Rick Leavitt, Smith GroupRick Leavitt, Smith GroupSteve Rulis, Munich American ReSteve Rulis, Munich American Re

Session 103F: Group Disability ForumSession 103F: Group Disability ForumAnaheim Spring MeetingAnaheim Spring Meeting

May 21, 2004May 21, 2004

Modeling Alternative Pricing Modeling Alternative Pricing StrategiesStrategies

Modeling Alternative Pricing Modeling Alternative Pricing StrategiesStrategies

OutlineOutlineOutlineOutline

Rationale for ModelRationale for Model

Model ConstructionModel Construction

•New Sale DynamicsNew Sale Dynamics

•Renewal DynamicsRenewal Dynamics

Model OutputModel Output

Questions and DiscussionQuestions and Discussion

LTD Pricing IssuesLTD Pricing IssuesLTD Pricing IssuesLTD Pricing Issues

Manual Rate VarianceManual Rate Variance

Carriers Buying Market ShareCarriers Buying Market Share

Underwriting CycleUnderwriting Cycle

Short Term versus Long Term StrategiesShort Term versus Long Term Strategies

Pricing Slow to Respond to Risk DynamicsPricing Slow to Respond to Risk Dynamics

Manual Rate VarianceManual Rate VarianceManual Rate VarianceManual Rate Variance

0

0.5

1

1.5

2

2.5

0 0.5 1 1.5 2 2.5Average Rate

Car

rier

Rat

e

Pricing Model AssumptionsPricing Model AssumptionsPricing Model AssumptionsPricing Model Assumptions

7 to 10 Carriers on Every Quote7 to 10 Carriers on Every Quote

All Manual Rates are Equally ValidAll Manual Rates are Equally Valid

Level of discounts determined by other quotesLevel of discounts determined by other quotes

All Sales Reps are equally proficientAll Sales Reps are equally proficient

New Case AssumptionsNew Case AssumptionsNew Case AssumptionsNew Case Assumptions Carriers more than 25% above the lowest rate have Carriers more than 25% above the lowest rate have no chance for saleno chance for sale

All Carriers within 5% of the lowest rate have equal All Carriers within 5% of the lowest rate have equal chance for sale chance for sale

Carriers between 5% and 25% above the lowest rate Carriers between 5% and 25% above the lowest rate have a diminishing chance of sale have a diminishing chance of sale

Carrier Rates are distinguished by three parametersCarrier Rates are distinguished by three parameters

Aggregate levelAggregate level

Variance of RateVariance of Rate

Maximum Discount AllowedMaximum Discount Allowed

New Sale: Price ElasticityNew Sale: Price ElasticityNew Sale: Price ElasticityNew Sale: Price ElasticityMaximum Discount 20%Std Dev of Rates 10%

Manual Rate

MarginClose Ratio

Sold Discount

Sold Rate Margin

15% 2.7% 11.0% 0.3%

13% 3.2% 10.5% -1.4%

10% 3.8% 10.0% -3.3%

8% 4.4% 9.2% -4.7%

5% 4.9% 8.7% -6.3%

2% 5.6% 8.0% -8.1%

0% 6.2% 7.2% -10.0%

-3% 6.9% 6.8% -12.0%

-5% 7.8% 5.8% -14.5%

-8% 8.6% 5.2% -16.5%

-10% 9.6% 4.4% -19.0%

-13% 10.8% 3.8% -21.8%-15% 12.0% 3.2% -24.1% -25.0%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

-15% -10% -5% 0% 5% 10% 15%

Manual Rate Margin

Close Ratio

Sold Discount

Sold Rate Margin

New Sale: Price ElasticityNew Sale: Price ElasticityNew Sale: Price ElasticityNew Sale: Price ElasticityManual Rate Margin 5%Std Dev of Rates 10%

Maximum Discount

Close Ratio

Sold Discount

Rate Margin

0% 2.8% 0.0% -1.2%

5% 3.2% 2.0% -2.0%

10% 3.8% 4.1% -3.8%

15% 4.3% 6.5% -4.8%

20% 4.9% 8.7% -6.5%

25% 5.5% 10.9% -8.0%

30% 6.1% 12.9% -9.4%

35% 6.6% 14.8% -11.0%40% 7.1% 16.4% -12.3%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

0% 5% 10% 15% 20% 25% 30% 35% 40%

Maximum Discount

Close Ratio

Sold Discount

Sold Rate Margin

New Sale: Price ElasticityNew Sale: Price ElasticityNew Sale: Price ElasticityNew Sale: Price ElasticityManual Rate Margin 5%Maximum Discount 20%

