss how the assumptions for morbidity and withdrawals might differ from
those used in the existing critical illness insurance product. [6]
(iii) Describe the underwriting arrangements you would consider appropriate for this
contract at outset. [6]
(iv) Comment on the level of underwriting which might be appropriate when the
policyholder is re-underwritten. [5]
(v) Comment on the reinsurance arrangements that are likely to be appropriate for
this business. [8]
[Total 33]

Question 6.8
A life insurance company is one of the market leaders in critical illness insurance in the
country in which it operates, selling its business chiefly through brokers. Details of the
existing policyholders are as follows:
● 80% male 20% female
● 90% non-smoker 10% smoker
This mix has been constant for many years.
In keeping with the other major companies in this market, a non-smoker is defined to be
a person who has not smoked any tobacco product for a period of at least three years.
Because of the mix of business, the pricing morbidity assumption is set for male
non-smokers. Females are assumed to have the same morbidity as a male three years
older and smokers are assumed to have the same morbidity as a non-smoker five years
older.
(i) List the possible sources of data that could be used by the company to set its
pricing morbidity assumption and describe how the data would be used. [6]
(ii) The company is considering altering its non-smoker definition by reducing the
three year period to one year.
(a) Discuss the differences this would make to the pricing basis by
considering the following categories of people:
● non-smokers, including those who gave up smoking more than
three years ago
● those who gave up smoking between three years and one year ago
● smokers, including those that gave up less than one year ago.
(b) Discuss the overall effect the change might have on the company’s
premium rates for this product. [7]
(iii) The company has entered into an arrangement with the country’s leading chain
of women’s clothes stores. The company has direct access to the chain’s
database to market a specifically-designed critical illness insurance product.
Discuss the factors that need to be considered in setting the morbidity

assumption for the pricing of this product in comparison to the existing product.
[3]
[Total 16]

Question 6.9
In a particular PMI market, most insurance companies have been charging different
premium rates to males and females. Your company had noticed very little difference
in its claims experience between the sexes in the past, and over the last year has been
selling PMI policies on identical terms to males and females. During this time you have
noticed a marked increase in sales, especially to female lives.
Discuss the possible reasons for this change in new business experience, and the
possible implications of this change for the insurer. [10]




using the course.

Solution 6.1
Data for a recent period would be subdivided into homogeneous risk groups, according
to some or all of:
● type of contract (eg comprehensive or budget plan)
● age of policyholder
● sex of policyholder
● duration from entry (number of past renewals)
● smoker status
● underwritten status (eg exclusions)
● source of business (eg distribution channel, territory)
● occupation
● hospital band
● amount of excess
● NCD level (if applicable)
● number of people covered (if applicable). [¼ each, maximum 2½]
It would be necessary to combine groups, depending on the volume of data in each cell
and the degree of similarity between cells, so as to produce a credible amount of data in
each (combined) cell. [1]
Similarly, the investigation period would be chosen to be the best compromise between
volume of data and ensuring that it is as up to date as possible. [½]
A sensible definition of what constitutes a claim would need to be decided. [½]
Actual claim incidence rates would be calculated for each group, for each
benefit/procedure class, by dividing the number of new claims by the number of
exposure years in each cell. [1]
These would then be compared with the rates expected according to the pricing
assumptions. [½]
It is also necessary to analyse the claim amount experience. [½]

The average claim amount per claim would be calculated for each cell, further
subdivided by type of benefit or procedure class. [½]
These would again be compared with expected amounts. [½]
Further subdivisions may be possible, eg by hospital chain or even down to the

individual surgeons or consultants involved, depending on the purpose of the
investigations. [½]
Both claim incidence and claim amount experience would be examined for trends. [½]
The reasons for any trends in incidence rates would need to be investigated, in order to
ascertain whether or not these are likely to continue. [½]
Increases in past claim amounts would be compared against a standard inflation index,
and in relation to market information. [½]
Again, reasons for departures from expected would need to be investigated. [½]
[Maximum 9]
Solution 6.2
(i) Data required
The relevant data would need to be available for this contract type separately from the
company’s other business. [½]
Data would be required in a form suitable for calculating the appropriate exposed to
risk. This might take the form of regular censuses of policies in force during the
investigation period, or censuses of policies surviving to their policy anniversary each
year, for example. [1]
Counts of the number of withdrawals during each year of the investigation will also be
needed, subdivided by type of withdrawal (ie paid-up, surrender, or lapse). [½]
Both exposure and withdrawal data could be subdivided by the following:

● the duration since inception of policy (hence would need date of entry)
● age (hence would need date of birth)
● sex
● the sales channel used for selling the policy, and possibly the individual sales
agent involved

● the commission and/or other terms of rewarding sales which are given
● the size of any guaranteed benefit
● the size of the premium
● the frequency of premium payment
● the mode of premium payment (eg by some automatic payment method or by
cash payments)
● the choice of investment fund
● the original term of the policy. [¼ each, maximum 2½]
Note that if switching between fund-links is allowed under a unit-linked policy, any
switch between funds should not be counted as a simultaneous withdrawal and new
entry. [½]
When subdividing the data for analysis, a compromise needs to be struck between the
need to identify the important factors that affect the withdrawal experience, and the
need to have sufficient volume of data in each cell in order to obtain estimates that are
statistically credible. [½]
Several iterations of the grouping process would be inevitable. Begin at the highest
level of subdivision and then combine groups which both appear too small and
statistically indistinguishable. [½]
Hence it is very likely that age groups would be combined (eg into quinquennial or
decennial groups), and also duration groups at later durations (eg above a duration of
five years). [½]
On the other hand (assuming there are sufficient data) it would almost certainly be
necessary to subdivide data by individual years for durations of, say, five years and
under, because of the likely significant differences between their withdrawal rates. [½]
Initially it would be advisable to analyse each time period (say each year) of the
investigation period separately. [½]
This might be extended down to sub-periods of a year if the volume of data permits, and
if the time effects on withdrawal rates are that significant. [½]
The aim here would be to identify external and internal time-related influences on the
company’s withdrawal experience for this business. [½]
[Maximum 7]

(ii) Why current experience might not be indicative of the future.
Withdrawal rates occur in the context of the external and internal circumstances at the
time. [½]
Future withdrawal rates may therefore differ for the following reasons:
The external economic environment may be different. For example, economic changes
can affect personal disposable income, which may make a policy less affordable and so
increasing withdrawal rates. [1]
Inflation of care costs may outstrip the benefit to be provided by the policy, making the
benefit less attractive and so reduce the incentive to keep paying premiums. [½]
Alternatively, very high inflation of premiums may encourage people to withdraw. [½]
Changes in the State sector provision can be material. For example, a significant
enhancement in State long-term care provision may encourage a large number of private
long-term care policyholders to discontinue their policies. [½]
Other changes in legislation and political influences can affect withdrawal rates. For
example: changes in the tax treatment of policies and the effects of Government
campaigns to promote certain kinds of financial services. [1]
The commercial environment may be different. If new competitor products are

introduced which appear more attractive to policyholders, then the existing business
may lose its popularity. [½]
Publicity in the media can affect discontinuance rates, for example when industry-wide
good or bad practice is highlighted, or some other factor is publicised which leads to
increased or reduced public confidence in the industry as a whole. [½]
Internal factors may influence future withdrawal rates. For example the effect of a
demutualisation, a rights issue, or particularly good or bad performance or publicity
relative to competitors can be influential. [½]

Future withdrawal rates could also differ significantly for future new business. This
could be due to any change in the company’s selling strategy or to the product design,
including: [½]
● the sales channel or channels used
● the target market for sales
● the approach to selling practices (eg more disclosure, greater focus on selling to
the customers’ needs, improved training of sales staff)
● the commission structure
● the size of policies sold and their premium payment structures
● changes to the levels of any surrender penalties imposed.
[½ each, maximum 2]
With particular reference to the current experience, this may itself be quite atypical of
the company’s normal level of withdrawal rates (for many of the reasons just listed
above). [½]
Also the current experience will necessarily represent a relatively small sample of the
company’s historical experience and could be atypical simply just because of random
effects. [½]
[Maximum 8]
(iii) How the results might be used
As volumes are likely to be low, results may be combined with those from other
withdrawal rate investigations, eg based on those of other similar products, or external
industry data could be used, if available. [1]
The results will help the actuary to reassess his or her view of the future, essentially
feeding back into the control cycle. [½]
The company makes decisions based on the results of actuarial models. These decisions
will only be optimal if the assumptions made are actually borne out in practice. It is
therefore vital that the actuary’s information, with regard to the company’s emerging
experience, is kept as up to date as possible. The withdrawal investigation is an
important part of this process. [1]
For example, should the results of the withdrawal investigation lead the actuary to
believe that his or her assumptions are sufficiently out of line with the actual experience
as to make the decisions inappropriate, then the assumptions will be revised in line with
these results. [½]

Hence this feedback can lead to changes in product pricing bases and reserves, and to
any other strategy which is sensitive to the withdrawal experience. [½]
Other ways in which the withdrawal analysis might be used include the following:
● the extent to which the withdrawal experience is contributing to the company’s
profit or loss may lead to changes in the product design (to make it less sensitive
to withdrawal losses, for example) or to the discontinuance terms offered (to
reduce the financial impact of the risk) [1]
● it can help to provide a check on the data, for example to help reconcile the
policy movements with the in-force file over each year [½]
● it can be used to review the suitability of the company’s sales process, for
example by comparing persistency rates between different sales channels used;
could lead to a redesign of the sales reward system (commission rates, etc) to be
more sensitive to withdrawal rates [1]
● it can provide data for industry-wide or nationally collated persistency statistics.
[½]
Note that the results of these investigations would only be part of the information that
the actuary has in order to determine the assumptions. Other factors, particularly those
that might cause the future to differ from the past, would need to be taken into account.
[½]
[Maximum 6]
Solution 6.3
The companies might have different policy conditions such as:

● different deferred, linked-claims and waiting periods
● different exclusion clauses
● different rehabilitation clauses.
They might have different:

● definitions of sickness
● underwriting standards
● sales methods and target markets
● occupations and geographical location
● claims control.

