Canadian Institute of Actuaries PD-2

1. Canadian Institute of ActuariesPD-2 L’Institut canadien des actuairesTR-2

2. Sources of Earnings - Group • October 2007 - committee formed to develop Group-specific Sources of Earnings (SOE) guidance. • Chair is Tom Strickland • Committee representation : • 9 Group insurance • 1 Group reinsurance • 1 Group consulting • Working on final draft for exposure later this year • Today’s session will discuss the concepts developed so far and ask for feedback

3. Why is Group SOE Different? • For individual and annuity lines of business, reserves based on full future cash flows are projected as soon as a premium is received • CALM projection of cash flows can be done for Group - then SOE is very similar to individual • CALM allows an approximation that does not generate full cash flows if no material interest rate risk, pricing is adequate • Most companies apply the approximation for Group business, with the possible exception of Long Term Disability (LTD)

4. Implications of Group Valuation for SOE • CALM valuation - earnings after first premium based on variances from valuation assumptions • CALM approximation - most earnings based on variances from pricing assumptions at quote and renewal • Draft shows what to do when the approximation is used • Draft is fairly detailed – expect some companies will need to simplify • External reporting less detailed (need for consistency with other lines)

5. Characteristics of Group BusinessShort Term vs Long Term • For many companies, most premiums come from high credibility, short term benefits: Health, Dental, Short Term Disability (STD) • Life claims are mostly short term, but about 10% lead to long term reserves (waiver of premium on disability, paid up life) • Change in PfADs on reserves plays a minor role in earnings, except for LTD – could be ignored for other lines

6. Characteristics of Group BusinessUnderwriting/Pricing • Initial (quote) underwriting and renewal underwriting are separate processes, usually done in separate departments • Group underwriters / sales have substantial leeway to give marketing discounts or load rates at quote and renewal • Competition and lack of data at quote lead to generally lower earnings in first policy period • Renewal underwriting should gradually improve earnings each policy period after the first to achieve overall target profit levels • Overall underwriting process as critical as (maybe more critical than) tabular rates in maintaining profitability

7. Definition of New Business • For Group, the impact of the initial pricing really extends to the end of the first policy period, when the pricing can first be revised • The first policy period is typically 15 months, but could be longer (especially for Life and LTD) • Committee strongly recommends analyzing first policy period results vs renewal period results separately • Where to classify first policy period results in SOE?

8. Definition of New Business • Option 1: expected earnings (until the first repricing opportunity) in first policy period classified as New Business Gain • Advantage: Aligns well with the way the business is underwritten and managed (separate initial and renewal underwriting processes) • Disadvantage: Inconsistent with definition of NBG used in life and wealth businesses • Option 2: Group New Business gain is impact at time zero only • For most group benefits, no initial reserve is established hence NBG will be $0 • If option 2 adopted Committee recommends that expected earnings and experience gains be split into first policy period and renewal year components • Feedback would be appreciated!

9. Types of Group Business • The main portion of the draft deals with fully insured (pooled) and ASO (fee for service) business • There are also brief sections covering other types of business: • Refund accounting: • Profit margin from retention accounting • Limited risk if in surplus or covered by hold harmless agreement - but could still have risk elements: • Pooled elements (e.g. high amount Health) • Policy reserves different from valuation reserves • Expense charges in the retention accounting vs actual • Interest credits on policy reserves/deposits vs actual • Reinsurance ceded - recommend gross SOE with fairly simple reinsurance adjustments • Reinsurance assumed - depends on data available

10. Preliminary Information Needed • Expected pricing margins as % premium - commissions, premium taxes, expenses, standard risk and profit margins • Must also understand the pricing and underwriting philosophy (real profit margins by policy period) • Profit margins - both explicit and implicit (claims trend?) • Expected and actual marketing discounts by policy period • Likely larger discounts in first period than in later periods • Differentiate between risk adjustment and marketing discount • Risk adjustment • Real risk factor - not in base pricing module • Profit neutral (price could go up or down) • Marketing discount – only down • For many companies, expected profits as % premium would not be level by policy period

