Module 5: Exercise: ABC Health Insurance

Purpose & Goal

The primary purpose of this exercise is to review and use health claim data and models to
develop an analysis of profits for a block of business. This exercise will allow you to understand
the actuarial models used for reserving and pricing in the health insurance field, and how the
models interact. In addition, you will be able to observe the impact of a change in assumptions.

Your goal is to help the company determine reserve levels and use this information to develop
a recommended premium increase. You will assist management by identifying the risks and
sensitivities associated with the medical trend assumptions.

Your Role
You are an actuarial student in the Actuarial Department of ABC Health Insurance Company. In
your position you are responsible for determining the reserves that your company must hold for
the managed care insurance block of business in the Southeast region. In addition, you are
responsible for preparing a pricing recommendation and profit analysis for this geographical
area.

About ABC Health Insurance

ABC Health Insurance company is a mid-size health insurance company based in the
southeast United States. It sells group managed care insurance products in all regions of the
country. Its target market is mid-size companies with less than 10,000 employees.

The Business Problem

The time frame is early 2006 and ABC needs to determine the reserves levels to be held for
claims incurred in 2005 and prior years. In addition, prices need to be determined for 2007

Your Assignment
As ABC begins to plan for 2007, the Vice President of the Actuarial department, A. Harper, has
asked you to prepare an analysis of projected 2007 profits for the Southeast region. As part of
this analysis you should determine the current level of reserves as well as the prices to charge
in 2007. Since your initial discussion with A. Harper, he has followed up with a memo that
details what should be addressed in the assignment. Included was an Excel spreadsheet
containing multiple worksheets, prepared by the previous actuarial student. A. Harper has
asked you to include your calculations in this Excel file so that a complete package can then be
handed over to management. Read the memorandum and complete all the tasks Harper
describes. When complete, return to the Fundamentals of Actuarial Practice course and use
the facility to upload your completed exercise files.

© 2003 – 2006 Society of Actuaries | SOAFAPMod5Exercise01-01Assignment.doc | Page 1

Memorandum
To: FAP Module 5 Candidate

From: A. Harper
VP Actuarial Department

Subject: Earnings Projections – Southeast Region

Thank you for your continued support in regards to the financial analysis of the Southeast region.

As the 2007 selling season is approaching, ABC needs to determine prices for the Southeast region. The current market is
very competitive so it is important that the prices are set correctly. However, ABC would still like to maintain a 6% target
profit. In addition, the expense area has informed me that they expect selling, general, and administrative expenses to be 10%
of premiums.

For me to understand not just the determination of the current prices but also the risks surrounding them, I would like you to
provide a financial analysis that outlines these risks.

I have already obtained the current normalization factors from underwriting for you to use in this process. Underwriting has
determined that our demographic factor is 1.05, benefit factor is .92, and rating area factor is .99. I have included the models
currently being used for reserving and pricing that you should use in your analysis.

Based upon this information, please provide a written memorandum that addresses or answers the following questions or
issues:

1. A reserve analysis for year end 2005 has not yet been completed. Please review the assumptions and data in the attached
reserve model. Give a recommendation for the final reserve. Include what assumptions you used and why. Also include
details on sensitivity of these assumptions.
2. After the completed claims for 2005 are compiled, determine the 2007 prices using the Trended Claim model that should
be charged in the Southeast markets. Use the information provided above, in the attached pricing model, and final
completed claims (including reserves that you determined in #1). Include a discussion of assumptions used. Please
compare the results from the Trended Claim model to the Trended Premium model. Which results would you
recommend using? How sensitive are the prices to changes in the assumptions?
3. Management is very concerned by the accuracy of the medical trend assumption. What risks are there to our projected
medical trend and what could cause actual to differ from expected?
4. What would happen to 2007 expected profits if the medical trend was 1% higher than expected (use results from #2
above)? What actions could be taken to offset higher than expected medical costs and preserve the initial level of
assumed profit?
5. What are the potential downsides if medical trend was 1% lower than expected?

Your Deliverables
You should prepare two deliverables, a written memo and an enhanced spreadsheet. These are described below.

The Memorandum
After you’ve completed your analysis to arrive at your answers or to address the issues presented above, please write a
memorandum reporting your results. Your memorandum, which you should create in Microsoft Word (or compatible word
processing program), could be organized with the following sections:

• Executive Summary – This section of the memorandum briefly summarizes the issues that we should be most concerned
about and provides background to the reader in a few sentences. It should clearly state your major conclusions. Good
executive summaries state recommended actions to address any outstanding issues and state any outstanding concerns in a
compelling way.
• Introduction – This section of the memorandum expands upon the background offered in the executive summary and may
provide an outline of the remaining sections.

