Research Report. Premium Deficiency Reserve Requirements for Accident and Health Insurance. by Robert W. Beal, FSA, MAAA

2002 Milliman USA All Rights Reserved M I L L I M A N Research Report Premium Deficiency Reserve Requirements for Accident and Health Insurance by Robert W. Beal, FSA, MAAA peer reviewed by Eric L. Smithback, FSA, MAAA

MILLIMAN USA RESEARCH REPORT September 2002

Premium Deficiency Reserve Requirements for Accident and Health Insurance Table of Contents I INTRODUCTION.................................................. 1 PAGE II NAIC MINIMUM RESERVE STANDARDS FOR HEALTH INSURANCE.................. 3 III SSAP 54...................................................... 4 IV NAIC HEATH RESERVES GUIDANCE MANUAL............................... 5 Calculation of Premium Deficiency Reserves................................. 5 Investment Income............................................... 5 Time Period of Calculation........................................... 6 Contract Grouping............................................... 7 Assumptions.................................................. 8 Documentation................................................. 9 V COLORADO REGULATION 3-1-15...................................... 10 Basis and Purpose............................................... 10 Applicability and Scope............................................ 10 Definitions................................................... 10 Calculation of Premium Deficiency Reserves................................. 12 Restrictions and Other Guidelines...................................... 12 VI OUTSTANDING ISSUES............................................. 14 Definition of Contract Groupings....................................... 14 Investment Income.............................................. 14 Period of Deficiency Reserve Calculation.................................. 14 Rate Increases................................................. 15 Conservatism.................................................. 15 VII APPENDIX A: COLORADO REGULATION 3-1-15............................. 16 Premium Deficiency Reserve Standards for Individual and Group Health Benefit Plans.......... 16 September 2002 MILLIMAN USA RESEARCH REPORT

INTRODUCTION The solvency of an insurance company and its ability to meet long-term contractual obligations is the primary focus of statutory accounting principles, and requiring adequate statutory reserves is the principal means of ensuring financial soundness. For Accident and Health (A&H) businesses, statutory reserves include contract reserves, unearned premium reserves, claim reserves, and premium deficiency reserves. For various reasons, premium deficiency reserves for A&H insurance have not received as much attention as the other categories of reserves. A statutory premium deficiency reserve is the excess, if any, of the amount that a gross premium valuation determines is necessary to meet the company s obligations over the company s current statutory reserves. Premium deficiency reserves are required by actuarial practice and by the National Association of Insurance Commissioners (NAIC) Minimum Health Reserve Standard. However, no specific guidance on the calculation of premium deficiency reserves was available. Holding these reserves could often be avoided by grouping A&H policies with other business, or by choosing a projection period that covered both favorable and unfavorable parts of the underwriting cycle. As a result of the Codification of the NAIC statutory accounting principles and the release of a new regulation from the Colorado Division of Insurance, premium deficiency reserves will be receiving increased attention. The new requirements provide more guidance on the calculation of the reserves and may result in their being held more often. Under a requirement contained in the Statements of Statutory Accounting Principles of the NAIC and clarified by the NAIC Health Reserves Guidance Manual, not only must companies evaluate the need for premium deficiency reserves at least annually for all lines of A&H business, but specific guidance is provided on the calculation of the reserves. Colorado is the first state to issue a regulation or law applicable to all individual and group A&H businesses that specifically requires companies to annually test for and set up premium deficiency reserves, if necessary. 1 The Colorado regulation applies to all health insurance, including medical, dental, disability, and long-term care and is effective in 2002. This report discusses the recent developments in premium deficiency reserve requirements from the following sources: NAIC Minimum Health Reserve Standard The NAIC Minimum Health Reserve Standard states that the gross premium valuation is the ultimate test of reserve adequacy. Although premium deficiency reserves are not specifically mentioned in the Standard, the valuation actuary is expected to establish additional reserves if the combined reserves are not adequate, as measured by a gross premium valuation. The Standard is discussed in more detail in Section II of this report. Statement of Statutory Accounting Principle 54 The process of Codification resulted in the NAIC Accounting Practices and Procedures Manual, which is currently comprised of 84 Statements of Statutory Accounting Principles (SSAPs). Additional SSAPs are under consideration. According to the Manual s preamble, it is not intended to preempt states legislative and regulatory authority. Rather, it is intended to establish a comprehensive basis of accounting recognized and adhered to, if not in conflict with state statutes and/or regulations, or when the state statutes and/or regulations are silent. The SSAPs are intended to reflect current, not new, standards, although for many companies they will represent a departure from past practices. 1. There have been premium deficiency requirements that applied to HMOs, such as in Texas. 1 MILLIMAN USA RESEARCH REPORT September 2002

