David M. Dillon, FSA, MAAALewis & Ellis, Inc.

Clear as Actuarial MudPremium Deficiency Reserves vs.

Asset Adequacy Testing vs. Contract Reserve Strengthening

Over-Riding Questions

Are the Company’s reserves enough?

How do you know?

What are the testing methods?

Where are extra reserves reported?

Additional Actuarial Liabilitiesó Premium Deficiency Reserves (PDR)ó Premium adequacyó Test of short-term rate sufficiencyó Reasonable or best estimate assumptions

ó Asset Adequacy Analysis (AAA)ó Long-term solvencyó Ultimate test of reserve adequacyó Assumptions satisfy moderately adverse conditions

ó Reserve Strengthening (RS)ó Annual review of prospective reservesó Determine continuing adequacy and reasonableness

Additional Actuarial LiabilitiesMisconceptionsó The loss ratio is really low, so a PDR is not needed.ó Dental products are short term in nature and do not exceed one

year. Therefore, a PDR is not applicable.ó Only need to test blocks with rate guarantees longer than 1 year.ó Since both assets and liabilities are short-term, there are no asset-

liability mismatches. Therefore, liabilities are adequate in light of the assets held.

ó Once reserve factors are developed, they are set in stone.

Regulations and Guidanceó Statutory Accounting Principlesó SSAP #54 – Individual and Group Accident and Health Contractsó AAA – Sections 10, 23 & 25ó PDR – Section 18ó RS – Section 21

ó SSAP Appendix A-010 – Minimum Reserve Standards for Individual and Group Health Insurance Contractó RS – No. 37ó AAA (PDR?) – No. 23 & 24

ó SSAP Appendix A-822 – Asset Adequacy Analysis Requirementsó NAIC Health Annual Statement Instructions - Revised NAIC

Actuarial Opinion Effective 12-31-10ó PDR – Section 5

Regulations and Guidanceó Actuarial Standards of Practiceó No. 7 – Analysis of Life, Health, or Property/Casualty Insurer Cash Flowsó No. 28 – Statements of Actuarial Opinion Regarding Health Insurance Liabilities

and Assets (Revised 2011)ó AAA – Section 3.12

ó No. 22 – Statements of Opinion Based on Asset Adequacy Analysis by Actuaries for Life or Health Insurers (Revised 2011)

ó No. 42 – Determining Health and Disability Liabilities Other Than Liabilities for Incurred Claimsó PDR – Section 2.9, 3.4ó RS – Section 3.3.3

ó Additional Guidanceó NAIC 2007 Health Reserves Guidance Manualó PDR – Section 6

ó Academy 2011 Practice Note – Revised 2010 Actuarial Opinionó Academy 2010 Practice Note – Practices for Contract Reservesó Academy 2007 Discussion Paper - Premium Deficiency Reservesó Academy 2004 Practice Note – Asset Adequacy Analysis

Premium Deficiency Reservesó SSAP #54 – Section 18ó “When the expected claims payments or incurred costs, claim adjustment

expenses and administration 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…”

ó NAIC 2007 Health Reserves Guidance Manualó “A premium deficiency reserve is a reserve that is established when future

premiums and current reserves are not sufficient to cover future claim payments and expenses for the remainder of a contract period.”

ó ASOP NO. 42ó “A liability established when, for a period of time, the value of future

premiums, current reserves, and unpaid claims liability are less than the value of future claim payments and expenses plus anticipated at the end of the period.

PDRs - Issues & Assumptionsó Grouping of Businessó Time Period of Calculationó “Reasonable” Assumptionsó Enrollmentó Premium Rate Increasesó Claim Trendsó Expensesó Interest Rateó Investment Incomeó Taxes

PDRs - Grouping of BusinessDeficiencies shall not be offset by anticipated profits in other policy groupings.

ó SSAP #54ó “..grouped in a manner consistent with how policies are marketed, serviced, and

measured.”ó HRGMó “..reflect how premium rates are developed and applied. This will usually

result in groupings by product type and group size.”ó Other criteria: marketing methods, geographic ratings, guarantee periodsó Materiality.