The reinsurer might be comparing different contracts, such as:

● group or individual
● unit-linked versus conventional
● stand-alone versus a rider benefit.
[½ each, maximum 5]
Solution 6.4
(i) Reasons
Update assumptions as to future experience [½]
This will lead to the company reviewing its assumptions for future claim inception and
recovery rates, for pricing, valuation and other purposes. [1]
This would also allow the company to monitor trends in experience. [½]
Allow the company to take corrective actions [½]
Actions might be to review premium rates and rating structures, review the cover given,
underwriting and reinsurance arrangements. [1]
Provide management information [½]
This might include the decisions that have been made in the past and the consequences
of the corrective actions outlined above. [½]
[Maximum 4]
(ii) Rise in level of unemployment
The company might expect an increased level of fraudulent claims being incepted, or
more people claiming who wouldn’t otherwise take time off sick. [½]
Appropriate corrective action will be:

● stricter claims control (ie check that policyholder really is sick) [½]
● stricter financial underwriting. [½]
The company will expect a lower level of claims being terminated, since there will be
less opportunity for sick people to return to work. [½]

Corrective action could be stricter management of claims once in payment (eg more
frequent checks that a claim remains valid). [½]
There are likely to be higher withdrawals, since people need the cash or cannot afford to
pay the premiums. [½]
Withdrawals would be selective since those in poor health would be less likely to
surrender, resulting in worsening claims experience. [½]
As a consequence of everything mentioned above, the company should review its

pricing basis morbidity assumptions, but being careful regarding the effect of selective
withdrawals. [1]
The company should then review its:

● premium rates, relative to the market (market rates may well rise) [½]
● underwriting and rating of specific sub-groups, eg by occupation [½]
● policy conditions, cover given and exclusions. [½]
However this would apply only to new policies. [½]
The company might also need to strengthen the valuation basis to reflect the
deterioration in expected future experience, if existing margins in the basis are no longer
sufficiently prudent. [1]
[Maximum 6]
Solution 6.5
(i) Analysing claims experience
The claims data will be put into homogenous groups, such as:
● age-group
● type of illness or treatment (eg cancer, heart problems and other major
categories)
● sex
● duration since inception
● smoker status
● sales method
● underwriting status

● occupation
● size of benefit (in bands). [¼ each, maximum 2]
The number of groups will be restricted by the volume of the data in each cell – it needs
to be sufficient to be credible and some cells may have to grouped with others in order
for this to be the case. [½]
Non-standard cases (eg with loaded premiums) will initially be excluded. [½]
An allowance for claims that have been incurred but have yet to be reported to the
insurer needs to be made – particularly relevant for the most recent years’ experience
due to the delay in reporting/acceptance and also because it is the most recent years of
experience that we are most concerned about. Be careful to record the correct year of
claim. [1]
Although the experience since inception will be analysed, more effort should be put into
analysing the results from the last three years. This is because volumes have increased
significantly over that period. [1]
Also, the experience in the most recent years will be indicative of future experience and
will thus be more relevant when setting premium rates going forward. [½]
An annual time interval should be used, as the data are likely to be credible at this level
and critical illness rates only change gradually. [½]
The data should be adjusted for any changes in the underlying risk, such as changes in
policy conditions, claims or underwriting processes, or changes in the target market. [½]
We will also need corresponding exposure details over the same period in order to
calculate claims frequency. [½]
Policies in-force (averaged over the year) will be a useful measure for claims frequency,
although premiums will be needed in order to calculate overall loss ratios. [½]
The data are then analysed for trends, particularly over the last three years. [½]
Ideally this would be done separately by type of illness (as different illnesses may
experience different trends. [½]
Depending on the volume of data we have available, we may need to consider external
data sources such as competitor experience (if available) to see whether the whole
industry is affected by any features that we find. [½]
[Maximum 7]

(ii) Profitability assumptions
The results can be used to set the assumptions for claim incidence rates for each type of
illness or treatment, data volumes permitting. [½]
The assumptions will need to differ by age, sex, smoker status, and possibly by other
factors out of the list given in part (i). [½]
The starting point will be the past experience, particularly the most recent years as these
will probably be most relevant. [½]
However, this will need to be adjusted for any differences between past conditions and
those expected in the future (such as target market, underwriting, and policy
conditions). [½]
Any anticipated trends, reflecting other underlying changes to the experience, need to be
factored in to the projection. [½]
Although the most recent experience may be a good indicator of current levels, it is
likely that this level would be expressed in terms of a published standard table or
reinsurer’s rates. The current pricing basis might also serve as a useful reference. [½]
[Total 3]
(iii) Why future experience may be different
Past experience may differ from that in the future due to the following reasons:
● the underlying morbidity experience will evolve, for example:

– developments in medicine will enable an improvement in health and thus
lower claims, but on the other hand will probably also enable more
illnesses to be diagnosed that may otherwise have gone unnoticed [1]
– improved medical screening of the population may lead to earlier
diagnosis, resulting in more claims being included within the fixed term
of the policy [1]
– there may also be latent claims, from conditions that were previously
thought to be non-existent [½]
– new diseases may occur, or existing diseases may develop increased
virulence (eg of virus-induced cancer) [½]
● changes in cover, via changes in policy wording, or changes in claims and

underwriting procedures will alter the claim settlement pattern and may alter the
frequency of allowable claims [1]

● changes in mortality rates as a result of other events (eg AIDS) will affect
critical illness claim frequency, particularly if there is a survival period on the
policies [½]
● selective withdrawal rates may change, whereby lives who believe themselves to
be in a good state of health may withdraw, leaving poorer lives (this also
depends on competitors’ rates) [1]
● the use of different sales methods, eg the internet, or changes in the target
market, will change the underlying risk and hence the claims experience [1]
● above all of these possibilities, random fluctuations alone will mean that
experience will always differ, even if only slightly, from expectations [½]
● in addition, the volume of experience for policies of greater than three years’
duration may be small, and so we might naturally expect some deviation from
our expected experience. [½]
[Maximum 7]
Solution 6.6
Reminder: the embedded value (EV) is the shareholders’ share of the company’s free
assets plus the expected present value of the shareholders’ share of the future profits
from the existing business.
(i) Lower than expected PMI renewals
Less business will have been in force during the year than expected, which (assuming
the business is profitable) will reduce profits earned during the year. This will reduce
the end-year free assets and hence the EV. [1]
There will be fewer policies in force at the end of the year than expected. This will
reduce the projected future profits as at the end of the year, further reducing the EV. [1]
This is made worse by the fact that the fixed expenses will be spread between fewer
policies. [½]
The changed experience may influence the future renewal rate assumption used to
project the future profits as at the end of the year. A reduction in future renewal rates
will reduce future profits and will reduce the EV further. [1]
[Maximum 3]

(ii) Fall in investment yields
A major impact will be an increase in asset values over the year. [½]
However, corresponding increases to supervisory reserves (on long-term business) are

likely, following probable reductions to valuation rates of interest. [½]
Whether the free assets (and hence EV) increase or decrease as a result will depend on
the degree of matching … [½]
… and also on the effect of any supervisory restrictions on valuation bases. [½]
The fall in yields will also cause future investment return assumptions to be reduced,
which will reduce the projected future profit. [½]
But it will also reduce the risk discount rate, which will have the effect (all else being
equal) of increasing the value of the expected future profits. [½]
If the insurer has any unit-linked business, lower unit fund values will be projected,
which will reduce future fund-related charges, and so reduce the value of the expected
future profits. [½]
Overall, the likely increase in the supervisory reserves will have the effect of delaying
the emergence of future profits. So, even with a reduction in risk discount rate, the
overall effect of these changes would be to reduce the expected present value of profits
and so reduce the EV. [1]
[Maximum 4]
(iii) Increased diagnosis rates
Higher claim costs during the year will reduce profits, reducing the end of year free
assets and so reducing the EV. [½]
This change would be expected to continue, and so the expected future profits will be
lower than before, reducing the EV. [½]
Reserves are likely to be increased with immediate effect to reflect the changed
expectations: this will have the effect of delaying the emergence of future profit and so
reducing the EV, in a similar way to (ii) above. [1]
The effect of the above may be less if future premium reviews are permitted under the
in-force contracts, in which case higher premiums may be projected from future review
dates, so reducing the negative impact on profits. [½]

The possibility of some selective lapsing at such future review dates must also be
allowed for, though, which will again worsen the EV. [½]
[Total 3]
(iv) Lower than expected sales of new IP product
Assuming the product is expected to be profitable, then lower than expected sales will
result in a smaller increase to the EV during the year than anticipated. [½]
As there will then be fewer policies in force at the end of the year than expected, then
the expected future profits will also be reduced, producing a lower EV (in a similar way
to part (i)). [½]
[Total 1]
Solution 6.7
(i) Expense loadings
Note that although the question says that a detailed description of an expense
investigation is not required, references to key aspects are going to be necessary if you
are to produce a sensible answer worth 9 marks. It is vital, though, that you include
points which specifically relate to the details of the question.
The company has plenty of experience of CI insurance costs, such as underwriting. So

it should investigate its own expense experience on CI insurances. [1]
It should identify per policy, per premium and per sum assured costs. Per policy costs
will probably need most work in the allocation process. [1]
Costs should also be split between initial, renewal and claim management. [½]
Allowance for any costs directly associated with the business and an appropriate share
of overheads such as property costs would need to be made. [½]
Allowance should be made for any relevant changes, eg inflation. [½]
Initial underwriting costs will be significant, and may need to be adjusted if the
company is planning a different level of underwriting for the new contract. [1]
Development costs for the new product will have to be estimated, and amortised over
the expected lifetime of the new product. [½]

There will be some systems development work to allow for, but may not be substantial
given the existing product. There may also be significant sales and marketing costs. [1]
Renewal expenses would increase as a result of the costs of re-underwriting. [1]
Also, the costs of administering the increases in cover, if the marketing manager’s
proposal is accepted, should be allowed for in the renewal expense assumption. [½]
In order to turn total expenses into expense loadings it will be necessary to estimate
business volumes and mix, so that product overheads can be spread. [1]
Volumes and mix will be difficult to predict. Policy size will be particularly difficult to
predict if the marketing manager’s suggestion is adopted. [½]
[Maximum 8]
(ii) Morbidity and withdrawal assumptions
Morbidity
The impact depends on the level of initial underwriting. If the underwriting is similar to
that on the existing product, experience should be at least as good. [1]
How much better the experience is depends largely on how strict the further
underwriting is. The stricter it is, the better the experience should be. Experience
should remain select (of some sort) throughout the whole of the policy. [1]
There might be a slight additional improvement in morbidity, in that policyholders who

expect their health to deteriorate over the next 25 years may be less likely to purchase
this contract (ie there will be an improvement in the business mix). [½]
The re-underwriting means a lower requirement for margins. So even if expected

experience were to be no different from that of the existing product, actual morbidity
assumptions might be lighter. [1]
Withdrawals
Levels may be similar, except, probably, when re-underwriting takes place. [1]
There are likely to be some “enforced withdrawals” when re-underwriting causes some
policyholders to be declined further cover or implies some premium rate increase. [1]
Re-underwriting will remind policyholders of the policy’s existence, and this may
trigger some lapses. Some policyholders may be put off by the need to go through
underwriting again. [1]

On the other hand, offering the opportunity to increase cover by 50% may encourage
persistency. [½]
[Maximum 6]
(iii) Initial underwriting
As a protection policy, the contract will require a significant amount of underwriting.