SSAP 54 establishes statutory accounting principles for income recognition and policy reserves for all individual and group A&H contracts covered by the NAIC Minimum Reserve Standard. SSAP 54 states when premium deficiency reserves must be established. SSAP 54 is discussed further in Section III of this report. NAIC Health Reserves Guidance Manual The NAIC A&H Working Group, with assistance from the American Academy of Actuaries, prepared the Health Reserves Guidance Manual (published November 6, 2000) to provide guidance regarding the calculation and documentation of health reserves for statutory financial statements as described in the NAIC s Health Insurance Reserves Model Regulation. Its intended audience consists of (1) actuaries and other parties who estimate reserves for health coverage and (2) examiners who review the statutory financial statements on behalf of regulatory agencies. It outlines the guidance for valuing minimum health reserves based on actuarial principles and standards of practice and provides guidance with respect to claim reserves, contract reserves, provider liabilities and premium deficiency reserves. The treatment of premium deficiency reserves within the NAIC Health Reserves Guidance Manual is discussed in Section IV of this report. Colorado Regulation 3-1-15 Colorado is the first state to develop a regulation applicable to all forms of individual and group A&H insurance that requires companies to annually test for premium deficiency reserves and provides specific guidance for their calculation. Regulation 3-1-15 combines the requirements of SSAP 54 and aspects of the NAIC Health Reserves Guidance Manual. Some definitions and requirements are different or more specific than those provided in either SSAP 54 or the Health Reserves Guidance Manual. Regulation 3-1- 15 is discussed in Section V of this report, and Appendix A provides a complete copy of the regulation. The author identified several issues pertaining to the premium deficiency reserves within these various sources. In some cases, the sources appear to be in conflict with other sources. This report examines these areas within the discussion of each source and covers specific issues in Section VI. In addition to the four sources discussed within this report, a draft of Actuarial Standard of Practice (ASOP) on nonclaim liabilities, including premium deficiency reserves, is currently being developed by the Actuarial Standards Board of the American Academy of Actuaries. Since the draft has not been released, it is not addressed in this report. The regulations discussed in this report apply to statutory reserves and not GAAP reserves. Much of the commentary on these regulations provided in this report reflects the perspective of Life companies and may not be applicable to property and casualty (P&C) companies, HMOs, or Blue Cross/Blue Shield companies. Many aspects of these requirements are subject to interpretation and actuarial judgment and the commentary in this report often expresses the interpretation of the author. Readers are encouraged to consult the referenced sources. September 2002 MILLIMAN USA RESEARCH REPORT 2

NAIC MINIMUM RESERVE STANDARDS FOR HEALTH INSURANCE The NAIC Minimum Reserve Standard for Individual and Group Health Insurance Contracts (also referred to as the Health Insurance Reserves Model Regulation) states the following regarding the adequacy of a company s health insurance reserves: When an insurer determines that adequacy of its health insurance reserves requires reserves in excess of the minimum standards specified herein, such increased reserves shall be held and shall be considered the minimum reserves for that insurer. a prospective gross premium valuation is the ultimate test of reserve adequacy as of a given valuation date. Such a gross premium valuation will take into account, for contracts in force, in a claims status, or in a continuation of benefits status on the valuation date, the present value as of the valuation date of: all expected benefits unpaid, all expected expenses unpaid, and all unearned or expected premiums, adjusted for future premium increases reasonably expected to be put into effect. Such a gross premium valuation is to be performed whenever a significant doubt exists as to reserve adequacy with respect to any major block of contracts, or with respect to the insurer s health business as a whole. In the event inadequacy is found to exist, immediate loss recognition shall be made and the reserves restored to adequacy. Whenever minimum reserves, as defined by these standards, exceed reserve requirements as determined by a prospective gross premium valuation, such minimum reserves remain the minimum reserve requirement under these standards. Adequacy of an insurer s health insurance reserves is to be determined on the basis of all three categories [claim reserves, premium reserves and contract reserves] combined. Effectively, the NAIC Minimum Reserve Standard requires that a company s combined reserves be at least as large as the greater of the amount determined by a prospective gross premium valuation or reserves based on the minimum specified standards. The standards do not specify how frequently a gross premium valuation must be performed, only that it be performed whenever a significant doubt exists as to reserve adequacy with respect to any major block of contracts or the insurer s health business as a whole. Reported statutory reserves are expected to be adequate, which implies that the valuation actuary must regularly monitor the adequacy of the reserves. The NAIC Minimum Reserve Standard is fairly general, and there is enough room for interpretation that different actuaries could derive different reserves for the same coverage. For example, the expression any major block of contracts could be interpreted in many ways. The other three sources covered in this report attempt to give guidance on this phrase as well as other areas that are open to interpretation. 3 MILLIMAN USA RESEARCH REPORT September 2002