11. Treatment of PfADs • For most Group lines, PfAD buildup/release has a very small impact on overall earnings • The exception is LTD: • Increase in reserves typically 70-100% of first year claims • Total initial PfADs could be 20-25% of reserves • Should model the buildup and runoff of PfADs by policy period as additional expected profit elements

13. % Premium Earnings by Policy Year

14. Typical Group SOE Report • + Expected profit on inforce operations • + new business gain (loss) • + Experience gains • + Changes in assumptions and other changes • = Earnings on operations Option 2, NBG measured at t=0, assumed

15. Expected Profit on Inforce Operations • Profit margin on first policy period business premiums (including expected release of PfAD) • + Profit margin on renewal business premiums (including expected release of PfAD) • + Expected gain on interest • + Expected gain on commission, expenses, and premium taxes • + Expected gain on fee income

16. Develop Margin Gains (Beginning of Year) • Identify expected % gain for various sources of earnings: • Potential source for assumptions below: prior pricing, Business Plan, last year’s SOE • Net risk and profit as % premium • Explicit margin + implicit margins - marketing discounts + gain/loss from PfADs (LTD) • Should be analyzed by policy period (at least period 1 vs renewal) • Expected % gain on interest • Expected % return on assets backing liabilities - % required interest on liabilities • Expected % gain on fee income • (fee income - expenses allocated to fee income groups) / fee income • Expected % gain on commissions and premium taxes • Usually explicitly priced for - most companies would assume zero expected gains • Expected % gain on expenses • (expense loads - actual expenses - change in expense reserves) / expense loads • Excludes fee income groups

17. Calculate Expected Profits (Quarterly Reporting) • From net risk and profit margin = actual premium received * (net risk and profit as % premium) • Split between first policy period business and inforce (renewal) • Could split renewal into multiple years • From interest = actual mean liabilities * expected % gain on interest • From fee income = actual fee income * expected % gain on fee income • From expenses = actual premium * expense margin * expected % gain on expense margin • From commissions, premium tax – same as expenses (but usually zero) • First policy period expected profits are just net risk and profit margin – remainder are inforce (renewal) items for simplicity • Seasonality in claims experience could be reflected in expected earnings

18. Comparison to Plan • SOE expected profits based on actual premiums received • If mix of premium is much different from Business Plan (e.g. big new business), this may create a variance from Plan • You may wish to do an analysis of expected profits from Plan premiums vs actual premiums to better understand this variance – would be outside the core SOE process

19. Experience Gains & Losses • + Claims experience gain: renewal business • + Claims experience gain: first policy period • + Investment income experience gain • + Expense experience gain • + Commissions experience gain • + Premium taxes experience gain • + Fee income experience gain

20. Experience Gains and LossesClaim Experience Gain • Usually the biggest source of experience gain • Split between first policy period and renewal business • “Actual” claims vs “Expected” claims • “Expected” claims = premiums + required investment income – expense loads – commission loads - premium tax loads – net profit loads • “Actual” claims = claims paid + actual change in claim reserves

21. Experience Gains and LossesClaim Experience Gain • Refinements for longer term lines of business • Long Term Disability • Incidence gain + Termination gain • DLR portion + IBNR portion + Paid Claim portion • Settlement Gain • Offset Gain • Actual vs expected incidence & termination rates • Life • Mortality Gain + Morbidity Gain • Actual vs expected mortality rate

22. Experience Gains and LossesInvestment Income Experience Gain • “Actual” vs “Expected” investment income • “Actual” = income statement investment income • “Expected” = actual required interest + expected profit from interest • Impact of fair value accounting • Fair value of assets (CICA 3855) vs • Fair value of liabilities (through CALM) • Net market gain (loss) • Mismatch (C3) PfAD

23. Experience Gains and LossesExpense Experience Gain • “Actual” vs “Expected” expenses • “Expected” = expense loads (non-fee income) + required investment income on expense reserves - expected expense gain • “Actual” = income statement expenses (non-fee income) + change in expense reserves

24. Experience Gains and LossesOther Expenses Experience Gain • Commissions experience gain • Premium taxes experience gain • Fee income experience gain • Calculated using same principles as expense gain, except no reserves

25. Other items • Other SOE items can generally be treated same way as for regular life SOE • Of particular interest are: • Changes in assumptions • Other changes and management actions

26. Feedback • Questions or comments?