Scope for re-underwriting does not change this: the company must still not risk
anti-selection. [1]
The company will require a detailed proposal form to be completed covering: [½]
● personal details
● medical history of proposer and family
● current health
● occupation
● hazardous pursuits
● need for cover
● lifestyle. [¼ each, maximum1½]
In some cases the company will require further forms to be completed, for example on
specific illnesses or lifestyle questionnaires (eg for AIDS). [1]
Financial details of the applicant may be obtained, particularly for high sums insured, to
counter the risk of overinsurance. [½]
For cover above specified limits, or where there is other cause for concern, the company
will require a report from the proposer’s regular doctor, if such reports are available, or
a medical examination, or both. [1]
If the marketing manager’s suggestion is adopted, it may be necessary to apply these

limits to the maximum total eventual sum assured under the policy … [½]
… although this might not be necessary if the re-underwriting is also going to be quite
strict. [½]
Further specialist medical tests such as ECGs and blood tests might be used. [½]
[Maximum 6]

(iv) Level of re-underwriting
The key principle, as always, is that degree of underwriting should be justified in terms
of cost of underwriting and improvement in experience achieved. [1]
One possibility is to have underwriting as heavy as initially. [½]
It should have the positive feature of achieving very good experience. [½]
However, this level is unlikely to be cost-justified. The health of many applicants

would be similar to five years earlier, and so much effort would be duplicated and
wasteful. [½]
Re-underwriting could be made lighter in various ways, eg fewer medical questions or

higher limits for doctor’s report, medical examination and further tests. [1]
For example, one might argue that a lifestyle questionnaire would be unlikely to yield
different information in a significant number of cases, and so its use might be much
more restricted. [½]
The main information sought should be whether or not there have been any changes
since last underwriting, with further underwriting where this is so. [1]
One possibility would be to have different levels of underwriting at different points.

For example, underwriting at first review might be relatively light, with something more
strict after 10 years. [½]
[Maximum 5]
(v) Reinsurance arrangements
The company has a large portfolio of CI business, which will reduce the need for
reinsurance ... [½]
... although this depends on other factors, eg the extent of the free assets. [½]
However, critical illness insurance is always subject to considerable parameter

uncertainty, due to medical advances in disease diagnosis, problems with interpreting
claim definitions, etc. [½]
So we will still need reinsurance protection against parameter error … [½]
… and cover for large individual risks. [½]

A reinsurer should be able to help in pricing for unfamiliar aspects of the new contract
(eg differences in underwriting compared with existing contract). [1]
If the company needs capital then it may seek reinsurance for this reason (but there is no
evidence of this requirement in the question). [½]
It might use risk premium or original terms reinsurance. [½]
Reserves are relatively small and so there is little difference between the two types for
the purpose of transferring morbidity risk. [½]
But original terms also involves the sharing of lapse and expense risk, and so the
company will have to decide whether it wants this (bearing in mind the cost). [½]
Quota share and individual surplus are both likely to be used. [1]
The first is to reduce the exposure to the parameter error, while the second reduces the
risk from large cases. [1]
The contract is slightly unconventional and so will need special discussion with the
reinsurer. However, the reinsurer may like the high degree of underwriting. [1]
Will need to think carefully about retention limits if the marketing manager’s suggestion
is adopted, and ensure any required reinsurance will be in place for policies where the
sum assured is increased. [1]
[Maximum 8]
Solution 6.8
(i) Sources of data
● company’s own data

● industry-wide data
● reinsurers’ experience
● population statistics
● data from other countries.
Company’s own data
This is likely to be the most relevant. [½]

Would be grouped into smoker/non-smoker and by sex. The aim is for homogenous
groups. [½]
A suitable investigation period would be used to ensure credibility and relevance, say at
least five years. [½]
Incidence rates would be analysed separately for the different disease and treatment
categories. [½]
Allowance would be made for any changes in terms and conditions, underwriting levels
and claims control. [½]
We then compare the observed claim incidence rates with those expected by the current
premium basis morbidity assumption. [½]
Any differences should be investigated further, perhaps by subdividing the data further,
for example, by occupation. [½]
Trends would be identified and projected forward, … [½]
… taking a view of how experience may change in the future as a result of

improvements in medical advances, new diseases, etc. [½]
Other data
In practice, the shape of the morbidity curve could be obtained by using a standard table
from industry data, if available, adjusted for the insurer’s own experience. [½]
Comparisons can be made with reinsurer’s experience. [½]
Comparisons can also be made with population statistics, although these would
normally exhibit quite different characteristics from the insured population, primarily
due to the effects of class selection. [½]
Statistics from other countries may also be helpful, but could be less relevant. [½]
We would aim for the slightly prudent side of best estimate, and so we would want to
allow sufficiently for any projected deterioration in morbidity. Alternatively, we could
use best estimates and adjust the risk discount rate. [½]
[Maximum 6]

(ii) Effects of changing non-smoker definition from three to one year
(a) Effect on pricing basis
Non-smokers, including those who gave up smoking more than three years ago
Previous non-smokers will still count as non-smokers. This group’s morbidity

experience would be unchanged. [1]
Those who gave up smoking between three years and one year ago
Previously, this group would have been counted as smokers, and now they will count as
non-smokers. Hence we would expect non-smoker morbidity to increase, and smoker
morbidity to increase since this group used to be keeping smoker rates down. [1]
Note that there is no penalty if people start smoking after they take out a policy. There
is therefore a chance that the more recent non-smokers may start smoking again, so
non-smoker morbidity would increase further. [½]
There is also a greater risk of lapse and re-entry. Existing policyholders in this category
(currently on smoker terms) might re-enter on the more preferable non-smoker terms.
[½]
Smokers, including those that gave up less than one year ago
This group will continue to count as smokers. Some occasional smokers might be
tempted to wait a year to benefit from non-smoker rates, and so again we would expect
both non-smoker and smoker morbidity to worsen. [1]
However, smokers under the new system will now include a greater predominance of
“die-hard” smokers (who could not bear to face a year without smoking), and so
morbidity should worsen overall for smokers. This depends largely on the
competitiveness of the new rates in each category. [1]
Other points
We need to be consider people who have stated that they have given up smoking
carefully. It may be that they have done so due to poor health. Underwriting must
therefore be vigilant. [½]
(b) Overall effect on premiums
We expect non-smoker premium rates to increase due to the increased morbidity of the
redefined group. [½]

True non-smokers may go elsewhere, depending on competitors’ rates and definitions.

If this happens, it would leave this company with a group of poor risks, for which
morbidity would worsen, rates increase, etc, leading to a spiral of worsening experience.
[½]
Smoker premium rates overall are also likely to increase. If this is the case, then the
existing pricing differential may continue to be appropriate. The morbidity
investigation needs to be re-performed allowing for the new definitions. [1]
However, the whole idea behind the change is probably to increase business due to the
enhanced attractiveness of less strict criteria. Although there might be a slight increase
in withdrawals, due to the risk of lapse and re-entry, overall the change may lead to a
better spread of overheads and thus cheaper premiums for all policies. [1]
[Maximum 7]
(iii) Different distribution channel
This is a type of direct marketing. It will be directed to a specific class of lives,

although the experience will depend on the clientele of the clothing store (for instance,
it may be either an up-market fashion store attracting financially aware women, or may
just attract the general population of women). [1]
The selling circumstances are very different − there is no face-to-face advice − and so
there will be different selection experience. [½]
The company must consider how much underwriting will be involved. This might well
be based on simple questions, which will have an impact on expected experience,
compared with the existing product. [½]
It is less likely that the basis can now be linked to the standard male non-smoker basis
of the company’s other business, though for simplicity, it may be chosen to start this
way − particularly if volumes from this new arrangement are expected to be small. [½]
Premium rates and experience can then be monitored and altered if necessary. [½]
The smoker/non-smoker mix may be very different from the current portfolio. So in
particular the current treatment for female smokers may have to be revisited. [½]
Current experience of the company’s other business can be looked at to get a handle on
this, though industry or reinsurance data may be more useful here. [½]
[Maximum 3]

Solution 6.9
Possible reasons
The removal of apparent discrimination may be popular with the public (especially, it
seems, with females), making the company’s products easier to promote and easier to
sell than those of competitors. [1]
The rise in sales to females may be because this company’s premium rates might now
be substantially cheaper than those typically offered to females by the rest of the
market. [1]
The application procedure has been simplified, which might make it more attractive for
intermediaries to sell this product rather than others. (Unlikely to be sufficient reason
on its own.) [½]
Possible implications
Provided recent experience is consistent with previous years, then the rise in volume
should increase profits, increase return on capital, and cover a bigger share of the
company’s overhead costs. [1½]
The increased volume, if continued, may possibly require the employment of extra staff,
both for policy and for claims administration. Provided economies of scale can be
achieved, this should ultimately improve returns for shareholders. [1]
There may be short-term administrative delays, which could damage the company’s
reputation with policyholders, intermediaries, or both. [½]
The increased volume, especially if it persists, may put a strain on the company’s capital
resources. This will only be a major issue if the company is short of free capital. [1]
Additional financing reinsurance may then be necessary. [½]
There is a concern that the claims experience of the new policyholders may differ from
previously. [½]
There is a real possibility of anti-selection for a company that charges aggregate rates
when the rest of the market charges differentially. [½]

The suggestion here is that the competition must be charging higher rates for females,…
[½]
… and if this is a true reflection of future claims experience then this company could
incur significantly higher claims costs but without an increase in premium rates. [½]
This could occur despite the company’s own past equality of experience between the
sexes, for example because the new product design might appeal to a different sector of
the market or a different class of life ... [½]
… or because the company did not correctly identify the real differences between the
sexes in the past due to inadequate grouping of data in its analyses. [½]
The result could be significant losses for the company. [½]
On the other hand, the business may still be profitable (although yielding less per-policy
profit than before), but if increased volumes more than compensate for this then the
company may not be unhappy with the situation, at least in the short term. [½]
Changes to underwriting may be necessary to help bring the female experience back
into line, though this might be counter-productive in terms of the costs involved. [½]
The company could go back to charging different rates to males and females. [½]
[Maximum 10]

Question 7.1
Many European countries have experienced fertility rates (number of children born per
woman aged 15 to 49) during the last twenty years that are insufficient to maintain the
size of the population.
List the ways in which a State might use the healthcare and welfare system to encourage
increased fertility. [7]
Question 7.2
(i) State the reasons why group private medical insurance (PMI) policies may be
experience rated. [4]
(ii) Explain the concept of experience rating as it applies to group PMI policies, and
no-claims discount systems as they apply to individual PMI policies. You
should also mention the similarities and differences between them. [5]
[Total 9]

Question 7.3
The government of a Western European country is worried about the effects of an

ageing population. There is a strong private pension market, whereby many people have
insurance policies that provided a lump sum payment at retirement age and which are
then applied to buy an annuity. However, there is little private insurance provision for
long-term care.
Currently, private pension holders are allowed to take up to 20% of the retirement lump
sum proceeds of their pension as a cash lump sum, rather than use it to buy an annuity.
The annuity and the lump sum are taxable at the person’s highest rate of tax on income.
In order to encourage private long-term care provision, the Government has proposed a
concession whereby any part of the lump sum that is used to buy long-term care
insurance can be received tax-free.
You are the actuary to a health and care insurance company in the country. The
company markets its products predominantly through independent intermediaries. Your
marketing manager wishes to be ready to take advantage of this opportunity and has
proposed two alternative product designs:
Product A is a unit-linked pre-funded single premium long-term care insurance product.