SSAP 54 SSAP 54 states the following with respect to reserve adequacy and premium deficiency reserves: Paragraph 18 [ Additional Reserves ] When the expected claims payments or incurred costs, claim adjustment expenses and administrative costs exceed the premiums to be collected for the remainder of a contract period, a premium deficiency reserve shall be recognized by recording an additional liability for the deficiency, with a corresponding charge to operations. For purposes of determining if a premium deficiency exists, contracts shall be grouped in a manner consistent with how policies are marketed, serviced and measured. A liability shall be recognized for each grouping where a premium deficiency is indicated. Deficiencies shall not be offset by anticipated profits in other policy groupings. Such accruals shall be made for any loss contracts, even if the contract period has not yet started. Paragraph 23 [ Reserve Adequacy ] As discussed in [the NAIC Minimum Reserve Standards], a prospective gross premium valuation is the ultimate test of the adequacy of a reporting entity s accident and health reserves as of a given valuation date and shall be determined on the basis of unearned premium reserves, contract or additional reserves, claim reserves (including claim liabilities) and miscellaneous reserves combined; however each component shall be computed separately. Paragraph 34 [ Disclosures ] If a premium deficiency reserve is established in accordance with paragraph 18, [the reporting entity must] disclose the amount of that reserve. If a reporting entity utilizes anticipated investment income as a factor in the premium deficiency calculation, disclosure of such shall be made in the financial statements. Paragraph 18 of SSAP 54 states that premium deficiency reserves are required when the expected claims payments or incurred costs, claim adjustment expenses and administrative costs exceed the premiums to be collected for the remainder of a contract period. This wording was likely drafted from the perspective of a P&C company, since the formula described is not typically used by Life companies. For a Life company, a classical reserve calculation would normally include the current reserves in addition to the future premiums, and the reference to incurred costs would be removed. The statement would then be, Premium deficiency reserves should be set up when the expected claims payments, ending reserves, claim adjustment expenses, and administrative costs exceed the sum of the current reserves and the premiums to be collected for the remainder of a contract period. The wording in the NAIC Health Reserves Guidance Manual and Colorado Regulation 3-1-15 are closer to this statement, and are therefore more appropriate for a Life company. Under SSAP 54, if there is a premium deficiency reserve for any contract grouping, the company must set up an additional reserve equal to the premium deficiency reserve and take a corresponding charge to operations. Further, the company must disclose the amount of that reserve. SSAP 54 states the contracts should be grouped for the purpose of calculating premium deficiency reserves in a manner consistent with how policies are marketed, serviced and measured. These criteria leave room for interpretation by each company. Common practices in defining contract groupings for the various A&H lines of business should emerge over time. The definition of contract groupings is discussed further in Section IV: NAIC Health Reserves Guidance Manual, and Section VI: Outstanding Issues. Paragraph 34 of SSAP 54 refers to utilizing anticipated investment income as a factor in the premium deficiency calculation. The inclusion of the present value of investment income is also mentioned in the NAIC Health Reserves Guidance Manual and Colorado Regulation 3-1-15. As discussed later in this report, these documents may have created some confusion about how to treat investment income in the calculation of premium deficiency reserves. September 2002 MILLIMAN USA RESEARCH REPORT 4

NAIC HEATH RESERVES GUIDANCE MANUAL This section discusses premium deficiency reserves as presented in the NAIC Health Reserves Guidance Manual (the Guidance Manual). Calculation of Premium Deficiency Reserves The Guidance Manual defines premium deficiency reserves as follows: The [premium] deficiency reserve is the sum of: Present value of future paid claims through the end of the deficiency period, Present value of future expenses, and Present value of claim and contract reserves at the end of the deficiency period. Less: Current claim reserves including special large claims reserves, Current contract reserve, Present value of future earned premiums, and Current balance sheet accrual for future expenses. In effect, the premium deficiency reserve is the amount determined necessary from a gross premium valuation less the current contract reserve and claim reserve, where the gross premium valuation is only for the deficiency period. In the above definition, unearned premium reserves are included in the present value of future earned premiums. Presumably, the future expenses are only those through the end of the deficiency period. This definition changes Paragraph 18 of SSAP 54 by including claim reserves along with future premiums and removing the reference to incurred costs. This formula is now a classical reserve calculation used by Life companies. The Guidance Manual states that the premium deficiency reserves should closely correspond to the anticipated risk of the insurer. For group contracts, if a premium deficiency should exist, it typically occurs during a period when rates are guaranteed. The Guidance Manual states that the premium deficiency reserve should be reviewed at least annually and adjusted as necessary. Although neither the NAIC Minimum Health Reserve Standard nor SSAP 54 explicitly specifies the frequency in which such a review should take place, the Guidance Manual emphasizes that valuation actuaries need to perform this review at least annually. Investment Income There appears to be some confusion regarding the treatment of investment income in the Guidance Manual and elsewhere. This may be due to the use of two different types of valuations by Life companies: In a classical reserve calculation, cash flows (not including investment income cash flows) are discounted using a fixed rate of interest. For example, an LTD claim reserve is the present value at the valuation interest rate of the expected claim payments. Investment income is inherent in this calculation, and is not added as a cash flow. In an actuarial appraisal or in cash flow testing, investment income is projected, often using asset modeling that reflects the expected cash flows associated with the actual assets. 5 MILLIMAN USA RESEARCH REPORT September 2002

