The issue of profitability is one of many factors relating to why companies entered the market but it is an absolutely central factor in understanding why many of these same companies ultimately exited the market. Clearly, there was a belief that LTC insurance could be priced and managed in a way that assured reasonable returns to companies. The key drivers of profitability are embedded in the underlying pricing assumptions used to develop premiums and are a function of company strategies related to underwriting and claims management, product design, premium structure, inflation adjustment rates, sales and marketing costs and investment strategies. Table 4 shows the key assumptions underlying the pricing of LTC insurance.
|Pricing Parameter||Description||Typical Assumptions|
|Morbidity||The claims that are expected to be paid out based on the specific benefit design of the policy.||SOA Experience reports National public data sources Insured Experience.|
|Mortality||The underlying mortality table employed to determine how long individuals who have policies are expected to live and pay premiums and collect benefits.||Annuitant mortality tables (e.g., 1994, 2000).|
|Interest Rate||Because the product is level-funded, there is a great deal of pre-funding occurring at early durations of policy ownership and this is the rate or return assumed on invested premiums and risk-based capital (RBC).||
1990s: 5% - 8%
2000s: 3% - 5%
Current: 2% - 4%
|Voluntary Lapse Rates||Not all individuals will hold their policies until death. For a variety of reasons people may cease paying premiums. High voluntary lapse rates lead to lower premiums because premium reserves from a lapsed policy are retained by the company without related future claim expenses.||
1990s : 8% first year declining to 4%
2000s: 6% first year declining to 3%
Current: 4% first year declining to 0.5%
|Underwriting Selection Effect||A group that is underwritten tends to be healthier than a non-underwritten group and this has a positive impact on the morbidity.||Claims reductions factors typically wearing off within 5-7 years of policy issue.|
|Acquisition Costs and Administration||These are the costs associated with "producing" and servicing the policy and include marketing and sales expenses (commissions), underwriting, claims management, ongoing policyholder billing and premium collection and other administrative expenses.||Sales costs typically greater than 60% of first year premiums and then leveling out at lower levels. Ongoing policyholder administration and claims management as a fixed per policy fee or percent of premium.|
|Profit||This is the amount of load or additional charge put into the product to assure an adequate return for the insurer.||Profit measures including pre-tax profits, post-tax profits, internal rate of return (IRR), pricing to lifetime loss-ratio.|
Small variations in actual experience compared to expected performance of each of the pricing assumptions can have a major impact on product profitability. In order to demonstrate this, we developed a LTC insurance pricing model that allows us to evaluate the impact of small changes in various pricing assumptions on overall product profitability. Table 5 shows these impacts. Baseline profitability is defined as the addition of a 10% margin on the premium that is generated to cover the present value of all claims and expenses. Thus, the pre-tax profit margin is set at 10% of the premium.
What this model shows, for example, is that if a company assumed that it would be able to earn 6.5% on its reserves, and instead, earned 5.5%, then depending on age, premiums would have to increase between 5% and 10% to maintain the initial 10% level of profitability as defined above. Again, depending on age, if the actual interest rate earned on reserves was 5.5%, compared to the priced interest assumption of 6.5%, then the profit margin would vary between 0.5% and 5.2%. This represents declines in the margin of between 48% and 95%.
|Change in Profit Margin (no change in premium)||Profit Margin (no change in premium)||Required Change in Premium Level to Maintain 10% Profit Level||Premium Needed to Maintain 10% Profit Level||Age||Lapse||Interest||Morbidity||Mortality|
|SOURCE: LifePlans Long-Term Care Insurance Pricing Model, 2012.
Assumptions: 5 year policy; $100/ day; 10% margin; 60% minimum loss-ratio.
Better claims = 10% lower than priced; Worse claims = 10% higher than priced.
Better mortality = 10% higher than priced; Worse mortality = 10% lower than price.
Better lapse = 1 percentage point higher than priced; Worse = 1 percentage point lower than priced & year 7+ ultimate lapse rate of 0.25% versus 0.75%.
As shown, a percentage point difference in the underlying interest rate assumption has a very major impact on underlying profitability. Moreover, the impact is most pronounced at the younger ages. As well, even small errors on multiple assumptions can lead to major changes in the product's underlying profitability. Finally, the assumptions are subject to a wide degree of volatility given changes in the provider landscape, trends in disability rates, macro-economic policy vis-à-vis aggregate interest rates, and other factors. Thus, it is not surprising that given the level-funded nature of this product, along with the long-tail morbidity risk, the product is viewed as inherently more risky than other insurance products, and regulated in a way that requires greater levels of capital to support it.
Noteworthy is the fact that since the late 1990s, all of these major determinants of premium and product profitability have been going in the wrong direction: interest rates are significantly lower than what was priced for, voluntary lapse rates are lower than for any other insurance product, morbidity is somewhat worse than expected and mortality is actually improving. For these reasons, the prior decade saw a major exodus of companies from the market, as returns on the product have been significantly below expectation. More recently, major ratings agencies have highlighted the poor profit results of companies and issued reports cautioning about the future of the industry.44