ó ASOP #42ó “…consider blocks of business in a manner consistent with applicable

financial reporting requirements”ó Characteristics of a block of business may include:ó Benefit typeó Contract typeó Demographic groupingó Length of rate guarantee

PDRs – Time Period of Calculationó SSAP #54ó “..remainder of a contract period.”

ó HRGMó “The ending of the time period is more difficult to determine, and requires a

substantial amount of judgment in many cases.”ó “A deficiency period is defined for any block where the internal calculations result in

a positive result…if the values vary for different periods, the deficiency period is the period with the greatest value.”

ó “..there may be a block of business that renews annually, but for which the premiums are subject to regulatory restrictions…the “contract period” implicitly lasts until the business can be restored to profitability or lapses completely.”

ó “Cancellation of groups in a loss position is technically an option, but may not always be a realistic option in practice. Any assumptions made about cancellation of groups must be justifiable…”

ó ASOP #42ó “The end of the time period is generally the earlier of the contract period or the point

at which the block no longer requires a premium deficiency reserve.”

PDRs – Other Assumptionsó Enrollmentó “Reasonable” assumptionsó Tied to morbidity and should reflect mortality, lapses, and the impact of

expected premium rate increases

ó Premium Rate Increasesó “Reasonable” in relation to the projected claim costs and

regulatory restrictions (by law or by expectation)ó Claim Trendsó Should include durational wear-off and adverse selection

resulting from premium increases

PDRs – Other Assumptionsó Expensesó “Reasonable” allocation of all expensesó May reflect that some expenses not applicable to a specific grouping,

e.g. new business expensesó If other groupings can cover overhead, then the deficiency test can

use direct expensesó Interest Rateó “Reasonable” and consistent based on period of deficiency.

ó Investment Incomeó May reflect investment income that is appropriately attributable.ó Commonly ignored for short-duration products

ó Taxesó PDR calculated on a pre-tax basis

PDRs – Other Considerationsó In-force vs. New Businessó A PDR should consider:ó Contracts in force at the valuation date, including any increase or decrease in

enrollment under group contracts reasonably anticipated to occur after valuation date

ó Contracts expected to become effective after the valuation date, for which rate guarantees were made prior to the valuation date ( e.g. Medicare Advantage plans)

ó Documentationó HRGM and ASOP #41ó Even if a PDR is not required, the testing and results that determined

it was not necessary should be documented.ó Documentation should include:ó Description of groupingsó The rational for the groupingsó LOBs combined due to immaterialityó Changes from prior years

ó All assumptions used in projectionsó Rationale for time periods chosen

PDRs – HRGM CalculationReserve Equalsó Sum of:ó PV of future paid claims thru end of deficiency periodó PV of future expenses & commissionsó PV of claim & contract reserves at end of deficiency period

ó Less the sum of:ó PV of future earned premiumsó Current claim & contract reservesó Current accrual for future expenses

PDR – 2011 Delta Dental Annual Statements24 2011 Annual Statements available via NAIC