When the Guidance Manual defines the calculation of deficiency reserves, it appears to refer to a classical reserve calculation, and in this case, the inclusion of investment income is inappropriate. However, since the premium deficiency reserve can be calculated using a cash flow model 2, it adds the following wording: The question has been raised whether it is appropriate to include investment income in the analysis, given the future income streams are also being discounted to the valuation date. It is appropriate, because the future profit or loss is partly dependent on the amount of future investment income, and the present value of that profit or loss must include a discount for the time value of money. This paragraph can be confusing, since it is never made clear what type of valuation is being talked about. The A&H Working Group appears to be suggesting that a cash flow model is appropriate, although the paragraph is unclear, especially since they appear to call for the use of the classical reserve calculation earlier. Because the guidance is unclear, the actuary must decide what is appropriate. Practical considerations suggest that for short-term projections, as would be encountered in typical group medical projections, using classical reserve calculations may be appropriate. For long-term projections, such as for disability income, a cash flow model might be more suitable. What is important is that the method used should be appropriate given the circumstances and the materiality of the block, and the method should only take into account investment income if appropriate. Time Period of Calculation The Guidance Manual states the following regarding the time period of calculation: The valuation date is the beginning of the time period over which to project financial losses from a block of insurance policies for determining a premium deficiency reserve. The ending of the time period is more difficult to determine, and requires a substantial amount of judgment in many cases. Looking at SSAP 54, the NAIC Minimum Health Reserve Standard, and the Guidance Manual, each uses different terminology and apparently conflicting standards for the time period covered by the calculation: SSAP 54 states that the premium deficiency period should be calculated over the remaining contract period. The term contract period is not defined. The NAIC Minimum Health Reserve Standard states that a gross premium valuation should take into account all expected benefits unpaid and all unearned or expected premiums, adjusted for future premium increases reasonably expected to be put into effect. This seems to imply that time beyond the contract period should be included, and therefore doesn t appear to agree with SSAP 54. The Guidance Manual refers to the contract period, but in the calculation of the premium deficiency reserve it uses the term deficiency period. The Guidance Manual recognizes that the Minimum Reserve Standard and SSAP 54 have conflicting definitions. The term contract period is not defined. The term deficiency period is discussed at length, although it is recognized that the actuary s judgment will be necessary to determine the deficiency period in any particular set of circumstances. 2. Also, P&C companies may add investment income on reserves if they are using incurred claims instead of paid claims, and the incurred claims are based on undiscounted claim reserves. September 2002 MILLIMAN USA RESEARCH REPORT 6

There are at least two possible definitions of contract period: The contract period is the longest period of time for which the company is contractually obligated to cover new claims. For individual contracts, this would be to the end of the coverage period, e.g., typically to age 65. For group contracts, this would often mean in perpetuity, since many group contracts are guaranteed renewable and have no limiting age or number of years. The contract period, applicable to group contracts, is to the end of the period for which rates are guaranteed. This definition assumes that the company will raise rates to profitability (or lapse) at the earliest opportunity if it is financially necessary. For group contracts, the contract period would generally be one year in the absence of multi-year rate guarantees. According to the Guidance Manual, the second definition is the one implied by SSAP 54, and it appears to have support in the accounting community. The text of the Guidance Manual generally seems to support use of the first definition, as long as it is reasonable. However, the use of the term deficiency period in the calculation appears to suggest truncating the projection as soon as profitability is restored. The NAIC Minimum Health Reserve Standard appears consistent with the first definition. The Standard suggests that for group contracts, the time period for the premium deficiency reserve may extend beyond the contract period if the company can reasonably expect to obtain premium rate increases at the next renewal date. However, the Guidance Manual cautions, The actuary should consider whether market forces, such as competition, will not permit a block of business to be profitable enough to make up for earlier losses. The Guidance Manual also states, The actuary must consider realistic assumptions regarding lapsation, rate increases, and claims trends. If the company is anticipating future rate increases in its projection of future premiums, the valuation actuary should take into account the impact that the higher rates will have on lapsation and resulting higher claim rates in the premium deficiency reserve calculation. Contract Grouping The Guidance Manual states the following regarding the criteria for defining contract groupings: Premium deficiency reserves should be determined for distinct groupings of policies. Generally, the groupings should reflect how premium rates are developed and applied. This usually will result in groupings by product type and case size. Other criteria that may be considered include (but are not limited to) marketing methods (e.g., direct marketing vs. agent/broker sales), geographical rating areas, and length of rate guarantee periods, to the extent that such criteria materially affect premium rates. Whatever criteria are used, each grouping should be large enough to be material relative to the size of the reporting entity as a whole. In some cases, considerations of similarity and materiality may result in the entire health business being treated as a single grouping. SSAP 54 offers criteria for selecting appropriate contract groupings for the purpose of calculating premium deficiency reserves. Specifically, such groupings should be consistent with how policies are marketed, serviced and measured. In addition, the Guidance Manual mentions the importance of materiality in selecting contract groupings. Considerable actuarial judgment is needed in determining the appropriate contract groupings for each company and its various A&H businesses. 7 MILLIMAN USA RESEARCH REPORT September 2002

