Aging and Interest Rates - The Impact on Long Term Disability Profit
Note: This article is an abbreviated version of one that will appear in Best's Review December 2013 issue.
Pricing long term disability (LTD) policies is complex. Estimating claim costs requires both the data and the expertise to project incidence rates and claim termination rates, as well as Social Security and other offsets. While much time and discussion is given to these topics both within companies and at industry meetings, pricing for workforce aging and low interest rates gets less attention.
The aging of insured lives and interest rate assumptions may not seem related, but they do have one thing in common. Both have known premium impact on several fronts that is not always factored into pricing, leading to earnings pressure. This article discusses the pricing issues associated with both workforce aging and low interest rates, as well as strategies to reflect them in a disability pricing structure.
The American population is getting older and as a consequence, the workforce is aging. Older workers are staying in the workforce longer to make up for retirement investment losses experienced during the Great Recession, to supplement inadequate retirement savings and to maintain employer-sponsored health insurance. In addition, young people are not being hired into the workforce at the same rate as in past years due to the sluggish employment environment.
The impact of workforce aging is broad, but our focus here is LTD pricing. Aging is an issue for both manual and experience rating formulas. Manual rates are formula-driven, where a key input to the formula is the group census. The census consists of individual insured life data: typically age, gender, salary and occupation. The lives on the census are then priced based on their current age and other demographic and plan design information.
If the workforce were in a steady state with respect to age, there would be no pricing problem. But given that insured groups are getting older, aging should be considered in setting manual rates. A common rule of thumb is that employer groups are aging one quarter to one third of a year for every calendar year. An example will illustrate the impact on rates (See figure below).
Example: A quote is requested, with census and plan data provided on July 1, for coverage effective on January 1 of the following year. The census provided is from the previous year end.
In this scenario, the census data used to price the LTD coverage will be a year old once the policy is in force. Using our rule of thumb, the group will be a quarter of a year older when the rates go into effect, as compared to the ages in the current census. In addition, if a typical two-year rate guarantee is offered, the policy should be priced to the mid-point of the rate guarantee period, which in this case is January 1, 2015. By then our group will be a half of a year older. That may not sound like a lot, but with the exception of the youngest and oldest working ages, LTD claim costs increase around 5%–10% per year of age, depending on where you are on the age curve. Pricing a policy 2.5%–5% too low is a direct and significant hit to profitability.
Our example focuses on manual rates, but the same concepts apply to experience rating. Experience rating is usually based on three to five prior years of claim experience, so is an entirely retrospective pricing process. Any expected changes to a group’s future demographics and experience are often not considered in the experience rating formula. Just as with the manual rates, an adjustment should be considered to account for a group’s increased claims due to aging over the rate guarantee period.
In a highly-competitive market, it’s difficult to account for higher expected costs when it’s not standard industry practice; however, it is possible to create advantages by being ahead of the curve and incorporating aging into the rating and underwriting process.
For manually-rated groups, it isn’t practical or cost-effective to underwrite each case individually for aging. Instead, aging can be factored into the manual rate formula using assumptions developed from company and public information. For example, an aging study on the carrier’s exposure data over time can be segmented by industry, geographic area, case size and other variables.
Many experience-rated groups are large enough to base aging assumptions on the group’s own history. Where multiple censuses can be obtained, past aging can be used to help predict future aging and can be priced into the experience rate.
The advantage to this approach is that the cases that sell are in segments where aging assumptions lead to a lower rate than the market, and the pricing will be both competitive and accurate. The reverse is also true. Cases won’t sell where the aging assumption drives the price above the market, so those cases won’t be written at inadequate rates.
If aging impacts are ignored, companies will ultimately still price for them. As the increased cost from insuring underpriced groups works its way through incurred claims, the resulting earnings pressure will lead to higher prices for the block of business as a whole. Rather than implementing a broad-brush rate increase on the entire LTD block, it may be advantageous to take a more surgical approach by addressing aging impacts when cases are priced and sold.
In addition to aging, another source of LTD earnings pressure is low interest rates. Unlike aging, many companies have recognized today’s low interest rate environment in their rate structures, but some carriers’ pricing may not have fully reflected current interest rates.
Interest rates have been low for several years. After slowly drifting down, rates dropped sharply in 2007 and 2008. Rates are now beginning to increase, but remain at historically low levels.
Asset balances backing LTD liabilities are large for well-established companies, and it takes time for lower new money rates to impact portfolio yields. Gen Re research shows that companies are quicker to adjust discount rates for experience-rate formulas than for manual rates. Since several LTD insurers have now lowered valuation discount rates, it makes sense that experience rates are adjusted in a similar way.
An experience rate example will show the impact of lower interest rates on case-level profitability. A rule-of-thumb relationship between interest rates and LTD claim reserves asserts that for every 100-basis-point-decrease in the valuation discount rate, claim reserves increase by 4%–5%. On a typical large LTD case, claim reserves may comprise 70% of incurred claims. Using these averages and assuming an 80% tolerable loss ratio (10% expenses and 10% profit), profit decreases by 25% when interest rates fall by 1% but the claim reserve discount rate is not lowered. This is a simplified example, but illustrates the sensitivity of pricing and profitability to interest rate movements. Manual rates are impacted in a similar way.
Pricing appropriately for LTD interest earnings is crucial since investment income is a key driver of LTD profits, and it may be more important now than ever. Using industry financial data, Gen Re splits companies' earnings into those earned from the core insurance business—risk management, product development, pricing, and so on—and earnings on investments. Gen Re's analysis shows that the LTD industry is currently earning more on investments than it is earning on the core business of insurance. Not only are more profits coming from investments than insurance operations, but investment margin is becoming a much larger share of total profit recent years.
The good news is that pricing for low interest rates is easier for brokers and employers to understand than aging. In fact, it's a dynamic that has affected most companies and individuals beyond the insurance realm.
LTD industry profitability for 2012 was at its lowest level since 2004, according to Gen Re’s Group Disability Profit Studies. Workforce aging and low interest rates, among other things, contributed to this result. Since neither of these phenomena appears to be going away anytime soon, sound pricing and business practice dictate that they both be incorporated into the rate structure as strategically as possible.
For more articles in this publication, view the Table of Contents.