Group life and disability products use a similar premium basis (a rate applied to a unit of exposure linked to salary), but the transition from a premium exposure to an incurred claim amount is quite different. This article compares the products and how their exposure basis and claim processes contribute to volatility and reinsurance decisions.
From exposure to claim
Benefit amounts for group life insurance and disability insurance are both typically a function of employees’ salary. Group life benefits are usually a multiple of annual salary up to a per-person maximum, and premium is paid based on this monthly covered volume. Disability benefits are expressed as a percentage of monthly salary, up to a maximum monthly benefit; premium is paid based on covered monthly salary. While the exposure and premium basis appear similar, the impact of plan maximums and the transition from an exposure basis to claim amount is different.
Group life claim amounts are relatively straightforward: The loss on a covered life is either zero or the face amount. The maximum net loss on any individual covered by a policy is the policy’s plan maximum; similarly, an insurer can limit its net maximum loss with a per-person excess of loss reinsurance program. Plan maximums and excess of loss reinsurance have a direct and obvious impact on the largest individual claim that can be incurred.
An individual covered under a group disability policy will have a known gross monthly benefit, but the actual claim amount will depend on a number of variables, including how long the claimant remains disabled and eligible for benefits. The reserve amount and total incurred loss for a claim will increase rapidly over early durations if a claimant continues to be disabled despite high expected termination rates (Figure 1). The final incurred liability is not known until the claim’s final payment is made. Excess disability reinsurance is available to cover the monthly benefits above a certain gross monthly benefit threshold.
Figure 1: Incurred Disability Losses by Claim Duration
The maximum possible incurred loss for a disability claim is a function of the covered monthly benefit, maximum length of benefit (typically retirement age) and the discount rate. The initial incurred loss—the expected loss given a claim—is a function of the covered monthly benefit, the maximum length of benefit, the discount rate and expected length of disability.
A bumpy ride
For long-term disability, at the claimant level and at the group policy level, actual incurred claims vary substantially from the initial reserve set up. Across a large enough block of business the disabled life reserves should be correct on average, but the ride can sometimes be rough on specific claims and policies, especially when dealing with the largest claims.
To demonstrate, I followed a sample of five of RGA’s largest reinsured LTD claims to see how the reserves developed over time. I also graphed the combined total incurred loss for these same claims (Figure 2). As shown in the graphs, a large reopened or terminated claim can result in a multimillion-dollar swing on our income statement, whereas terminations below what we expected will result in gradual but significant losses over time. In this case, the total incurred losses on these five claims after two years are slightly less than what we initially expected, with periods of slowly bleeding losses followed by large reserve terminations that have a big impact on income.
Figure 2: Sample Volatility of Disabled Life Reserves Over Time – Five Large Claims
Applying excess reinsurance: an example
To demonstrate how the severity of life and disability claims differs by age, I graphed the potential claims from a hypothetical insured across a theoretical career (assuming this person got consistent salary increases every year until age 60). This isn’t a realistic representation of an insured group, but it helps demonstrate how plan maximums and the attachment of excess of loss reinsurance differ between life and disability.
Figure 3: Life Claim Severity, Volatility, and Reinsurance Impact by Age
In the case of life insurance, the face amount, maximum loss and average loss for a claim are equal at any age and increase with salary (Figure 3). There’s a clear point where an insurance company’s per-life losses will be limited by excess of loss reinsurance or by a plan maximum.
Figure 4: Disability Claim Volatility, Severity and Reinsurance Impact by Age
In the case of LTD, the impact of monthly plan maximums or reinsurance on the maximum loss on an individual is less obvious. This example assumes the insured’s initial exposure is below the reinsurance attachment point, but eventually generates reinsured exposure starting at age 50. As the insured’s wages and monthly benefit increase above the reinsurer’s attachment point, the reinsurer takes an increasing share of the claim (Figure 4). Note that with LTD, some of the largest potential claims may not be reinsured (where the monthly benefit is lower but the potential length of benefit is long), though the probability of these claims is very small. The actual shape of this graph will vary based on age and salary distribution—an extreme example with no wage increases would result in a situation where excess reinsurance was equivalent to quota-share reinsurance on a specific claim.
Plan maximums and excess of monthly benefit reinsurance are effective at reducing risks for disability insurance. Our simulation models demonstrate a substantial reduction in the volatility risk (on a present-value basis) and that most of the largest claims will be in the reinsurance layer. However, the impact of reinsurance on individual lives is less obvious, and the best attachment point depends on the salary and age characteristics of covered lives. Some companies find varying their reinsurance attachments by industry—which will have different salary distributions and benefit maximum guidelines—allows for a more effective reinsurance program that covers the riskiest lives. Similarly, multiple classes with different plan maximums may be considered when dealing with risk on insured policies.
A comparison to medical
Group medical insurance offers an interesting contrast to the salary-based life and disability exposure measures. There is little notion of an exposed benefit measure –any person could generate a multimillion-dollar claim. The exposure unit boils down to any covered life, referred to as a member. Since benefit plan maximums are generally not permitted, an insurer and its per-person excess of loss (specific) reinsurer will essentially have the same number of covered lives. To compare with our previous discussion, the variability in claim amounts would seem to have more in common with disability, but the impact of specific excess reinsurance looks more similar to life insurance (a clear maximum loss on any individual).
Former Secretary of Defense Donald Rumsfeld made his famous “unknown unknown” statement regarding uncertainty surrounding military intelligence, but if he were an actuary, his remarks could have referred to life claims as the known known, disability the known unknown, and medical insurance (considering recent regulatory changes) as the unknown unknown. The exposure bases for group life and disability insurance appear similar but offer different challenges for managing volatility.
RGA Group Insurance Insight is published by the Group Reinsurance Teams of RGA Reinsurance. This publication’s mission is to provide news and information to group insurance professionals and to support the group insurance market. The information contained in the articles represents the opinion of the authors and does not necessarily imply or represent the position of the editors or RGA Reinsurance Company. Articles are not intended to provide legal, consulting or any other form of advice. Any legal or other questions you have regarding your business should be referred to your attorney or other appropriate advisor.
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