Critical Illness: Guarantee Issue and the Law of Large Numbers
March 04, 2013| Von Steve Rowley |
Region: North America
Our last blog outlined some of the challenges of multi-life underwriting for Critical Illness in the U.S.. This post focuses more narrowly on the need for required participation levels.
Every multi-life underwriter knows that each group encompasses a multitude of individual characteristics which in combination form a unique entity. It is important to identify and consider all relevant factors in order to perform an adequate analysis. Unfortunately, the underwriter is often presented with information that is neither comprehensive nor specific enough in nature to do so, making it difficult to formulate an appropriate Guarantee Issue offer. That being said, even when the best of information is available, there is no guarantee that a group will perform as anticipated.
Perhaps the most important aspect of Guarantee Issue (GI) risk management is to understand the law of large numbers. The scope of this blog does not permit for a full discourse on probability theory and the law of large numbers, but the goal is to illustrate the principle that large numbers are needed to mitigate the impact of anti-selection so that actual losses will closely approximate expected losses. Despite this generally accepted axiom, much of our industry has migrated to the point of considering “10” (and sometimes fewer) to be a “large number.”
Let’s explore how the “Law of Large Numbers” might apply to Critical Illness insurance in the United States. To do this, we can start with an average group CI premium of $9.94 per $1,000 of benefit and an average face amount of just over $22,000 as reported in the 2012 Gen Re Critical Illness Insurance Market Survey. Under this scenario, the average insured pays an annual premium of $219. If we subtract the 40% needed for commissions, expenses, and profit, we arrive at an average “risk premium” of $131.
In order for our profit objectives to be met, 168 employees need to pay $219 ($131 of which is risk premium) in order to pay a single claim and for the company to pay its commissions, expenses and achieve their profit objective. This is in line with what an insurer might expect if issuing a very large group at 100% participation. Unfortunately, there are very few employer paid CI groups being sold today.
Given that most True Group and Worksite Critical Illness insurance is sold on a voluntary basis, and that even the few employer pay CI groups sold are too small for full credibility, serious consideration must be given to the risk associated with anti-selection. First and foremost, one should understand that living benefits (i.e., CI, LTC, Disability, etc.) generally face greater anti-selection than Life Insurance as the purchaser is also the beneficiary and may have financial gain as a result of the transaction.
A study of basic human behavior suggests that consumers are more apt to buy something when they perceive the value to be greater than the price. Clearly, those individuals who know themselves to be at high risk for a critical illness due to past history of an event, a strong family history of critical illnesses, or a significant pre-disposing history, are more likely to purchase than healthy individuals who have no such factors. As such, it is reasonable to assume that in a voluntary enrollment situation, high risk individuals are far more likely to purchase coverage.
Insurers hedge against this anti-selection risk by requiring an adequate degree of employee participation. The greater the participation level achieved, the greater the number of healthy lives who will enter the pool to mitigate the anti-selective buying behavior of those most likely to purchase.
Guarantee Issue programs make perfect sense for the group and worksite Critical Illness markets. Absent the protective value of simplified or full underwriting tools, the only tool remaining is participation level, which ensures that a sufficient number of healthy risks enter the risk pool so that your block of business will resemble the population on which the critical illness business is priced. Insurers would benefit from ensuring that their risk managers fully understand the risk involved in liberalizing participation requirements.
Check back next month for our blog entry on how underwriters assess which factors are most likely to lead to successful participation levels.