CompanyLoss Ratio Expense

Ratio2011 Profit

% 2011 PDR 2010 PDR

1 80.0% 22.7% -2.7% No Yes

2 77.8% 22.9% -0.7% No No

3 85.2% 14.8% 0.0% No No

4 74.2% 25.7% 0.1% No No

5 83.9% 16.0% 0.1% No No

6 83.4% 16.3% 0.3% No No

7 84.5% 14.5% 1.0% No No

8 58.9% 38.7% 2.4% No No

PDR – 2011 Delta Dental Annual Statements

CompanyLoss Ratio Expense

Ratio2011 Profit

% 2011 PDR 2010 PDR

9 79.1% 18.4% 2.5% No No

10 77.8% 19.6% 2.6% No No

11 84.0% 13.3% 2.7% No No

12 79.5% 17.5% 3.0% No No

13 80.9% 15.8% 3.3% No No

14 84.2% 12.3% 3.5% No No

15 81.8% 14.6% 3.6% No No

16 72.3% 22.7% 5.0% Yes No

PDR – 2011 Delta Dental Annual Statements

CompanyLoss Ratio Expense

Ratio2011

Profit % 2011 PDR 2010 PDR

17 82.4% 12.0% 5.6% No No

18 44.2% 49.4% 6.4% No No

19 81.4% 12.0% 6.6% No No

20 83.5% 9.3% 7.2% No No

21 78.9% 13.6% 7.5% No No

22 76.0% 15.9% 8.1% No No

23 80.9% 10.5% 8.6% No No

24 46.4% 43.9% 9.7% No No

PDR – Contract Grouping ExampleUnderwriting Cash Flows

Testing Grouping 2011 2012 2013 2014 2015 2016

PDR Test

Lg Grp Dental

-13 -15 0 1 1 1 15

Sm Grp Dental

20 17 12 10 9 5 -17

Ind Dental -23 -9 -6 -4 0 1 19

Grp Vision 18 15 10 5 4 2 -15

Ind Vision

-8 -10 -5 -2 0 0 17

PDR – Contract Grouping ExampleUnderwriting Cash Flows

Combined 2011 2012 2013 2014 2015 2016PDR

Report

All -6 -2 11 10 14 9 2

Underwriting Cash Flows

Combined2011 2012 2013 2014 2015 2016

PDR Report

Grp – D&V 25 17 22 16 14 8 0

Ind –D&V -31 -19 -11 -6 0 1 36

PDR – Contract Grouping ExampleUnderwriting Cash Flows

Combined2011 2012 2013 2014 2015 2016

PDR Report

Dental –G&I

-16 -7 6 7 10 7 7

Vision –G&I 10 5 5 3 4 2 0

PDR – Contract Grouping ExampleUnderwriting Cash Flows

All Separate2011 2012 2013 2014 2015 2016

PDR Report

Lg Grp Dental

-13 -15 0 1 1 1 15

Sm Grp Dental

20 17 12 10 9 5 0

Ind Dental -23 -9 -6 -4 0 1 19

Grp Vision 18 15 10 5 4 2 0

Ind Vision

-8 -10 -5 -2 0 0 17

PDR – Projection Period ExamplesYear UW G/L PDR Prior YE

2012 -15 15

2013 3 0

2014 8 0

2015 12 0

2016 8 0

Year UW G/L PDR Prior YE

2012 -15 18

2013 -3 3

2014 8 0

2015 12 0

2016 8 0

PDR – Projection Period ExamplesYear UW G/L PDR Prior YE

2012 -15 69

2013 -15 54

2014 -14 39

2015 -13 25

2016 -12 12

Year UW G/L PDR Prior YE

2012 1 2

2013 -3 3

2014 2 0

2015 4 0

2016 2 0

Asset Adequacy Analysisó Statutory Accounting Principlesó SSAP #54 – Individual and Group Accident and Health Contractsó Section 25 (b)– Additional reserves required based on asset adequacy analysis as discussed in

Appendix A-822ó Actuarial Standards of Practiceó No. 28 – Statements of Actuarial Opinion Regarding Health Insurance Liabilities

and Assets (3.12)ó “This standard does not obligate the actuary to undertake evaluation of the adequacy of the

assets supporting the stated liability amount except as may be needed to comply with any applicable law, regulatory requirement, or other ASOP.”

ó “Guidance on statements of opinion based on asset adequacy analysis is provided in ASOP No. 22”

ó No. 22 – Statements of Opinion Based on Asset Adequacy Analysis by Actuaries for Life or Health Insurers (pg. v)ó “Actuaries performing work for health benefit plans such health insurers, health service

plans, and HMOs should note that this standard potentially applies to each of these types of plans. Applicable law will determine for which of these types of plans an appointed or qualified actuary is required to submit a statement of actuarial opinion based on asset adequacy analysis subject to this standard.”

AAA – Methodsó ASOP No. 22 - 3.3.2 Analysis Methodsó “A number of asset adequacy analysis methods are available to, and

used by, actuaries. The most widely used method is cash flow testing (see ASOP No. 7). Cash flow testing is generally appropriate where cash flows of existing assets, policies, or other liabilities may vary, or where the present value of combined asset, liability, or other cash flows may vary under different economic or interest-rate scenarios.”ó “Asset adequacy analysis test methods other than cash flow testing

may be appropriate in other situations... These methods would test moderately adverse deviations in the actuarial assumptions, except for the investment rate-of-return assumptions.”

