Solvency Reporting and Pricing Assessment

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Solvency Reporting and Pricing Assessment

• 9 June 2003

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Agenda

• Current challenges for solvency measurement
• Principles of RBC
• Some examples of solvency issues
• An alternative framework

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Measuring solvency in South African Medical
Schemes
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Need for free assets

• Random variations
• Catastrophes
• Individual
• Accumulation
• Pricing inadequacies
• Default by third party
• Membership movements

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Scheme specifics

• Size
• Benefit options
• Number
• nature
• Investment strategy
• Membership characteristics
• Relationships with other parties

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Reserving

• Scheme calculation
• Technical
• Flexible
• Multiple factors
• Statutory minimum
• Accurate
• Conservative
• Simplicity

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Regulations

• 25 of gross contributions
• Historical basis
• Does not include IBNR
• Campagne Report (1957)
• 10 insurers in Germany
• 25 of net premiums plus 1 of reinsurance

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Current challenges (1)

• Risks passed to third parties
• Providers
• Managed care contracts
• Reinsurance
• Role of financial regulation
• Insurance regulation
• MHC Act

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Current Challenge (2)

• Savings contributions
• Role of savings
• Nature of risk
• Bad debt
• Fraud/abuse
• Lack of management

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Current challenges (3)

• Scheme size
• Viability (absolute minimum)
• Statistical predictability
• Number of benefit options

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Influence of Scheme Size
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Current Challenges (4)

• Scheme membership
• Open vs. restricted membership
• Age profile
• Gender differences
• Link to HIV exposure
• Membership changes

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Current Challenges (5)

• Pricing adequacy
• Certification/validation
• Gross contributions are only reference point
• Link to claims experience (at risk) is supported

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Current Challenges (6)

• Contractual arrangements
• Administration
• Managed care
• Reinsurance
• Term and discontinuance provisions

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Current Challenges (7)

• Benefits
• Exposure to large claims
• Limits
• Reinsurance
• Variation in experience
• Benefit management

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Risk Based Capital

• An Alternative Solvency Measure for Medical
  Schemes in South Africa

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Risk Based Capital

• Formula that calculates the minimum amount of
  capital required by a medical scheme.
• Takes into account various categories of risk, as
  appropriate for each scheme.
• Capital required is specific to each scheme and
  reflects its risk profile.

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NAIC Example Risk Categories

•  

• The RBC formula defines 4 risk categories
• Asset Risk
• Affiliates (H0) Other (H1)
• Underwriting Risk (H2)
• Credit Risk (H3)
• Business Risk (H4)

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Asset Risk

• Affiliates (H0)
• Subsidiaries of medical schemes
• Unlikely to be relevant to South African medical
  schemes

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Asset Risk

• Other (H1)
• Decreased asset values leading to a reduction in
  surplus.
• For example
• risk of default of company issuing bonds or
  equity
• reductions in market value in respect of equity
  investment
• concentration of assets.

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Underwriting Risk (H2)

• Unfavourable fluctuations in underwriting results
  
• i.e. contributions will be insufficient to cover
  claims (net of reinsurance) and expenses.
• For example
• inaccurate pricing
• random fluctuations in claims. 

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Credit Risk (H3)

• Creditors, including reinsurers, may default.

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Business Risk (H4)

• variability in administration expenses
• excessive growth risk

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The Calculation

• Using the RBC formula, the capital requirement
  can be reduced by up to a half depending on how
  the risk is distributed.
• The RBC calculation recognises the fact that the
  risk is very remote that surplus will be
  simultaneously reduced by all the risk
  categories.
• The RBC formula reduces the importance of the
  smaller items and increases the importance of the
  biggest items.

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Levels of Capital

• In the US, the levels at which varying degrees of
  intervention is required are as follows
•  
• Mandatory Control Level Assets/RBC lt 70
• Authorised Control Level Assets/RBC 100
• Regulatory Action Level Assets/RBC 150
• Company Action Level Assets/RBC 200

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Levels of Capital

• In the US it is recommended that health insurers
  hold 400 of RBC or the Authorised Control Level.
  
• This will provide the necessary margin should
  experience be worse than expected.
•  
• Similarly, in South Africa, different levels of
  assets relative to RBC will need to be determined
  together with the actions required at each level.

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Aims of RBC in South Africa

• The capital requirement should reflect more
  accurately the different risk structures of
  different medical schemes.
• Simplicity i.e. easy to explain to users.
• Easy to calculate and not too onerous to produce.
• It should be possible to apply objective
  assumptions.

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Aims of RBC in South Africa

• Information used should be readily available.
• The results should be comparable between
  different medical schemes and over time.
• The formula would need to evolve over time we
  need to be aware of the fact that the
  introduction of a new system needs to be done
  gradually and that there should always be room
  for improvement of the formula and principles.

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Priorities

• Pricing inadequacy
• Savings
• Reinsurance
• Next
• Membership nature and changes
• Benefits

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Framework for Solvency Regulation

• Minimum reserve requirement
• Pricing assessment
• Reserving assessment

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Examples of solvency issues
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Hypothetical example

• How does solvency requirement affect required
  contribution increase?
• Category 2002 increase 2003
• Admin 11 25 13.75
• GP 9 12 10.08
• Spec 19 12 21.85
• Dental 6 15 6.90
• Hosp 29 15 33.35
• Meds 27 20 32.40
• Other 9 12 10.08
• TOTAL 110 128.41
• Hence, 16.7 increase due to increase in admin
  and claims cost.