The level of long-term care benefit would be set at the minimum necessary to qualify
for the proposed tax concession. This level would allow daily home visits by a care
assistant to help with essential tasks. The benefit would be linked to an index of
consumer price inflation. On death or surrender, the bid value of units would be
payable. The cost of cover would be met by monthly cancellation of units. The
company can review the levels of future charges.
Product B is a conventional (non-linked) without-profits pre-funded single premium

contract. The benefit would again be linked to an index of consumer price inflation.
The contract would pay 90% of the cost of care, including the cost of full nursing home
care where this is judged (on independent medical advice) to be necessary. On death or
surrender, no benefit would be payable.
Under both contracts, the benefit would become payable once the policyholder is no
longer able to perform a set number of specified activities of daily living. Under the
legislation, surrender of the policy is allowed where contract terms permit, but the
policyholder would be required to repay the tax rebate with interest.
For these two contracts, compare and contrast the following:

(i) The extent to which the products meet consumer needs. [11]
(ii) How reinsurers could assist the company. [6]
[Total 17]

Question 7.4
A life insurance company is planning to launch a new critical illness product. This will
be a unit-linked term insurance with an acceleration of benefit, where the policyholder
can choose an acceleration of between 50% and 150% of benefit on diagnosis of one of
five critical illnesses. The costs of cover and administration expenses will be deducted
monthly from the unit account, and are not guaranteed for more than a twelve month
period. On discontinuance the unit account less discontinuance expenses is paid as a
surrender value.
(i) Outline the main risks to the company of this product. [10]
(ii) In finalising the product design, the following suggestions have been made:
(a) to define critical illness as “any illness, event or condition rendering the
policyholder unable to carry out basic bodily functions without
assistance”, rather than the current list of five specific illnesses, or
(b) to sell the product by direct marketing, rather than through brokers.
Discuss the advantages and disadvantages to the company of these proposals. [7]
[Total 17]
Question 7.5
A health insurance contract pays a lump sum of £100,000, on total permanent disability
of the policyholder occurring during the three-year policy term. Total permanent
disability is deemed to occur once the policyholder has been sick and unable to carry
out any occupation for a continuous period of twelve months. The policy terminates
after three years, on the payment of the disability sum insured, or on death, whichever
occurs first. Policyholders who are sick after three years, but have less than twelve
months of continuous sickness up to that point, do not receive any benefit.
(i) Calculate the single premium payable for the contract for a life aged 30 at entry,
using the following assumptions:
● morbidity: S(ID)
● mortality and expenses: ignore
● interest: 5% pa [3]

(ii) The company now proposes to offer the policy with an option to extend the term
for a further three years beyond the normal expiry date, without requiring further
evidence of health at the time of extension. Those taking up the option would be
required to pay the company’s standard single premium for the additional cover
as at the extension date.
Calculate the additional amount of single premium that would have to be

charged to the policyholder in Part (i) to cover the cost of this option, given the
following additional assumptions:
● all policyholders sick after the first three years, who would ultimately go
on to qualify for claim payment, are assumed to take up the option (and
thereby receive the claim benefit in their fourth year of total cover)
● 30% of all other policies still in force at the end of the third year are
assumed to take up the option, from which point their claim inception
rates are assumed to be 150% of the rates in the S(ID) tables
● the inception rates shown in the S(ID) tables are to be assumed to apply
also to lives who were originally healthy at age 33, as well as to those
who were originally healthy at age 30. [7]
(iii) Describe the particular morbidity risks that are taken on by the company in
offering the option in Part (ii). [2]
(iv) Discuss whether it is appropriate to ignore mortality in the pricing basis for this
contract. [3]
(v) State the reasons why the company might want to offer the option. [2]
[Total 17]

Question 7.6
A health insurance company has an established portfolio of group income protection

insurance policies, which it sells through brokers. It now wishes to launch a similar
contract to be sold to individuals using its own salesforce.
The existing policy has the following features:

● deferred period 6 months
● benefit starts at 60% of current salary, increasing in payment in line with a
published national prices index
● benefit payments cease on full or partial return to work, age 65, or on earlier
death.
The new product will be of conventional design, having premiums and monetary
benefits which both increase in line with the above prices index at all times. Premiums
will be waived whenever sickness benefits are payable. All terms are guaranteed.
(i) Describe the cashflow model that would be used to price this product, using the
claim inception and disability annuity method, and explain how the model would
be used in the pricing process. [15]
(ii) Describe the data you would use in order to set the morbidity assumptions for
your pricing model, explaining how the assumptions would be derived. [18]
[Total 33]




using the course.

Solution 7.1
The healthcare and welfare system will need to be designed to subsidise the costs of
producing and raising children. [½]
The components of the cost are:

● medical costs associated with pregnancy and childbirth [½]
● medical costs associated with childhood illnesses [½]
● childcare costs. [½]
If the State requires a contribution to the cost of medical care, this could be made zero
for all care associated with pregnancy and childbirth. [½]
Medical treatment for children could be made free, even though others have to
contribute to the cost of their treatment. [½]
The State might fund the development of new ways of delivering medical care to
children (eg special child clinics). [½]
The costs of childcare could be subsidised by a direct payment to those who care for
children. This could be related to the age of the child, so as to reflect the actual costs of
care at any time. [1]
If particular forms of childcare (eg minding children while the carer works) are thought
important then these costs could be met directly, or indirectly through tax allowances.
[½]
Benefits could be related to the number of children (eg greater benefits for third and
subsequent children). This would encourage those, who were predisposed to having a
family, to make it larger. [1]

Other things that could be done to increase fertility rates include:

● bring in or increase tax allowances to encourage marriage [½]
● bring in or increase tax allowances to allow parents to be full-time carers [½]
● provide generous maternity and paternity leave [½]
● subsidise (or make free) infertility treatment [½]
● encourage (or force) employers to provide facilities for more flexible working
patterns for parents of young children. [½]
[Maximum 7]
Solution 7.2
(i) Why group PMI may be experience rated
Experience rating is partly necessary because group PMI experience is likely to differ
from employer to employer, even if involved in the same industry. [½]
This can be because:

● employers might operate in different geographical locations, and this might lead
to different private medical treatment costs [½]
● the nature of the work or occupations lead to different private medical treatment
needs of the employees, through its overall effect on health and through the
presence of health risks that may be specific to the particular workplace [1]
● different employers have different attitudes to health and safety in the
workplace, which can affect the number and extent of claims. [½]
Previous claims history is often a powerful indicator of expected future experience for a
particular group. [½]
This all means that a single book-rate premium (without an experience adjustment)
could not accurately reflect the expected risk of different group policies, even where the
rating factors were identical. [½]
Applying more group-specific premiums (through experience rating) should be

attractive to customers and so improve marketability and hence sales volume. [½]

By effectively passing back some of the claim costs to the employer, the insurer could
also hope to:
● reduce its risk from adverse claim experience [½]
● encourage employers to take steps to reduce claim costs, further reducing the
risk to the insurer [½]
● create satisfied customers, who should be able to reduce their insurance
premium costs by having good health management practices – this should
improve persistency and so increase profitability. [½]
[Maximum 4]
(ii) Experience rating and no-claims discount (NCD) systems
Experience rating is where the premium for the group contract depends wholly or partly
on the past experience of the group. [½]
The total premium is then a weighted average of the insurer’s standard rate for the
group risk, and a rate based on some historical experience of the group itself. [½]
The relative weighting of own to standard rates is the “credibility” applied to the group.
The more credible (larger) the group’s past experience data, the larger the credibility
factor (weighting) given to the group’s own experience rates in the premium
calculation. [1]
The result is to encourage good claims experience, as the employer will be “rewarded”
by being charged lower premiums in the future. [½]
Under individual PMI policies, each policyholder will be charged the appropriate
book-rate premium for his or her current risk classification (eg age, type of cover). [½]
Policyholders who go on to renew into their second and subsequent years may have
discounts applied to their premiums, reflecting (if applicable) one or several consecutive
claim-free years up to the current policy year. [½]
One (or several) subsequent claims may remove (or reduce) the discount, after which
future discounts will need to be re-earned by having more claim-free years thereafter.
[½]
Like experience rating, this system may also promote better claims experience, as
policyholders will only tend to claim if the cost of the treatment exceeds the increase in
premium they would suffer through the resulting loss of future discount. [½]

In both cases, the policyholder bears some of the risk of poor claims experience to the
extent that it is reflected in the future premiums. For group business, this risk is borne
by the employer, whereas for individual business it is claimants themselves who
suffer. [½]
The group experience-rating system also operates differently in that no individual

employee is penalised for claiming. Instead, the employer is encouraged to reduce
claim costs in other ways – eg by promoting health and safety in the workplace. [1]
[Maximum 5]
Solution 7.3
(i) Meeting needs
Either product will provide some level of care that meets an important need. [½]
The tax concession should allow this to be met cost-effectively for the policyholder. [½]
Product A
This product may not meet the eventual care costs … [½]
… especially if care inflation exceeded consumer price inflation, … [½]
…or on deterioration of the claimant’s condition to the level that required residential or
nursing home care. [½]
If overall experience deteriorates compared with that assumed in the pricing basis,
charges could increase dramatically. [½]
However, the fact that the company is not guaranteeing the level of charge with this
product means that the premiums should be lower for the same intended final benefit
than under a guaranteed product (such as Product B). [½]
There will be a payment on death or surrender, which is good for policyholders or their
dependants. [½]
This may help to address a fear that the premium would be “wasted” on early death, or
concerns over lack of flexibility. [½]
However, this might also be viewed as a bad thing, because it diverts premium away
from the core need for long-term care. [½]