Assumptions The Guidance Manual provides guidance with respect to actuarial assumptions pertaining to enrollment, premium rate increases, claim trends, risk sharing arrangements (pertaining to medical providers), expenses, interest rates, and taxes. Enrollment Unlike other reserve calculations that consider only coverage in force at the valuation date, the Guidance Manual states that the premium deficiency reserve calculations should consider the following additional group situations: Any increase or decrease in enrollment under in-force group contracts that is reasonably anticipated to occur after the valuation date; Contracts expected to become effective after the valuation date, for which rate guarantees were made prior to the valuation date; Individuals whose coverage originated under contracts or certificates that were terminated before the effective date, but whose coverage remains in force because of claim status or waiver-of-premium coverage. Taking certain policies or coverages into account that are not effective on the valuation date may be a new practice for many valuation actuaries. Premium Rate Increases The Guidance Manual states that reasonable rate increases and any market and regulatory restrictions should be considered in establishing deficiency reserves. It further states that assumptions for future rate increases should be reasonable in relation to the assumed level of future claim costs. In other words, it is reasonable to assume higher future rate increases if they can be justified by the expected claim costs, subject to market constraints or regulatory restrictions. However, as discussed within the Manual, the valuation actuary should take into account whether marketing pressures will allow the company to implement the projected rate increases, as well as the impact higher rates may have on lapsation and resulting claim costs. Claim Trends The Guidance Manual states that durational wear-off and adverse selection resulting from premium increases and plan design should be considered in setting up deficiency reserves. Expenses The Guidance Manual states the following with respect to assumed expenses: Expenses for any contract grouping should represent a reasonable allocation of all the reporting entity s expenses. If other lines of business can cover overhead expenses, the test for a deficiency and the calculation of the deficiency reserve can be performed using only direct costs. Thus, the company will need to demonstrate how overhead expenses are covered in total if not all contract groupings assume overhead expenses in the calculation of premium deficiency reserves. September 2002 MILLIMAN USA RESEARCH REPORT 8

Presumably, the intention is that expenses will be allocated on a unit cost basis. In some group insurance projections, current practice may be to allocate all expenses, including acquisition related expenses, to the contract groupings. In most situations, however, there would be separate expense units for new business. Since the projection includes only existing business, most new business-related expenses, including marketing costs, will not be included. The Guidance Manual is not clear on this point, although it allows that new business expense may not be applicable to a particular grouping. Interest Rate The Guidance Manual states that the interest rate used in the determination of the present values should be reasonable for the period of deficiency. This suggests that the interest rate should be based on realistic assumptions. No guidance is given on whether it should provide for adverse deviation. Cash flow testing results should help to determine a reasonable interest rate. Taxes The Guidance Manual states that the premium deficiency reserve should be calculated on a pre-tax basis. Pre-tax refers to federal income tax. Premium taxes, including state income taxes, and other licenses and fees should be included in the premium deficiency reserve calculation since they are directly incurred as a result of the insurance coverage. However, a deferred tax asset may result from the establishment of a premium deficiency reserve. This possibility is covered in SSAP 10. Documentation The Guidance Manual specifies that documentation is necessary whether or not premium deficiency reserves are set up. If they are not set up, the valuation actuary needs to document the actuarial tests used to make that determination. If premium deficiency reserves are set up, the Guidance Manual lists certain information that should be documented: Description of the contract groupings Assumptions used in calculating the premium deficiency reserve The time period over which revenues and costs were projected 9 MILLIMAN USA RESEARCH REPORT September 2002