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Hypothetical example

• Solvency example (continued)
• Assume 9 investment returns
• What is contribution required in 2003 to meet 22
  SSM with existing solvency of
• 0 contribution R162.69, i.e. a 47.9 increase
• 8.7 contribution R150.03, i.e. a 36.4 increase
• 17.5 contribution R137.23, i.e. a 24.8
  increase
• I.e. to take solvency up 4.5 (from 17.5 to
  22), we need an increase of 8.1 in excess of
  increase in claim and admin costs (i.e. 24.8
  minus 16.7)

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Hypothetical example

• Solvency example (continued)
• What if scheme doubles membership on 1 January
  2003? Then required increases with existing
  solvency on 31/12/2002 would be
• 0 contribution R162.69, i.e. a 47.9 increase
• 8.7 contribution R156.36, i.e. a 42.1 increase
• 17.5 contribution R149.96, i.e. a 36.3
  increase
• SSM sensitive to membership growth impact
  larger if already higher reserve. Now, to move
  from 17.5 solvency to 22, require increase of
  19.9 in excess of claim and admin cost increases

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Real-life example

• Solvency
• Consider solvency in more detail. E.g. for
  real-life medical scheme, where, in 2002
• Projected solvency at 31/12/2002 11.43
• Admin fee and expenses 12.76
• Investment income 2.9
• Projected claims inflation 11
• Projected membership growth 3
• Projected admin fee increase 11
• Projected investment income increase 15

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Example alternative

• Solvency
• Now consider detailed and complete solvency
  formula
• Compare current solvency requirement against
• One that excludes administration expenses from
  gross contributions in solvency calculation (i.e.
  no margin i.r.o. admin fees), although it is
  included in its effect on accumulated funds
• Plot both as a function of contribution increase
  in 2003

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Example alternative
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Example alternative

• Solvency is an asymptotic function of
  contribution increase i.e. the higher the
  solvency requirement, the greater the increase
  required to improve solvency by 1
• E.g. using current solvency requirement formula
  (blue line)
• Moving solvency from 10 to 11, requires
  contribution increase of 1.39 more
• Moving solvency from 24 to 25, requires
  increase of 2.07 more
• Hence, a scheme that falls behind eventual 25
  requirement, will have trouble to catch up

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Example alternative

• The lines are not parallel
• Hence, if schemes are not required to hold
  solvency margin in respect of admin non-medical
  expenses, members will suffer less when scheme
  has to improve solvency (purple line)
• The same would hold for other elements where
  schemes carries no or minimal risks (reinsurance
  savings), and is even more valid where all
  three of these are removed from the ratio
• Need 26 increase to meet solvency under current
  formula, and 21 where no admin fee in
  calculation

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Example alternative

• Now consider scenario where claims inflation is
  higher than expected (11)
• If claims inflation 20, impact on four lines
  dramatic significantly higher contribution
  increases required
• Then require 42 increase under current solvency
  formula and 36 increase where admin fee removed
  from solvency calculation

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Example alternative
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Example alternative

• Finally consider scenario where claims increase
  as expected (11), but where administration and
  other expenses increase by 20 instead of 11
• Impact on four lines not dramatic at all
• Then require contribution increase of 28 under
  current arrangements and 23 where admin fee
  removed from solvency calculation

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Example alternative
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Example alternative

• In numbers contr to reach 22 solvency
• Description Central Claims Admin
• assumptions overrun overrun
• Current 26 42 28
• No admin 21 36 23
• Hence 9 admin overrun 2 contr impact
• 9 claims overrun 15 -16 contr impact
• Solvency requirement is highly significant driver
  of contribution increases

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Fundamental problems

• Fundamental problems with current solvency
  measure
• the only source of capital to a medical scheme is
  contribution increases. High solvency requirement
  requires high contribution increases. High contr
  increase requires even higher solvency margin!
• Solvency requirement is highly geared for schemes
  who grow or fall behind statutory level (where
  medical inflation gt investment return, always
  falling behind)
• It does not take into account real risks faced by
  scheme, by inclusion of admin fees and savings
• It imposes a double reserving requirement in
  respect of reinsurance
• Risk-based capital should be a priority

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An alternative
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RBC

• Counter-arguments
• It is American and hence not suited to SA
• But currently using a Belgian standard of 1957
• Applied incorrectly
• RBC used in several insurance industries all over
  the world
• Trustees do not understand it
• Give Trustees some credit
• If they cannot understand simple RBC formula, can
  they understand the complex consequences of the
  current solvency requirement?

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RBC

• Practical suggestion
• Entire formula need not be implemented at once
• Gradual move to RBC also helpful
• Start with removing from gross contributions
• Savings
• Administration non-medical expenses
• Reinsurance

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RBC

• Practical suggestion
• Can even make above allowance only for those
  schemes that follow professional certification of
  contribution rates
• But such professional certification should be
  based on professional guidelines subject to
  professional discipline

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RBC

• Practical suggestion
• Critical issue once full SA formula implemented
  what is percentage solvency impact on schemes?
• Formula on its own is not meaningful the level
  at which it is pitched determines whether
  solvency requirement is onerous or not

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RBC

• Notes
• RBC as a concept ltgt American formula
• Current solvency requirements are costing members
  dearly RBC implementation is urgent

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Questions