AAA – Methodsó ASOP No. 22 - 3.3.2 Analysis Methodsó Gross Premium Valuationó A gross premium valuation may be appropriate where the policy and

other liability cash flows are sensitive to moderately adverse deviations in the actuarial assumptions underlying these cash flows, but are not sensitive to changes in interest rates.

ó Loss Ratio Methodsó For short-term health insurance business that tends to be supported by

short-term assets, loss ratio methods may be appropriate.

ó Demonstration of Extreme Conservatismó Risk Theory Techniquesó Product Design Limitations

AAA – Moderately Adverse Conditionsó ASOP No. 22 - 2.15ó Conditions that include one or more unfavorable, but not

extreme, events that have a reasonable probability of occurring during the testing period.

ó Examplesó 10% increase in lapseó 10% increase in morbidityó 5% increase in lapse & 5% increase in morbidityó Stochastic simulation where reserves are adequate 75-80%.

AAA – Measures of Reserve Adequacyó Present value of ending surplusó PDR-like calculationó Sum of:ó PV of future paid claims thru end of deficiency periodó PV of future expenses & commissionsó PV of claim & contract reserves at end of deficiency period

ó Less the sum of:ó PV of future earned premiumsó Current claim & contract reservesó Current accrual for future expenses

AAA – Differences versus PDRó Grouping of Businessó More aggregation typically allowed since Actuarial Opinion is based on

aggregate ó ASOP No. 22 – 3.4.5ó “…the actuary may offset deficiencies in one business segment with sufficiencies in

another business segment for the purposes of reporting and documenting the results of testing. The actuary should review applicable law regarding the aggregation of results.”

ó Time Periodó Typically 20-30 yearsó ASOP No. 22 – 3.3.4ó “Asset adequacy should be tested over a period that extends to a point at which, in the

actuary’s professional judgment, the use of a longer period would not materially affect the analysis.”

ó Assumptionsó Moderately Adverse vs. Reasonable

AAA – 2011 Delta Dental Annual Statementsó CFT was not necessary and not performed, due to the high

degree of liquidity of the asset portfolio and the short duration nature of dental claim liabilities (1 Incidence)ó I have not examined the company’s assets, and have formed

no opinion as their validity or value (2 incidences)ó Silent (All others)

Reserve Strengthening

ó Use GPV to determine if needed

ó Recalculate Contract Reserves using new assumptions regarding claim costs, terminations, etc.

Reportingó PDRó Blue Bookó Exhibit 6ó Line 2 – Additional contract reservesó Line 3 – Additional actuarial reserves – Asset/Liability analysis

ó Orange Bookó U&I Exhibit 2Dó Line 2 – Additional policy reservesó Line 5 – Aggregate write-ins for other policy reserves

ó Notes to Financial Statements 30.

Reportingó AAAó Blue Bookó Exhibit 6ó Line 3 – Additional actuarial reserves – Asset/Liability analysis

ó Orange Bookó U&I Exhibit 2Dó Line 2 – Additional policy reservesó Line 5 – Aggregate write-ins for other policy reserves

ó Reserve Strengtheningó Blue Bookó Line 2 – Additional contract reservesó Notes to financial statements 2.

Testing – When to do wható Considerationsó Product line groupingsó PDR typically by lineó AAA in aggregate (within reason)ó RS typically by line

ó Tax deductibilityó PDRs not tax-deductible, ó Title 26 Section 807 (d)ó Title 26 Section 816 (h)

ó Additional contract reserves generally are tax-deductible with 10-year spreadó Title 26 Section 807 (f)

Testing – When to do wható Considerationsó Tax deductibilityó Asset Adequacy Reserves - ?ó Title 26 Section 807 (d) (6)

o The term “statutory reserves” means the aggregate amount set forth in the annual statement with respect to items described in section 807(c).

o AAA reserves not mentioned in (c)ó Title 26 Section 816 (c) (3)

o all other insurance reserves required by law.ó Title 26 Section 816 (h)

o For purposes of this section…, the terms “life insurance reserves”and “total reserves” shall not include deficiency reserves.

ó Generally considered non-tax deductibleó CONSULT WITH TAX EXPERT!

Testing – When to do wható Considerationsó Flexibilityó Change in valuation more permanentó PDR and AAAó Amortized ó Typically calculated more frequentlyó Flexibility in assumptions