COLORADO REGULATION 3-1-15 This section discusses key definitions and requirements contained in Colorado Regulation 3-1-15. Basis and Purpose The basis of Regulation 3-1-15 is to establish minimum standards for determining when a Premium Deficiency Reserve is necessary, for companies providing individual and group health coverage, and to implement rules for calculating the reserve. Applicability and Scope Regulation 3-1-15 applies to all licensed companies conducting business in Colorado who issue any line of health coverage including, but not limited to, major medical, long-term care, and disability insurance. Each company is required to establish a premium deficiency reserve, if necessary, on each financial statement submitted to the Colorado Division of Insurance. The premium deficiency reserve is in addition to claim and contract reserves, rate stabilization reserves, retroactive premium liabilities, provider reserves, provider withhold or bonus pool reserves, and other reserves not held to specifically make future benefit payments. Definitions A description of certain key definitions in this regulation is provided below. The reader should refer to the full regulation (in Attachment A). Contract Grouping a collection of health benefit contracts with similar benefits, such as comprehensive major medical plans, Medicaid, or small group health benefit plans. Each grouping should be determined in a manner consistent with how policies are marketed, serviced and measured. Generally, the grouping should reflect how the premium rates are developed and applied. The expression marketed, serviced and measured is taken directly from SSAP 54. Additional criteria for defining contract reserves are defined in the regulation s Restrictions and Other Guidelines section, discussed later in this section. Contract Period the period of time for which the company is liable for the provision of benefits as provided in the health benefit contract. This period may include multi-year arrangements. Unlike SSAP 54 and the Guidance Manual, Regulation 3-1-15 explicitly defines the contract period, although the definition is not detailed. Deficiency Period the period of time for which future earned premiums and current reserves are not sufficient to cover future incurred claim payments and expenses. This period may be for the remainder of the contract period and may include future contract periods. Regulation 3-1-15 requires extending the time period of the valuation of premium deficiency reserves beyond the current contract period if further losses are expected. In this respect, it appears consistent with the Guidance Manual, which refers to Present value of future paid claims through the end of the deficiency period, but may not be literally consistent with SSAP 54. In extending the deficiency period beyond the contract period, valuation September 2002 MILLIMAN USA RESEARCH REPORT 10

actuaries should follow the advice of the Guidance Manual by taking into account marketing forces and regulatory constraints regarding any expected increase in renewal rates, as well as the possibility that higher rates may create higher lapsation and anti-selection. Expenses a reasonable allocation, by contract grouping, of the company s expenses (including claims adjustment expenses) reasonably assumed to be incurred in the settlement of the claims to be paid in the deficiency period. Fixed expenses need not be allocated to each contract grouping. These expenses may be allocated as determined by the company and the calculation of the premium deficiency reserve may be performed using the direct costs only. Expenses for functions performed under a management agreement may not be waived and must be considered as part of the company s fixed expenses. The above definition of expenses could be problematic. A literal interpretation would suggest that only expenses related to the settlement of claims should be included. Most likely, the intent of the regulation is to include any expenses related to the contract grouping following the valuation date, including commissions, premium taxes, policy administration, and claims administration. The regulation refers to fixed expenses, whereas the Guidance Manual refers to overhead expenses. These terms are most likely meant to be synonymous. Although there is not an explicit definition of fixed expenses, the intent appears to be that fixed expenses are expenses that are not directly incurred by a contract grouping. Each company may have latitude in deciding which expenses will be treated as direct or fixed, but both the regulation and the Guidance Manual require that all fixed expenses be allocated among the contract groupings, leaving the company with discretion on how to allocate them. Investment Income for purposes of this regulation, any income, dividends, or other earnings that can appropriately be attributable to the contract grouping and the time period for which the calculation is being performed. This income normally can be attributable to earnings from earned premium reserves, reserves for known losses, and reserves for incurred but not reported losses. The regulation defines investment income in a manner similar to the Guidance Manual. Premium Deficiency Reserve a reserve established on the valuation date when it is probable that future premiums and current reserves are not sufficient to pay future claim payments and expenses for the remainder of the deficiency period. This reserve should be reviewed at least annually and adjusted as necessary. Regulation 3-1-15 clearly states that the premium deficiency reserve must be reviewed at least annually. This is consistent with the Guidance Manual. 11 MILLIMAN USA RESEARCH REPORT September 2002

Calculation of Premium Deficiency Reserves According to Regulation 3-1-15, the premium deficiency reserve for each contract grouping must be calculated as the sum of the: Present value of future paid claims through the end of the deficiency period; Present value of future expenses; Present value of the claim and contract reserves at the end of the deficiency period. Less: The claim reserves as of the valuation date, including special large claim reserves; The contract reserves as of the valuation date; The present value of the future earned premiums and appropriate investment income for the deficiency period; and Any current balance sheet accruals for future expenses. The calculation of premium deficiency reserves described above includes the present value of appropriate investment income for the deficiency period. According to the regulation, investment income is normally attributable to earnings from earned premium reserves, reserves for known losses, and reserves for incurred but not reported losses. In Section 6 ( Restrictions and Other Guidelines ), the regulation states that investment income should be reflected as a cash inflow in the calculation. Regulation 3-1-15 continues the confusing treatment of investment income found elsewhere, in that the formula is a classical reserve formula and should not include investment income, but the text requires the inclusion of investment income. It attempts to correct the problem by adding the word appropriate to avoid the double counting of investment income. However, literally complying with the requirements is probably impossible, and so the actuary should be prepared to demonstrate the appropriateness of the methodology used. Restrictions and Other Guidelines This section of Regulation 3-1-15 provides additional clarification and guidance to the regulation. Several of the topics in this section are discussed below: Accuracy Review The regulation states, The premium deficiency reserve must be re-evaluated and adjusted to reflect the losses that have been realized since the previous financial statement, and any deficiencies that have arisen. This requirement means that companies must re-evaluate the experience of each contract grouping in light of the prior reporting period and revise the assumptions, if necessary, for calculating premium deficiency reserves. Assumptions All underlying assumptions (e.g., lapse, interest rate, claim and expense trend, premium increases, and enrollment changes) should be based on company data if possible and other supporting data deemed necessary. Contract Groupings Consistent with the Guidance Manual, Regulation 3-1-15 specifies that each contract grouping should be large enough to be material relative to the size of the company as a whole. The regulation also states that in some cases, consideration of similarity and materiality may result in all health contracts being treated as a single grouping. Thus, the regulation offers the additional considerations of similarity and materiality in determining appropriate contract groupings. September 2002 MILLIMAN USA RESEARCH REPORT 12

