Inside the Black Box
Aspects of Actuarial Pricing
AcademyHealth
June 8, 2004
John C. Lloyd FSA, MAAA
Reden & Anders, Ltd.
Overview of the Black Box
 Underlying
 End
Concepts - Commercial Insurers
Game
 Predictability and Adequacy for Risks Assumed
 Generation of Surplus

Elements
 Claims Costs: Estimation and Management
 Expenses
 Profit / Surplus
© 2003 Reden & Anders, Ltd.
Pricing and Surplus – Linkages
Premium
Investment
Income
Balance
Sheet
Surplus
Benefits
Solvency
Investment
Expenses
Taxes
Viability
External
Capital
Service
Improvement
Contribution to Surplus
© 2003 Reden & Anders, Ltd.
Conceptual Model – Linkages
Premium
Benefits
75 - 90%
• Predictability
• Frequency Control
• Network Negotiation
Expenses
8 - 15%
• Recovery
• Efficiency
Benefits
Expenses
Profit
Profits
2-10%
• Risk / Reward
• Surplus Goals
© 2003 Reden & Anders, Ltd.
Reasons for Surplus
Solvency
 Minimum amounts of surplus to weather underwriting downturns
 Measured by RBC formula based on industry earnings simulations
Investment
 Multi-year capital investments in products and systems
 Amortize expense over several years
Viability
 Lower premiums for competitive positioning
 Pure R&D
 Mergers, acquisitions, strategic initiatives
© 2003 Reden & Anders, Ltd.
Solvency Surplus Health RBC
Market/Asset
Liability
Management
Risk
H1
Underwriting
Risk
• Asset Devaluation
• Asset Concentration
Credit Risk
H3
Operational /
• Reinsurance
• Capitation
• Receivables
Business Risk
H4
H2
• Admin Risk
• Rapid Growth
• ASO
• Product Specific Risk
• Managed Care Credit
• Rate Guarantees
H0
• Interest in Affiliates
H 0  H1  H 2  H 3  H 4
2
2
2
2
© 2003 Reden & Anders, Ltd.
Pricing - Framework
One-Year
Horizon
 Almost all employer group coverage focuses on a single year
 Prices are reset based on actual and anticipated cost
Pooling
Concept
 Average rate: low-cost individuals cover the catastrophic claim
 “ 80 / 20 Rule” bulk of the cost incurred by a few individuals
 Turnover
 Seldom the same individuals at risk or on claim
 Groups lapse, employees change
 Claimants recover, new accidents and illnesses are incurred
Underwriting
 Used to create and maintain a broad pool of risks
 Can be used to position and entire block of business
© 2003 Reden & Anders, Ltd.
Claims Costs – Pooling Concept
© 2003 Reden & Anders, Ltd.
Claims Costs – Changes over Time
Aging
Broader Coverage
Trend
© 2003 Reden & Anders, Ltd.
Underwriting – Maintaining the Pool
Contractual
Provisions - Eligibility
Rate
for Deviation from Pool – Demographics
Rate
for Deviation from Pool – Industry Factors
Historical
Claims Analysis – Rx; Large Claims
Employee
Medical Underwriting
Predictive
Modeling
Balance between cost, market acceptance, practicality
© 2003 Reden & Anders, Ltd.
Pricing Approaches

Experience Rating / Aggregate Claims Basis
 Historical Claims on Aggregate Year-of-Experience Basis
 Typical of Employer-Based Indemnity Group Insurance

Service Component Basis
 Utilization/1000 times Cost/Unit for Types of Service
 Typical of MCO

Selection-Based
 Anticipated Utilization by Group for Various Options
 Often Used in POS or Consumer-Driven Health Plans
© 2003 Reden & Anders, Ltd.
At Last – Formulas
Experience Rating Premium =
[(Claims t-1 * Cred) + (Pool Claims * (1-Cred)] * (1 + Trend)
(1 - %Expense - % Profit)
Claims:
Historical Claims Cost
 Employer experience if available
 Pool Claims
 Manual Rates (drawn from the broad pool of risk)
 Aggregate block of business claims, often throw out big claims and replace
with pool charge
 Credibility Blending
 Manual Rates or Prior Year Claims
 Credibility based on size of group, may be multiple years
Adjustments
to Resulting Claims Cost
 Benefit Changes
 Demographics
© 2003 Reden & Anders, Ltd.
Experience Rating Formula
[(Claims t-1 * Cred) + (Pool Claims * (1-Cred)] * (1 + Trend)
(1 - %Expense - % Profit)
Claims:
Historical Claims Cost
Adjustments
Expenses
 Recovery of cost of operations
 Can be flat or % of premium – often converted to % anyway
Profit
/ Surplus
Trend
Projection
 Claims Costs: Estimation and Management
 The primary factor in terms of impact and uncertainty
© 2003 Reden & Anders, Ltd.
Service Component Formula