With a relatively low level of long-term care provision, the contract is as much a
savings vehicle as a provider of protection, which is not the required need here. [½]
Also, having a surrender value may encourage people to surrender, … [½]
… going against the Government’s intention of encouraging personal long-term care

provision… [½]
… although loss of tax benefits limits the appeal of surrender. [½]
Policyholders are vulnerable to low fund performance. It would be inappropriate, given

the needs of the policyholders, to allow them to “play the markets”. [½]
Product B
The benefit is related to actual costs of care, … [½]
… for the claimant’s condition and needs, … [½]
… although there will always be a 10% shortfall. [½]
No benefit is paid on death or surrender, which some policyholders may want. [½]
However, it is more efficient not to have these benefits because they would require a
higher premium, and the fundamental role of the product is the care provision. [½]
The premiums will be relatively high due to the margins necessary to compensate for
the guarantee, … [½]
… and there will be no way for the policyholders to benefit if experience proves better
than the prudent pricing assumptions. [½]
If there has been little long-term care insurance written in this country up to now, then
the lack of experience is likely to lead to such margins being large… [½]
… although competition should keep premium rates down to reasonable levels. [½]
There is little for policyholders to worry about (eg no investment risk, no risk of higher
charges), … [½]
… so the security and peace of mind is better met than by Product A. [½]
The product is simpler than Product A. [½]

[Maximum 11]

(ii) How reinsurers can help
Technical assistance
For both contracts, reinsurers will be able to provide technical assistance in setting
appropriate assumptions for claim inception rates and longevity of claimants. [½]
They should be able to provide key underwriting advice, of which the company will
have no experience. [½]
However, even the reinsurers will have little local experience and their advice may be
heavily based on experience in overseas markets. [½]
They may also be able to provide assistance with claim underwriting and claim
For Product A, assistance with administration of variable charge unit-linked products

could be useful (depending on the company’s experience). [½]
Reducing claims fluctuations costs
For both contracts, reinsurance can be used reduce the risk to the company of claim
costs exceeding that assumed in the premium basis. [½]
However, the risk is much worse for Product B than it is for Product A due to the
guaranteed rates and the greater uncertainty over the benefit amount (under Product B it
depends on the level of care). [½]
Thus we are likely to use more reinsurance for Product B to reduce this additional
parameter risk. [½]
We would want a low retention at outset until we have acquired some experience. [½]
Risk premium or original terms reinsurance could be used for Product B. [½]
For Product A, only risk premium reinsurance could be used. This is because, if using
original terms, reinsurance of the unit-fund would be implied, which would put the
reinsurer under unnecessary and unacceptable investment risk. [1]
Financing assistance
Although these are single premium products, there may be significant new business
strain due to the guarantees of Product B. [½]

The company may therefore require some financing assistance if new business volumes
are high. [½]
Assistance might also be needed for A, if the company cannot make the product as
capital efficient as it would like to. [½]
[Maximum 6]
Solution 7.4
(i) Major risks
Critical illness inception
The main risk is that the incidence of the critical illnesses involved is not estimated
correctly (ie model and parameter risk). [½]
The extent of the risk will depend on the data available to the company for setting the
rates, in particular to what extent the data are applicable to the eventual policyholders
and to these specific illnesses. [1]
The risk is more significant for policies where there is critical illness cover above the
basic death cover (ie acceleration > 100%), otherwise the risk will often affect only the
timing of an eventual payment rather than whether or not that payment will ever be
made. [1]
The risk is greater than for death benefits, also because payment depends on a
subjective diagnosis of some condition. There may be “grey areas” where a condition
very similar but not identical to one of the specified critical illnesses is diagnosed as
being one of those critical illnesses. [½]
There is a risk that policyholders will not disclose all relevant information at the initial
underwriting stage and that this will remain undetected at the time of claim – leading to
higher claim incidence rates. [½]
Medical advances may lead to earlier disease diagnosis rates, increasing the cost of
claims to the company. [½]
The risks will be increased if there is no initial waiting period. [½]
However, in the event of underestimating these rates, the company could raise them
after 12 months, so the risk is not too severe – but raising rates may cause problems
with policyholders’ expectations, and lead to withdrawals or lower new business
volumes. [1]

Raising the charge could also be a problem if the premium has been calculated to just
cover the benefit, because the unit fund might run out. [½]
Also, claims costs will be subject to random fluctuations – this could be a problem for a
small company with low free assets. [½]
Expenses
There is the risk that the expense charges on the contract will not cover the expenses
actually involved. [½]
This is more likely if the expense charges involve any cross-subsidy of small policies by
large policies, since changes in new business mix from the level expected could cause
an expense coverage problem. [1]
Again, expense charges could be altered if felt necessary but this could be problematic.
[½]
There is no significant investment risk to the company if monies in respect of the units
are invested immediately in the unit funds. However, low-returning assets will lead to a
lower fund management charge, which might not cover the expenses it is designed to
cover. [1]
Withdrawals
There is some risk of loss on early withdrawals (when the asset share is negative). [½]
By offering the product with a surrender value, the company may encourage
withdrawals – this could lead to eventual claim experience being worse than expected,
because it is likely that those policyholders who surrender enjoy above average health.
[1]
Marketing / policyholders’ reasonable expectations
There is a risk of misleading policyholders by using a narrow range of critical illnesses.

It is quite likely that some people will take this policy out without reading the small
print, suffer some other critical illness and become very unhappy on discovering their
ineligibility for benefit payment. [1]
[Maximum 10]

(ii)(a) Broad critical illness
The advantages of this are:

● the product may appeal to more people [½]
● it avoids the risk of disgruntled policyholders who suffer some serious medical
condition not included in the list of five critical illnesses. [1]
The disadvantages are:

● the company may not have access to data which correspond to this claim
event [1]
● rates will be higher – this may put people off. For instance, people might not
want to pay for cover that will now include serious accidents [½]
● claims control may be more subjective – for instance someone who broke both
arms might claim that they were eligible for benefit under the definition, but that
is probably not the intention of the company in designing the product [½]
● underwriting may be more difficult and may need to be more extensive [½]
● reinsurance might be more expensive than before. [½]
(ii)(b) Direct marketing
The advantages are:

● the company may be able to reach a wider and different audience from that
which it would reach with broker sales [1]
● the company can target its audience precisely according to desired
socio-economic and demographic traits. [½]
The disadvantages are:

● it is a complex product to explain fully in a brochure or with a short telephone
call [1]
● underwriting will be problematic [½]
● a high withdrawal rate is likely [½]
● the company may not be able to price correctly for the policyholders involved,
for instance, 99% of the data used by the company might relate to broker sales
[½]
● the company might see lower average premiums with this distribution channel,
and this might cause a problem with expense coverage. [½]
[Maximum 7]

Solution 7.5
(i) Calculating the normal single premium
As we are ignoring mortality, and the central rates of claim inception are very low at
these ages, the initial (q-type) inception rates will be almost identical to the tabulated
central rates. So we will use the tabulated central rates as if they were initial inception
rates, without adjustment. We also note that no claims can be paid in the first year.
The inception rates required are those applicable to a deferred period of one year. So
the standard single premium will be:
È 0.000521 (1 - 0.000521) ¥ 0.000578 ˘

100, 000 ¥ Í + ˙ = £99.56 [3]
Î 1.051.5 1.052.5 ˚
The value 0.000521 is the claim inception rate in the S(ID) table for current age 31,
deferred period one year. This is the rate at which policyholders are expected to
complete one year of continuous sickness in the year of age beginning at exact age 31,
ie relating to people who first became sick during the first policy year.
Similarly, in the second policy year, (1 - 0.000521) is the expected proportion out of the
initial policyholders who are still exposed to the risk of becoming sick during the
second policy year. Multiplying this by the inception rate for age 32 gives the expected
proportion who end up claiming in the third policy year.
(ii) Calculating the option premium
We first need to calculate the standard premium, which the option-takers will each pay,
at age 33. This is calculated identically to Part (i). So the premium is:
È 0.000709 (1 - 0.000709) ¥ 0.000785 ˘

100, 000 ¥ Í + ˙ = £135.33 [1½]
Î 1.051.5 1.052.5 ˚
We now need to calculate the cost of claims for the option, as at time 3.
First, for those currently sick (and who will definitely go on to qualify for claim), the
present value of the cost is:
100, 000
= 97,590 [½]
1.050.5

For other policyholders who take up the option, the expected present value of the cost
is:
È1.5 ¥ 0.000709 (1 - 1.5 ¥ 0.000709) ¥ 1.5 ¥ 0.000785 ˘

100, 000 ¥ Í + ˙ = 202.96 [1]
Î 1.051.5 1.052.5 ˚
We now need to multiply these values by the respective probabilities of an initial

30-year old surviving to be a sick life (ultimately to claim) at time 3, or surviving to be
one of the other 30% who take up the option at time 3. The whole is then discounted for
three years in order to get the total expected present value of the claim cost from the
option. So we get:
1
97,590 ¥ (1 - 0.000521) ¥ (1 - 0.000578) ¥ 0.000641 ¥
1.053
1
+ 202.96 ¥ (1 - 0.000521) ¥ (1 - 0.000578) ¥ (1 - 0.000641) ¥ 0.3 ¥
1.053
= 53.98 + 52.51
= 106.49 [2½]
But we are going to receive premiums for all those who take up the option. These will
have expected present value (at age 30):
1
135.33 ¥ (1 - 0.000521) ¥ (1 - 0.000578) ¥ [0.000641 + (1 - 0.000641) ¥ 0.3] ¥
1.053
= 35.08 [1]
So the additional premium required at age 30, for a policy with the option, is:
106.49 - 35.08 = £71.41 [½]
This makes the total premium, for the policy that includes the extension option, equal to
99.56 + 71.41 = £170.97 . [Total 7]

(iii) Risks from the option
The main risk is that the company will make a loss if the cost of the option exceeds the
amount (71.41) assumed in the pricing basis. [½]
This will happen if any of the following occur:

● more than 30% of the healthy policyholders extend their policies [½]
● more than the assumed proportion (0.0641%) of policyholders are sick (and will
ultimately claim) as at time 3 [½]
● the morbidity rates of the healthy option-takers is higher than the assumed 150%
of the S(ID) rates. [½]
[Total 2]
(iv) Whether mortality should be ignored
Allowing for mortality reduces the expected cost of claims. [½]
So ignoring mortality is prudent, and therefore builds an implicit margin into the
basis. [½]
If the margin is not used (ie in covering worse than expected claims experience), this
will be a source of profit for the company. [½]
If margins are excessively large, this can make the product expensive and possibly
uncompetitive. [½]
This could be true for a much older policyholder, where mortality rates would be much
higher, in which case it may be necessary to incorporate mortality explicitly into the
basis. [½]
At young ages, such as here, the inclusion of mortality would have relatively little effect
on the price, and could even lead to accusations of spurious accuracy, given the likely
level of uncertainty regarding the morbidity assumptions themselves. [½]
Mortality should therefore probably be ignored in this case. [½]

[Maximum 3]

(v) Why the option might be offered
Possible reasons include:

● to improve the flexibility of the cover provided for policyholders, so as to better
meet their needs and so make the product more marketable [1]
● to match the product design of competitors (who may already issue similar
policies with an option) so to maintain the company’s competitiveness [½]
● to increase competitiveness relative to the market (if the other companies’
products don’t yet include the feature). [½]
[Total 2]
Solution 7.6
(i) Modelling
Cashflow model
The cashflow model would represent a single example policy (model point), for a
specified age, sex, occupation, smoker status and initial benefit size. [½]
The model would project the expected cashflows from the policy over its term. [½]
The expected cashflow each year would be the difference between the expected cash
income and cash outgo during the year, for each in-force policy. [½]
Income would be premiums and net investment return. [½]
Outgo would be expenses, and the expected cost of claims incepting during the year. [½]
The expected claim cost would be calculated as:
{starting benefit level} ¥ {claim inception rate} ¥ {disability annuity value} [1]
where:
starting benefit level = amount of benefit as at the average commencement

of payments from the year’s inceptions (allowing for
inflation from the start of the policy) [1]

claim inception rate = expected rate of claim inception in relation to all

in-force policies at the start of the year, specific to
the classification status of the policyholder and to
the age at the start of the year, and allowing for the
six month deferred period. [1½]
disability annuity value = the expected present value of a disability annuity

benefit commencing at £1 pa (after the expiry of the
deferred period), terminating at age 65 or on earlier
death or recovery. The inflation increases would be
included in the value. [1]
The projected increase in supervisory reserves over the year would be deducted from
the cashflow, and the interest on the reserves over the year added, to produce the
projected in-force profit (the profit vector). [1]
The end-year reserves would be calculated using a similar inception-annuity formula to

above. [½]
The in-force profit values would be multiplied by the probability of an initial policy still
being in force at the start of the year, allowing for mortality and lapses, to obtain the
profit signature. [½]
These values would then be discounted at an appropriate risk discount rate, and
summed, to give the net present value (NPV) for this model policy. [½]
The model would require best estimate assumptions of morbidity, mortality, interest,
expenses and inflation for projecting the cashflows. [½]
The reserve calculations would be based on the company’s expected supervisory

reserving assumptions, which would be very prudent. [½]
Using the model
Suitable profit criteria would need to be decided. Most likely we would use a function
of the NPV (eg that the NPV should equal 30% of the initial commission under the
policy) based on the central – best estimate – projection assumptions (as described
above). [1]
A premium would be found, by iteration, which satisfied the criteria. [½]

The premium would then be sensitivity tested using the model. This involves
recalculating the profit signature, and NPV, assuming the above premium rate applies
but under a whole range of different possible outcomes for the various experience
assumptions. [1]
It would be necessary to ensure that the different parameters were assumed to vary in a
mutually consistent fashion, reflecting realistically the correlations that may exist
between them. [½]
The assumed supervisory reserving bases in the profit test model should also
realistically reflect the conditions projected over each scenario. [½]
The sensitivity tests will identify to which future outcomes the profitability of the
contract is most sensitive. [½]
Any necessary actions could be taken. These might include:

● increasing premiums to reduce losses from adverse scenarios [½]
● changing the product design to reduce the downside sensitivity [½]
● abandoning the launch. [½]
The profit-test model can be used in other (related) ways, such as:
● for calculating other useful profit measures, such as the discounted payback
period, internal rate of return, or profit margin, which can help in determining
both the premium level and product design features [1]
● considering the shape (progression over time) of the profit signature to suggest
ways in which the design of the product might be improved (though scope for
such improvement is somewhat limited for a conventional product such as
this). [1]
Once premiums have been determined for a specimen range of model points, these
would be tested within a full model office, to check for capital adequacy and for the
expected overall impact on the company’s embedded value, over a range of possible
scenarios for new business volume and mix. [1]
If this is satisfactory (and other requirements such as marketability and competitiveness

have been met), the single-policy cashflow model can then be used to obtain a full set of
premium rates for the product, by repeating the individual policy pricing process over
the whole range of rating factors (eg sex, age, smoker status, occupation). [1]
[Maximum 15]

(ii) Obtaining the morbidity assumptions
Own data
The company does not have any data for this actual product, as it is new. [½]
However, its group policy data, as they relate to a similar product design, should be of
some help. [½]
A recent time period would be chosen for the investigation, long enough if possible to
produce a credible body of data but not too long so as be out of date and therefore no
longer relevant. [1]
Claim inception rates and claim termination rates would need to be analysed separately.
[½]
Exposed-to-risks would therefore need to be calculated separately for non-claiming

lives and for those with claims in payment. [½]
Further subdivisions would need to be made, for example by age, sex, occupation,
policy duration (in the case of non-claimants) and by duration since claim inception (for
claims in payment). [1]
It would probably be easiest to compare experiences with those of industry standard

tables (see below), if available. [½]
It may be necessary (and certainly useful) to separate terminations by recoveries and

deaths, as the standard tables may have separate rates for these, and their analysis may
give useful insights. [1]
Expected claim inceptions and terminations would be calculated by multiplying the

exposed to risk for a specific cell (ie age/sex/etc grouping) by the relevant inception or
termination rate from the standard table. [1]
The actual numbers of inceptions and terminations would then be compared to those
expected (eg by ratios) for each cell. [½]
Cells that appear indistinguishable from each other in this respect might be combined to
produce greater credibility. [½]

These data, though, will not be entirely relevant to this purpose because: [½]
● group policies exhibit different morbidity experience because of various
selective influences, eg employers tend to employ healthy people; group
schemes may have compulsory membership, reducing anti-selection; etc [1]
● a different distribution channel is involved, possibly targeting a different class
of lives [½]
● members of group schemes may well be involved in different occupations from
individuals, who may be largely self employed. [½]
The effect on the past experience of historical economic conditions should also be taken
into account when interpreting the results. [½]
Industry data
Pooled industry data on individual IP might be available. This could be more relevant
in that it relates to the correct policy type … [½]
… but suffers from not necessarily representing this company’s target market. [½]
There is also much heterogeneity in industry data due to different policy conditions,
distribution channels used, underwriting practices and claims management between the
contributing companies, which make them of less relevance. [1]
A comparison of industry data between group and individual policies could be useful, if
available. [½]
Industry data can provide standard tables (as above), that can ultimately be adjusted to
provide a working basis. [½]
These data can also help us to identify past trends in experience. [½]
Reinsurers’ data
Reinsurers should provide useful assistance in setting assumptions, based on their own
data. [½]
They may have experience that quite closely relates to the target market, and could also
advise on appropriate policy wordings, product design and underwriting approaches that
could make the future experience more predictable. [½]
Reinsurers’ data should also have good credibility, though not generally as good as
whole industry data. [½]

Population data
There are likely to be population-based data (eg medical studies) that could be used to
estimate sickness incidence and/or termination rates. [½]
Provided sufficient data exist from elsewhere, population data would probably only be
directly used as a last resort, as they do not relate to the experience of insured lives. [½]
On the other hand, the data are likely to be credible and could provide some useful
insights into past trends in morbidity (eg helping to identify possible reasons for trends).
[½]
Developing assumptions
The future assumptions would probably be defined as functions of the most relevant
standard tables (where available). [½]
A start could be made using the analysed group experience, but then use the other data
sources to help determine adjustments for differences due to: [½]
● different class of lives (individual rather than group), including the effect of the
different underwriting that will be used [½]
● any differences in policy conditions, eg if proportionate payments were to be
made on partial return to work [½]
● the use of the different distribution channel [½]
● changes in future experience compared with the past, eg through medical
advances; past trends might be extrapolated (if there is good reason to expect
their continuation) [1]
● the expected impact of future economic developments. [½]
The assumptions should be projected up to the mid-future time point for which they are
expected to apply. [½]
While the assumptions should basically be best estimates, … [½]
… it is necessary not to overstate future termination rates … [½]
… or to understate future claim inception rates. [½]
For example, any expected reductions in future recovery and/or mortality rates should
be fully included in the projected assumptions. [½]

Loadings for uncertainty in the assumptions will normally be accounted for in the risk
discount rate. [½]
[Maximum 18]




using the course.