Profit Recognition The regulation rephrases a portion of SSAP 54 (Paragraph 18) by stating, under no circumstances may anticipated future profits from contracts in one contract grouping from future renewal periods be used to reduce or mitigate the calculated premium deficiency reserve for prior periods for contracts in a different contract grouping. Although the literal meaning of this sentence may be hard to decipher, presumably Colorado intended something consistent with SSAP 54. Rate Increases Regarding the utilization of anticipated rate increases, the regulation states, if rate increases are on file with the Division of Insurance that increase rates for the new contract period, and these increases will be adequate to cover claims and expenses in the new contract period, the anticipated profits may be used to reduce or mitigate the calculated premium deficiency reserve for prior contract periods. This statement appears to permit inclusion of future profitable periods in the deficiency reserve calculation, despite the definition of a deficiency reserve as covering the period of time for which future earned premiums and current reserves are not sufficient to cover future incurred claim payments and expenses. The requirement that rate increases be on file with the Colorado Division of Insurance is troubling. Almost any individual or group medical product would result in a deficiency reserve, unless the assumption of end-of-year cancellation is used, which may be inconsistent with the Guidance Manual. This seems to be an area where judgment is needed. The regulation reinforces the point discussed in the Guidance Manual that considerable actuarial judgment, including consideration of all pertinent factors, should be incorporated to determine if it is highly probable that these future profits will offset the calculated deficiencies in the valuation period. Documentation Consistent with the Guidance Manual, the regulation also states that the company must maintain adequate documentation as to how the premium deficiency reserve was determined. In addition, comparable documentation is required to explain why a premium deficiency reserve was not necessary. The minimum documentation is specified in the regulation. All such documentation should be made available, upon request, from the Colorado Division of Insurance within 30 days of that request, or within 30 days of the filing date of the financial statements to which the request is directed. 13 MILLIMAN USA RESEARCH REPORT September 2002

OUTSTANDING ISSUES The following issues pertaining to the calculation of premium deficiency reserves are currently unresolved, in the opinion of the author. Definition of Contract Groupings SSAP 54, the Guidance Manual, and Regulation 3-1-15 provide guidance for a company to define appropriate contract groupings. Some of the criteria specifically mentioned in these documents are: Similar benefits Policies that are marketed, serviced, and measured consistently Material relative to the total company Similar case size Geographical area, rate guarantee periods, and marketing methods, to the extent that they materially affect premium rates These criteria allow considerable discretion for companies in selecting contract groupings. A valuation actuary may be inclined to specify fewer rather than more contract groupings in order to minimize the need for establishing premium deficiency reserves. However, the valuation actuaries must be able to justify their selection of contract groupings in light of the given criteria and demonstrate that the contract groupings were not chosen simply to cover the deficiencies of certain groups of policies with the profits from other groups. Common practices in defining contract groupings for the various lines of A&H business should emerge over time. Investment Income As discussed in this report, the various requirements regarding investment income are confusing. This confusion apparently occurred for two reasons: Life companies and P&C companies have different approaches to discounting reserves. Therefore, the treatment of investment income in their projections can be different. Life companies use two methods for determining liabilities, a classical reserve calculation and a cash flow modeling approach. The former implicitly includes investment income, while the latter explicitly includes it, so the formulas differ between approaches. To cover the differing approaches to modeling, several formulas would be needed. The Guidance Manual and Regulation 3-1-15 appear to use a classical reserve calculation formula, but at times appear to be referring to a cash flow model. This is confusing, and results in language that appears to suggest unsound methodologies. Because of the confusion surrounding this issue, the valuation actuary must choose an appropriate methodology and be prepared to demonstrate the appropriateness of the methodology, since no sound approach will literally conform to all the requirements. Period of Deficiency Reserve Calculation The deficiency period is the period of time for which future earned premiums and current reserves are not sufficient to cover future incurred claim payments and expenses. For individual guaranteed renewable (including noncancelable) policies, the deficiency period will most likely be the remaining contract period, which for many such policies continues to a specified age such as 65. September 2002 MILLIMAN USA RESEARCH REPORT 14