Utilization of Services times Cost/Service
Net Claims Cost is Trended and Expenses/Surplus Loaded
Cost Share:
Flat
Member
Type of
Type of Service
Hospital Inpatient:
Copay
Coins %
Util
Medical
Surgical
Ungroupable
Subtotal Non-MH/SA
Mental Health
Substance Abuse
Subtotal MH/SA
ECF/SNF
Subtotal Hospital Inpatient
Hospital Outpatient:
$200.00
$158.63
$152.18
Days
Days
Days
$153.18
$200.00
Days
Days
$67.26
Days
$50.00
$10.00
$25.00
Visits
Visits
Visits
Visits
Visits
Visits
Emergency Room
OP Lab
OP Radiology
OP Observation
OP Other
OP Surgery
Subtotal Hospital Outpatient
$100.00
Util/
1,000
Cost/
Unit
Gross
Copay
Net
PMPM
PMPM
PMPM
1,155
662
1
1,818
42
4
47
1,002
2,867
$1,172
2,462
1,172
$1,642
592
754
$607
381
$1,184
$112.77
135.81
0.14
$248.72
2.09
0.27
$2.36
31.83
$282.91
$19.24
8.75
0.02
$28.01
0.54
0.07
$0.61
5.62
$34.24
$93.53
127.06
0.12
$220.71
1.55
0.20
$1.75
26.21
$248.67
334
681
688
24
555
329
2,611
$435
74
375
1,014
213
1,199
$12.10
4.22
21.46
2.07
9.84
32.92
$82.61
$1.39
0.57
1.43
0.00
0.00
2.75
$6.14
$10.71
3.65
20.03
2.07
9.84
30.17
$76.47
© 2003 Reden & Anders, Ltd.
Selection-Based Pricing

POS blends In-Network and Out-of Network Versions
Cost Share:
Cost Share:
Flat
Member
Type of
Type of Service
Hospital Inpatient:
Copay
Coins %
Util
Medical
Surgical
Ungroupable
Subtotal Non-MH/SA
Mental Health
Substance Abuse
Subtotal MH/SA
ECF/SNF
Subtotal Hospital Inpatient
Hospital Outpatient:
$200.00
$158.63
$152.18
Days
Days
Days
$153.18
$200.00
Days
Days
Emergency Room
OP Lab
OP Radiology
OP Observation
OP Other
OP Surgery
Subtotal Hospital Outpatient

Util/
1,000
Cost/
Unit
Gross
Copay
Net
PMPM
PMPM
PMPM
1,155
662
1
1,818
42
4
47
1,002
2,867
$1,172
2,462
1,172
$1,642
592
754
$607
381
$1,184
$112.77
135.81
0.14
$248.72
2.09
0.27
$2.36
31.83
$282.91
$19.24
8.75
0.02
$28.01
0.54
0.07
$0.61
5.62
$34.24
$93.53
127.06
0.12
$220.71
1.55
0.20
$1.75
26.21
$248.67
334
681
688
24
555
329
2,611
$435
74
375
1,014
213
1,199
$12.10
4.22
21.46
2.07
9.84
32.92
$82.61
$1.39
0.57
1.43
0.00
0.00
2.75
$6.14
$10.71
3.65
20.03
2.07
9.84
30.17
$76.47
In-Network
$67.26
Days
$50.00
$10.00
$25.00
Visits
Visits
Visits
Visits
Visits
Visits
$100.00
Flat
Member
Type of
Type of Service
Hospital Inpatient:
Copay
Coins %
Util
Medical
Surgical
Ungroupable
Subtotal Non-MH/SA
Mental Health
Substance Abuse
Subtotal MH/SA
ECF/SNF
Subtotal Hospital Inpatient
Hospital Outpatient:
$200.00
$158.63
$152.18
Days
Days
Days
$153.18
$200.00
Days
Days
$67.26
Days
$50.00
$10.00
$25.00
Visits
Visits
Visits
Visits
Visits
Visits
Util/
1,000
Cost/
Unit
Gross
Copay
Net
PMPM
PMPM
PMPM
1,155
662
1
1,818
42
4
47
1,002
2,867
$1,172
2,462
1,172
$1,642
592
754
$607
381
$1,184
$112.77
135.81
0.14
$248.72
2.09
0.27
$2.36
31.83
$282.91
$19.24
8.75
0.02
$28.01
0.54
0.07
$0.61
5.62
$34.24
$93.53
127.06
0.12
$220.71
1.55
0.20
$1.75
26.21
$248.67
334
681
688
24
555
329
2,611
$435
74
375
1,014
213
1,199
$12.10
4.22
21.46
2.07
9.84
32.92
$82.61
$1.39
0.57
1.43
0.00
0.00
2.75
$6.14
$10.71
3.65
20.03
2.07
9.84
30.17
$76.47
Out-of-Network
Movement
Emergency Room
OP Lab
OP Radiology
OP Observation
OP Other
OP Surgery
Subtotal Hospital Outpatient
$100.00
CDHP blends interplay between Priced Options and PCA
Employe
r
PCA
Employee
Options
Employe
r
PCA1
PCA2
Employe
r
PCA3
Employee
Options
PCA
HMO
PPO
Employee
Options
© 2003 Reden & Anders, Ltd.