Subject ST1: Assignment X1
2008 Examinations
Time allowed: 2½ hours, plus 15 minutes reading time
Instructions to the candidate

1. Please note that we only accept the current version of assignments for marking, ie you
can only submit this assignment in the sessions leading to the 2008 exams.
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At the end of the assignment

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2008 Examinations
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ST1: Assignment X1 Questions Page 1
Question X1.1
Explain the problems for health and care insurance policyholders caused by inflation,
and set out the various ways in which product design can help overcome them. [3]
Question X1.2
A long-term health insurer sells both group and individual health insurance contracts.
(i) Explain the differences between the group contracts and the individual contracts
provided by this insurer. [6]
(ii) Describe the advantages and disadvantages to an individual of joining a group

insurance scheme rather than buying an individual policy. [2]
[Total 8]
Question X1.3
A health and care insurer is proposing to introduce a new IP insurance policy that
incorporates “objective cover”.
The insurer’s current IP insurance policies pay claims when the insured 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 insured’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. [5]
(ii) Discuss the advantages and disadvantages of this new definition for the
marketing of IP policies by the insurer. [3]
[Total 8]

Page 2 ST1: Assignment X1 Questions
Question X1.4
A health and care insurer currently sells stand-alone critical illness insurance policies
with terms varying from ten to twenty five years. The policies have premiums that are
reviewable every five years.
It is considering selling a new policy that will allow both of the following to be
reviewed every five years:
● the insured events
● the level of the premiums.
(i) Explain how the revised policy would be better for the insurer. [3]
(ii) Describe how this new policy might be designed so that it appeals to consumers,
and allows the insurer to manage the risks it faces. [4]
[Total 7]
Question X1.5
Discuss the following two ways in which a PMI insurer might seek to control the costs
of claims:
(i) pre-authorisation
(ii) preferred provider agreements. [5]
Question X1.6
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, focussing on:

● the restrictions on the monthly sickness payments that could be imposed
● the criteria for the payment of benefits. [9]

Question X1.7
(i) Discuss the advantages and disadvantages of the following alternative

commission structures, as means of remunerating intermediaries for the sale of
health and care insurance business:
(a) level commission in each year except the first, in which a significantly
higher commission is paid
(b) level commission paid in every policy year, including the first. [5]
(ii) Describe any ways in which the difficulties for either or both of the above
commission structures might be reduced. [5]
[Total 10]
Question X1.8
An insurer is proposing to launch a physiotherapy cash plan for sportsmen and

sportswomen.
Describe and explain a possible design for the policy including:

● the benefits that might be provided
● the policy conditions for claiming
● the underwriting procedures that might be used
● the premium rating structure
● the use of incentives to encourage the renewal of policies. [16]
You are not required to suggest a pricing basis or discuss how premiums might be
calculated.

Question X1.9
A health and care insurance company markets single premium immediate needs
long-term care annuity contracts. Cash benefits are offered, the level of which depend
on the degree of incapacity. The premium rates include an allowance for the company’s
administration costs equal to 1% of each cash annuity payment.
(i) List the features of the benefits that could be offered under the contract. [2]
(ii) Describe the mortality and morbidity risks the company faces in relation to the
contract, and outline how they could be controlled. [6]
(iii) Discuss the risks created by the method of charging for expenses, and outline
how these risks could be controlled. [6]
[Total 14]

2008 Examinations

be marked.)
marking.



4. Please comment on your last marker. We use this information to allocate markers,
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monitor these aspects of markers’ performance separately.
7. Post your script to 31 Bath Street, Abingdon, Oxon, OX14 3FF.

2008 Examinations
Name:
Address:
Attempt conditions
(see Note below):
_____ hrs _____ mins
yes / nearly / no
Please grade your Assignment X1 marker by ticking the appropriate box.
[ ] Excellent – the marker’s comments were thorough and very helpful

[ ] Good – the marker’s comments were generally helpful
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Question X2.1
Explain the ways in which State healthcare provision can be more comprehensive than
healthcare cover provided by insurers. [4]
Question X2.2
A life insurance company issues an income protection insurance policy to a healthy life
aged exactly 45. The policy has no waiting period, but there is a deferred period of one
year. A benefit of £10,000 per annum is payable continuously while the policyholder is
sick, after the completion of the deferred period. The benefit is payable until the
policyholder reaches age 65, dies or recovers.
Level annual premiums are payable continuously under the policy until age 65 or the
policyholder’s earlier death. Premiums are waived while the policyholder is in receipt
of benefit payment.
Calculate the annual premium.
Basis: Sickness: S(ID) Tables

Mortality: ELT(15) Males
Interest: 6% per annum
Expenses: Initial: 60% of the annual premium rate
Regular: £50 per annum, assumed incurred continuously in
all years of the policy, including periods of
sickness
Claim: 1.5% of sickness benefit payments made to the
policyholder [4]
Question X2.3
A State, which provides free healthcare, has a large PMI market. You are the health and
care actuary working for one of the largest providers of PMI products.
The directors of your company have decided to lobby the Government to change the
taxation system so that those over age 60 who buy an individual PMI policy can deduct
the premiums they pay from their income before it is taxed.
Explain the advantages and disadvantages to the State of this system of subsidising
premiums. [6]

Question X2.4
(i) Explain why it is important to incorporate lapse rates into product pricing. [5]
(ii) It has been suggested that, rather than analysing its own experience, a healthcare
insurance company should use industry statistics to estimate lapse rates
appropriate for pricing future product launches.
State reasons why this suggestion may be inappropriate. [4]

[Total 9]
Question X2.5
A Government is planning to provide State-funded income benefits for those who are
unable to earn a living as the result of sickness or injury. State the advantages and
disadvantages of each of the following proposals.
(a) A flat benefit equal to 40% of national average earnings. The benefit will be
increased each year as the latest data become available.
(b) A benefit of 70% of the individual’s average weekly earnings in the last thirteen
weeks of employment. This will be paid for the first 26 weeks of sickness. The
subsequent benefit is 40% of national average earnings with annual increases. [9]
Question X2.6
A proprietary healthcare insurance company that specialises in conventional critical

illness and long-term care insurance products is developing modelling techniques for
pricing work and profitability measurement.
(i) Explain what is meant by “risk discount rate”. [2]
(ii) Outline how the capital asset pricing model can help this company to derive
appropriate risk discount rates for it to use. [5]
(iii) Describe how the risk discount rate will be used by the actuary in product
pricing. [3]
[Total 10]

Question X2.7
A healthcare insurance company is reviewing its premium rates for conventional

income protection insurance business.
(i) Set out the advantages and disadvantages of using a formula method of pricing
compared with a cashflow approach. [6]
(ii) Describe how the expected cost of claims (for a policy with a deferred period of
d years) could be estimated using:
(a) a multiple state modelling approach
(b) a claim inception and disability annuity approach.
You can assume that you have the necessary data available to calculate the
required probabilities and financial functions for each method. [10]
[Total 16]
Question X2.8
You are the product development actuary in a healthcare insurance company in

Ruritania. The current product range consists of a number of unit-linked savings
products. Over the last year various critical illness products have started to appear on
the market. You have decided to launch such a product. You have already decided on
the precise design of the product, which is to be a stand-alone unit-linked product sold
via your existing brokers.
(i) Describe how, in order to price the contract correctly, you would estimate the
elements in the pricing basis relating to:
(a) the demographic assumptions [6]
(b) the investment assumptions [3]
(c) the expense assumptions. [6]
(ii) An initial charging structure and appropriate risk discount rate have been
recommended. Describe how you would examine the profitability of the
product, and what actions you might take as a result of your investigations. [7]
[Total 22]




using the course.

2008 Examinations

be marked.)
marking.




2008 Examinations
Name:
Address:
Attempt conditions
(see Note below):
_____ hrs _____ mins
yes / nearly / no

Please turn over

Have you:

Question X3.1
A healthcare insurance company issues a without-profits long-term care insurance

product, paid for by single premiums. The policy guarantees to pay 75% of the
policyholder’s long-term care costs as they arise, subject to appropriate medical
certification of need. Only those in good health are allowed to take out a policy.
Surrender is not permitted.
You are required to derive the assumptions needed, in order to value just the benefit part
of the company’s supervisory reserve for this product. Describe how these assumptions
would be determined, including the experience investigations that you would carry out.
[22]
Question X3.2
A healthcare insurance company writes a significant volume of critical illness insurance

business. New business volumes have fallen by 30% over the past three months.
Analysis of the market indicates that a 20% reduction in premium rates is required to
regain lost business and achieve the target of a 10% increase on the original
(ie pre-reduction) new business volume.
(i) Describe how the impact on profitability of this reduction in premium rates
might be determined. [6]
(ii) Discuss the factors that should be considered before a rate reduction is
implemented. [9]
[Total 15]

Question X3.3
(i) List the main rating factors used in determining the book risk premium rates for
a group PMI scheme. [3]
(ii) Explain how a company will determine its book risk premiums, broken down by
the appropriate rating factors. [8]
(iii) For many group schemes, the insurer’s book risk premium rates should be
adjusted before being used. Describe the kinds of adjustments that might be
made in practice. [4]
[Total 15]
Question X3.4
The government of a developed country is about to impose new legislation whereby it

will be illegal to discriminate on the grounds of gender or age for the purposes of selling
health insurance.
(i) Outline, with examples, the impact that this legislation may have on insurance
companies writing short-term individual health insurance business. [9]
(ii) Suggest actions that these companies may take in order to mitigate the adverse
effects of the legislation. [7]
[Total 16]

Question X3.5
An insurer sells a special 5-year single premium without-profits accelerated critical

illness insurance with an initial sum assured of £100,000 payable immediately a claim
event happens. This policy includes an option such that the policyholder can increase
the sum assured by £50,000 at the end of the second policy year by paying an additional
premium at that time, based on standard premium scales, without evidence of health.
(i) Use the conventional method to calculate the additional premium payable for the
option by a life aged 40 at the outset. Assume that:
Standard claim incidence rates: AM92 Select mortality for lives 20 years older
than the actual age.
Interest: 4% pa
Expenses: none [4]
(ii) Use the North American method to calculate the additional premium payable for
the option by a life aged 40 at the outset. Assume that:
Standard claim experience: Select

Claim experience of those taking up the option: 200% of Ultimate
Proportion of those eligible who exercise the option: 40%
Interest: 4% pa
Expenses: none
where “Select” and “Ultimate” refer to the select or ultimate mortality rates in
the AM92 mortality table, for ages 20 years older than the actual age. [8]
[Total 12]




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2008 Examinations
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Question X4.1
“Investment performance is of paramount importance to an insurer writing unit-linked

health and care insurance.”
Discuss, with reasons, whether or not you agree with the above comment. [7]
Question X4.2
The regulators within a developing country have decided that all health insurers must
from now on hold a minimum of 50% of their assets in domestic government bonds.
Previously there were no regulations on investments held at all.
(i) Outline possible effects of this new ruling on health insurers. [11]
(ii) Suggest, with reasons, possible improvements to the new ruling. [6]
[Total 17]
Question X4.3
A health and care insurer is putting itself up for sale. Suggest reasons why two different
consultant actuaries may put different values on its reserves. [9]
Question X4.4
A health and care insurer sells only private medical insurance business, where
premiums are paid annually and cover is renewable every year.
List and define the types of reserve held to meet the claims liabilities of the insurer and,
with reasons, give indications of their sizes. [9]
Question X4.5
You are the actuary to a health insurance company that sells only long-term income
protection business. Describe how you would determine the demographic, interest rate
and expense assumptions for the calculation of the company’s supervisory reserves. [13]