For other contracts, particularly group contracts, the deficiency period is less clear. In apparent conflict with SSAP 54 and some auditing practices, the Minimum Health Reserve Standard, the Guidance Manual, and Colorado 3-1-15 require the valuation actuary to project beyond the current contract period if the liability is expected to continue. If the deficiency cannot be eliminated through premium increases, the premium deficiency reserve will be higher than if the calculation were only over the remainder of the current contract period. The Health Minimum Reserve Standard and the Guidance Manual also appear to allow the inclusion of periods after the deficiency period, if based on reasonable assumptions. Rate Increases The Guidance Manual and Colorado 3-1-15 allow the valuation actuary to take into account premium rate increases, even if they result in anticipated future profits. However, in doing so, the valuation actuary must also take into account marketing and regulatory considerations affecting the implementation of future premium increases and the impact of higher lapsation and claim costs resulting from the higher rates. Colorado 3-1-15 also permits only premium rate increases currently on file with the Colorado Division of Insurance to be included in the premium deficiency reserve calculations. This requirement appears to limit the valuation actuary s ability to reflect future premium increases and may be very difficult to comply with. Additional guidance from the Colorado Department of Insurance on this requirement would be helpful. Conservatism It is not clear whether margins for conservatism, either explicit or implicit, should be added by the valuation actuary when performing gross premium valuations for the purpose of assessing the need for and establishing statutory premium deficiency reserves. The preamble to the NAIC Accounting Practices and Procedures Manual states the following regarding the utilization of conservatism in statutory reserves: Paragraph 29, In order to provide a margin of protection for policyholders, the concept of conservatism should be followed when developing estimates as well as establishing accounting principles for statutory reporting. Paragraph 30, Conservative valuation procedures provide protection to policyholders against adverse fluctuations in financial condition or operating results. Statutory accounting should be reasonably conservative over the span of economic cycles and in recognition of the primary responsibility to regulate for financial solvency. Valuation procedures should, to the extent possible, prevent sharp fluctuations in surplus. Subsequent to the preamble, the NAIC Accounting Practices and Procedures Manual specifically requires the use of best estimate reserves. Since this would be a radical departure from current practice for most Life company actuaries, and since the Preamble and the SSAPs are in direct conflict, Life actuaries have generally not changed their methodology and have continued the use of margins for statutory reporting. The Guidance Manual also addresses the need for conservatism in statutory reserves in the section on General Considerations. However, neither the NAIC Accounting Practices and Procedures Manual or the Guidance Manual specifically addresses the need for conservatism in premium deficiency reserves 15 MILLIMAN USA RESEARCH REPORT October 2002

APPENDIX A: COLORADO REGULATION 3-1-15 Premium Deficiency Reserve Standards for Individual and Group Health Benefit Plans Section 1. Authority Section 2. Basis and Purpose Section 3. Applicability and Scope Section 4. Definitions Section 5. Calculation Section 6. Restrictions and Other Guidelines Section 7. Documentation Section 8. Enforcement Section 9. Severability Section 10. Effective Date Section 11. History Section 1. Authority This regulation is promulgated pursuant to the authority of Sections 10-1-108, 10-1-109, 10-3-109, 10-3-208, 10-16-109, and 10-16-220, Colorado Revised Statutes, (C.R.S.) Section 2. Basis and Purpose The purpose of this regulation is to establish minimum standards for determining when a Premium Deficiency Reserve is necessary, for companies providing individual and group health coverage, and to implement rules for calculating the reserve. Section 3. Applicability and Scope This regulation applies to all licensed companies conducting business in the State of Colorado, as defined in Section 4, who issue any line of health coverage including, but not limited to, major medical, long-term care, and disability insurance. Each company is required to establish a Premium Deficiency Reserve, when necessary, on each financial statement submitted to the Colorado Division of Insurance. The Premium Deficiency Reserve is in addition to claim and contract reserves, rate stabilization reserves, retroactive premium liabilities, provider reserves, provider withhold or bonus pool reserves, and other reserves not held to specifically make future benefit payments. A reserve similar to the Premium Deficiency Reserve may also be necessary for other types of contractual arrangements, such as administrative services agreements, or any other health benefit contracts in which the administrative fees or compensation received are not sufficient to cover the expenses for the remainder of the deficiency period. This reserve should be calculated using the procedures outlined in this regulation. Section 4. Definitions A. Claims means, for purposes of this regulation, all amounts payable for losses incurred under the health benefit contract. Company means, for purposes of this regulation, a carrier as defined in Section 10-16-102(8), C.R.S., and includes, but is not limited to, licensed property and casualty insurance companies; licensed life and health insurance companies; non-profit hospital, medical-surgical, and health service corporations; health maintenance organizations; prepaid dental companies; and limited service licensed provider networks. B. Contract Grouping means, for purposes of this regulation, a collection of health benefit contracts with similar benefits, such as comprehensive major medical plans, Medicaid, or small group health benefit plans. Each grouping should be determined in a manner consistent with how policies are marketed, serviced and measured. Generally the groupings should reflect how the premium rates are developed and applied. September 2002 MILLIMAN USA RESEARCH REPORT 16