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• Data – This section of the memorandum summarizes data for the readers of actuarial reports.
• Analysis – Methods & Assumptions – This section of the memorandum describes the methods and assumptions used to
generate your results and to develop your observations, conclusions, and recommendations. Questions/issues #1 and #2
should be addressed in this section.
• Conclusions and Recommendations – This section of the memorandum succinctly reiterates the findings of the
memorandum. Questions/issues #3 through #5 could be addressed in this section.

The Enhanced Spreadsheet

The Excel spreadsheet SOAFAPMod5Exercise01-02Pricing&ReservingModel.xls should be used to complete your analysis.
(The appendix on the following page describes each worksheet in this spreadsheet.) As part of you assignment, you should
modify this worksheet to complete your analysis and to generate results to integrate into the data and analysis sections of
your memorandum. (Note that cells highlighted in yellow are parameters you can set. Cells highlighted in pink show the
results or output of the model. Blue boxes provide instructions or contain additional information to help you as you review
the model.) You can add any worksheets you believe would be valuable in the analysis.

Again, thank you for your continued support in the financial analysis of the Southeast region. I look forward to receiving
your results!

© 2003 – 2006 Society of Actuaries | SOAFAPMod5Exercise01-01Assignment.doc | Page 3

 Appendix A: Pricing & Reserving Model Workpapers

SOAFAPMod5Exercise01-02Pricing&ReservingModel.xls file
The Excel spreadsheet, SOAFAPMod5Exercise01-02Pricing&ReservingModel.xls, consists of four worksheets, which are
described below. In all worksheets, any yellow shaded box contains an assumption that can be modified to change the results.

Worksheet 1: Definitions/Abbreviations
Includes definitions for key terms and abbreviations used in other worksheets.

Worksheet 2: Reserving Model

This worksheet steps through the entire reserve process to determine the reserve using a common completion factor model.
You can change any indicator in yellow to see what impact that item (e.g., inventory changes, completion factor choice,
catastrophic claims, etc.) has on reserves. The pink highlighted box at the bottom of the page represents the final result or
output of the model. Blue boxes contain additional information to help you in reviewing the model. (Note: In the Health area
of practice, “inventory” refers to claims in the course of settlement or reported claims that have not yet been paid.)

The first three tables (labeled Step1a – 1c) are given inputs and include paid claims by paid month and month of service,
membership, inventory levels, and catastrophic claims. All claim and inventory information is organized by date of service
and paid or reported month.

Step 2 adjusts the paid claims for catastrophic claims and inventory levels based on the chosen indicators. The claims are
also adjusted for changes in membership. Membership changes will change the total claims expected to be paid out at a
certain time. Step 2 is trying to normalize for the membership changes by putting all paid claim information on a current
membership basis.

Step 3 determines the ratio of paid claims in successive lag months using the information from step 2. For example, what is
the increase in cumulative claims between month 3 and month 4? The information is organized by paid month and incurred
month.

Step 4 calculates the completion factors – which is the inverse of the product of development ratios calculated in step 3.
Completion factors are calculated for 3 month, 6 month, 9 month, and 12 month averages.

Step 5 uses the completion factors calculated in step 4 and paid claims, catastrophic claims, and inventory data from step 1 to
determine fully developed claims. The first month is determined using trends rather than development factors.

Step 6 organizes the total expected claims determined in step 5 by incurral month to view trend patterns. This information,
along with knowledge of future trend changes, is used to determine a base period and trend factor.

Step 7 uses the chosen base period and trend factor to determine the total claims expected for the non-credible incurral
months. The total claims already paid, given in step 1, are then subtracted to determine the reserve for these months.

Step 8 sums the reserve for all incurral months to determine the total reserve held as of December 2005.

Worksheet 3: Pricing Model

This worksheet steps through the pricing process for both the trended claim method and the trended premium method. The
results from the reserve model flow into this worksheet. Items in yellow are items that need to be updated/reviewed to see the
impact each (e.g, experience period, trend, SG&A %, profit %, etc.) has on rate increases. The pink highlighted boxes at the
bottom of the page represent the final results or outputs of the model. Blue boxes contain additional information to help you
in navigating the model. There are 2 different methods represented in this model.

Worksheet 4: Profit Analysis

This worksheet determines the expected profits from the Southeast region. The results from both the reserve model and the
pricing model flow into this worksheet. Items in yellow are assumptions that can be updated to change the results. The final
pricing results are shaded pink at the bottom of the worksheet. You can change any indicator in yellow to see what impact
that item has on expected profits. Results are in the pink box at the bottom of the worksheet.

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