Question X4.6
A medium-sized health insurance company has been issuing regular-premium long-term

care insurance contracts for the past three years. The contracts provide different levels
of benefit for different categories of long-term care. The policies are without-profits
contracts, with premiums payable until age 75, or to the first benefit payment date, if
earlier. Premiums and benefits increase automatically in line with a published national
index of residential and nursing home care costs.
The company has sold somewhat fewer policies than planned over the period, although
the average premium size has turned out significantly larger than expected. A number
of policyholders are already receiving benefits under their policies.
You are calculating the company’s supervisory reserves for the business in force at the
end of the current financial year.
(i) State, with brief reasons, the principal elements of the supervisory valuation
basis for this business. [6]
(ii) List the items of your own data that you would need in order to perform the
valuation, including those needed to enable you to determine an appropriate
basis. [10]
(iii) Explain how you would determine the principal assumptions you have listed in
Part (i). [17]
[Total 33]
Question X4.7
(i) State the investment principles that should be followed by a health insurance
company. [3]
(ii) Describe how the company’s investment strategy may be affected by the
regulatory framework in which it operates. [5]
(iii) Describe how a cashflow model could be used to assess the suitability of the
company’s investment strategy. [4]
[Total 12]

2008 Examinations

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Question X5.1
An insurance company is about to launch a conventional regular premium

without-profits critical illness contract on guaranteed terms.
Describe briefly the risks that the company faces from the future volume and mix of
business sold. [4]
Question X5.2
A health and care insurance company is setting the terms for a new conventional
individual income protection product with guaranteed premium rates.
(i) Explain why all policyholders’ applications would be underwritten. [4]
(ii) List the factors that would be considered when underwriting each proposal. [4]
[Total 8]

Question X5.3
(i) A proposal form for a stand-alone critical illness insurance contract includes the
following question:
“Have any of your close relatives (parents, grandparents or siblings) suffered

from heart disease, stroke or cancer before the age of 60? If so, please give
details.”
Explain the rationale for including this question in the proposal form. [3]
(ii) In a particular country, special procedures (genetic tests) have recently become
available, that can identify whether someone has a high propensity of developing
certain kinds of cancers.
The country’s government has, however, just made it illegal for any insurance
company to make use of such test results when underwriting applicants for
health insurance. So, for example, anyone who has had a genetic test prior to
applying for a critical illness insurance policy does not have to disclose to the
insurer either the results of the test or even that they have had the test carried
out.
Explain how this might affect the insurance company, and discuss the actions it
might take in response to the ban. [5]
[Total 8]

Question X5.4
A life insurance company has written unit-linked long-term sickness (income

protection) contracts in its domestic market for many years, and has a significant share
of that market. It now intends to start writing this business in an overseas market. In
that market unit-linked sickness contracts are rare, although there is a substantial
amount of without-profits sickness business written.
Discuss fully the problems related to the main sources of data that the company will
face in entering this market. [10]
Question X5.5
A health and care insurer offers a without-profits long-term care insurance contract.
Under this contract the regular premium and the amount of monthly benefit are both
indexed annually in line with a national index of retail prices. The indexation of benefit
applies both before and after a claim starts.
Premiums are payable until a claim starts or until age 75, whichever is sooner.
The contract gives four different levels of benefit, based on different amounts of care
needed. The lowest level provides for a minimum amount of home care whilst the
highest level provides for round-the-clock residential care. The benefits for the four
levels of care are set initially at fixed sums per month, sufficient at current prices to pay
for the amounts of care required. The need for care will be assessed independently.
Discuss the risks involved for the insurer in writing this contract. [11]

Question X5.6
A health and care insurance company currently issues regular premium without-profits
critical illness insurance policies on guaranteed terms. The company places its
reinsurance business with the NotonyourLife reinsurance company. For policies that are
accepted at the insurance company’s standard premium rates, the following reinsurance
treaty applies:
Type of reinsurance: Original terms, individual surplus.
Maximum sum insured covered by treaty: £500,000.
Retention level: £50,000.
Initial commission: 75% of the reinsurance premium.
Renewal commission: Nil.
Definition of standard risks: As defined in the NotonyourLife
underwriting manual.
(i) From the information available, state the most likely reasons for this insurance
company taking out reinsurance, and explain whether the reinsurance treaty
appears suited to these purposes. [8]
(ii) Describe how the insurance company might deal with critical illness policy
applications:
(a) for sums assured in excess of £500,000; and
(b) from people who are assessed to be substandard risks. [5]
(iii) The insurance company now intends to launch a unit-linked version of the
contract, with a view ultimately to phasing out the existing conventional
contract.
Giving reasons, suggest how the reinsurance treaty might be changed, if at all,
for the new product design. [5]
[Total 18]
Question X5.7
A small proprietary health insurance company sells only private medical insurance,
which it does through brokers.
(i) Describe the risks that the insurance company might be facing. [22]
(ii) Set out the various ways in which the insurer can control these risks. [19]
[Total 41]

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Question X6.1
A life insurance company transacting all types of life and health business last reviewed
its individual IP insurance premium rates five years ago. The current product is a
conventional without-profits product with guaranteed premium rates, offering a variety
of deferred periods and expiry ages up to a maximum expiry age of 65. The benefit is
payable until the termination of the disability or expiry of the contract, whichever is
earlier. The premium rates vary by age, sex, term to expiry, deferred period and
occupational class. It has been widely reported in the press that the industry sickness
claims experience is poor. You have been asked to analyse the claims experience and
review the product design and premium rates.
Describe the analysis of the claims experience you would carry out as part of this
investigation, and outline the problems you may encounter in practice. [6]
Question X6.2
An insurance company issues a wide range of conventional and unit-linked long-term

health and care insurance policies.
(i) Explain how each of model error, parameter error and random fluctuations can
lead to losses from morbidity experience, in each case giving a simple example
of how this can arise. [4]
(ii) (a) Suggest how the operation of the actuarial control cycle can help the
company to manage any problem that it may have with its morbidity
experience.
(b) Suggest and briefly describe the various steps that the insurance company
could take to manage any problem that it may have with regard to its
morbidity experience. [11]
[Total 15]

Question X6.3
A proprietary health and care insurance company issues a wide range of conventional
long-term without-profits products.
Explain how:
(a) the general economic and commercial environment, and
(b) the company’s ongoing experience
will influence the company’s embedded value calculations. [8]
Note: details of the individual investigations that may be carried out are not required.
Question X6.4
Explain the reasons why a health and care insurer needs to analyse its new business, and
describe the types of analysis that would be carried out. [10]
Question X6.5
A large life insurance company sells a wide range of health and care insurance business.
The company is worried that its claims management costs under its income protection
insurance policies are spiralling out of control, and wants to take action to remedy the
situation.
(i) Describe the investigations that would need to be carried out. [14]
(ii) Suggest possible actions that the company might be able to take, should there be
a problem. [7]
[Total 21]

Question X6.6
For a health and care insurer issuing substantial volumes of private medical insurance
business, describe how the renewal experience would be analysed and monitored, and
explain the importance of the results obtained. [11]
Question X6.7
The life insurance company for which you work offers a group unit-linked contract.
The contract is sold to employers as a way of allowing employees to save a lump sum
with which to provide an income in retirement. The group contract consists of a
collection of individual contracts that are administered together. Under the contract, the
allocation rate of premiums to units is level over the whole contract term, but varies
between individuals according to the term of the policy and the size of the premium
paid.
It has been suggested that the life company introduce a “waiver of premium” benefit.
Under this, the life company would pay the premiums for the contract on behalf of any
policyholder who is unable to work through illness or injury, during the period of their
incapacity. The life company’s marketing department has proposed that the benefit be
paid for by a fixed reduction in the allocation rate, irrespective of term or premium size,
and with no underwriting. They claim that the simplicity and convenience of this
arrangement will be a major selling point. Individuals would be given the option of
having waiver of premium or not.
As a pricing actuary, you have been asked to respond to this suggestion. Set out the
points you would make in response, suggesting any modifications you would like to see.
[8]

Question X6.8
A life insurance company has a large and established portfolio of immediate-needs

long-term care annuities currently in payment. These policies pay an index-linked
benefit, for a single premium based on the expected mortality experience of the
policyholder at the date the annuity payments start. To be eligible to take out a policy,
applicants must have a medically certified need for long-term care, based on criteria of
Activities of Daily Living (ADLs). Two levels of need are identified: “level 1” is where
the policyholder requires only non-nursing, residential home care, and “level 2” is
where full nursing residential home care is required.
Policyholders who satisfy the criteria for nursing home care at outset receive 175% of
the benefit level received by those who only meet the lower care level criteria.
However, benefit levels cannot be changed once payouts have commenced, except for
the automatic index-linked increases promised under the policy.
The company now proposes launching a third variant of the policy. This will provide
the lower benefit level initially to applicants who satisfy the less stringent ADL criteria,
but will also give the policyholder the right to apply for the enhanced benefit level at
any subsequent time, subject to then meeting the additional ADL criteria required but
for no extra cost at the time of benefit increase.
(i) Explain how, if at all, the mortality assumptions that will be used for pricing the
existing product types may alter if the proposal goes ahead. [2]
(ii) Discuss how the mortality assumptions for pricing the new variant of the product
are likely to compare with those used for the existing products. [2]
(iii) Discuss how the premiums charged for the three types of policy in the future are
likely to compare with each other, and with those charged for the existing policy
types before the new product launch. [5]
(iv) Describe the investigations that the company might undertake in order to help
determine appropriate mortality assumptions for pricing the new variant of
policy, and explain how the assumptions would be determined. [12]
[Total 21]

Final Assignment deadlines
For the session leading to the April 2008 exams – ST Subjects
Marking vouchers
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Series Subject Assignment Final deadline date
submission date
ST1-6 X1 28 November 2007 9 January 2008

X
ST1-6 X2 12 December 2007 23 January 2008
ST1-6 X5 13 February 2008 5 March 2008

X6
ST2, ST4, ST6 23 January 2008 27 February 2008

Y Y1
ST1, ST3, ST5 30 January 2008 5 March 2008

Y2

Y3
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Final Assignment deadlines
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Series Assignment Final deadline date
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X1 28 May 2008 9 July 2008

X
ST1 – ST6 X2 11 June 2008 23 July 2008
X3 25 June 2008 30 July 2008
X4 9 July 2008 6 August 2008
X5 23 July 2008 13 August 2008
X6 6 August 2008 20 August 2008
Y1 2 July 2008 23 July 2008

Y
ST1 – ST6 Y2 23 July 2008 6 August 2008
Y3 13 August 2008 20 August 2008
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1 The Subject ST1 course structure

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