StdDev of Rates

Close Ratio

Sold Discount

Rate Margin

0% 4.6% 10.6% -1.8%

5% 4.7% 10.2% -3.1%

10% 4.9% 8.7% -6.5%

15% 5.4% 6.7% -12.7%

20% 7.2% 4.6% -23.6%

25% 9.1% 3.0% -33.1%

30% 10.7% 2.4% -38.0%

35% 12.1% 1.9% -42.1%40% 12.7% 1.7% -44.4%

-50.0%

-40.0%

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

0% 5% 10% 15% 20% 25% 30% 35% 40%

Standard Deviation of Rates

Close Ratio

Sold Discount

Sold Rate Margin

New Sale: Price ElasticityNew Sale: Price ElasticityNew Sale: Price ElasticityNew Sale: Price Elasticity

0% 5% 10% 15% 20% 25%

0% 2.5% 0.6% -4.2% -12.4% -19.4% -25.9%

5% 1.3% -0.2% -5.0% -11.8% -19.8% -26.0%

10% 0.1% -1.2% -5.5% -11.6% -18.2% -24.8%

15% -1.0% -2.5% -5.4% -11.6% -17.4% -23.1%

20% -2.7% -3.8% -6.6% -11.3% -18.8% -23.6%

25% -4.0% -4.9% -6.8% -11.8% -17.6% -24.3%

Sold Rate Margin with Manual Rate Margin set to Produce a 7% Close Ratio

Standard Deviation of Rates

Maxim

um

Discou

nt

Renewal ModelRenewal ModelRenewal ModelRenewal Model

Some Cases will take almost any rate increaseSome Cases will take almost any rate increase

Some Cases will leave regardless of renewal actionSome Cases will leave regardless of renewal action

Incumbent has a rate advantage at time of sale Incumbent has a rate advantage at time of sale

Assumptions:Assumptions:

•95% Attrition95% Attrition

•Cases not shopped if increase is less than 5%Cases not shopped if increase is less than 5%

•25% cases are not shopped at any increase25% cases are not shopped at any increase

•Incumbent has 20% rate advantageIncumbent has 20% rate advantage

Renewal ModelRenewal ModelRenewal ModelRenewal Model

IncreasePct Not Shopped

Shopped Persist

Total Persist

0% 100% 53% 93%

5% 100% 25% 93%

10% 86% 24% 83%

15% 76% 25% 78%

20% 67% 27% 73%

25% 58% 28% 68%

30% 40% 27% 58%

0%

20%

40%

60%

80%

100%

120%

0% 5% 10% 15% 20% 25% 30%

Increase

Percent not Out to Bid

Persistency on Cases Out to Bid

Total Persistency

10-Year Simulation10-Year Simulation10-Year Simulation10-Year Simulation

Fixed General Assumptions:Fixed General Assumptions:

•Consider Start-up BlockConsider Start-up Block

•No Change in Risk Dynamics over TimeNo Change in Risk Dynamics over Time

•2% Annual Growth in Available Employers2% Annual Growth in Available Employers

•Other Carriers follow a Stable Pricing PhilosophyOther Carriers follow a Stable Pricing Philosophy

Test Assumptions:Test Assumptions:

•Manual Rate MarginManual Rate Margin

•Manual Rate VarianceManual Rate Variance

•Maximum DiscountMaximum Discount

•Target Increase on RenewalTarget Increase on Renewal

•Rate GuaranteesRate Guarantees

•Maximum Number of Rate IncreasesMaximum Number of Rate Increases

Scenario 1: On Target Pricing Scenario 1: On Target Pricing No Rate Increase on RenewalNo Rate Increase on Renewal

Scenario 1: On Target Pricing Scenario 1: On Target Pricing No Rate Increase on RenewalNo Rate Increase on Renewal

YearClose Ratio Persist Gain Premium Growth 1-Persistency

1 4.1% 9.7% 2,495K2 3.7% 97.6% 9.7% 4,583K 83.7% 2.4%3 3.6% 95.9% 9.9% 6,800K 48.4% 4.1%4 3.7% 93.2% 10.0% 8,943K 31.5% 6.8%5 3.7% 96.0% 9.9% 11,191K 25.1% 4.0%6 3.5% 94.7% 10.0% 13,020K 16.4% 5.3%7 3.7% 94.2% 10.0% 15,022K 15.4% 5.8%8 3.8% 95.3% 10.0% 16,914K 12.6% 4.7%9 3.8% 95.2% 10.0% 19,101K 12.9% 4.8%

10 3.7% 94.2% 9.9% 20,700K 8.4% 5.8%

0%

2%

4%

6%

8%

10%

12%

1 2 3 4 5 6 7 8 9 10

Year

0M

5M

10M

15M

20M

25M

Close Ratio1-PersistencyGainPremium

Scenario 2: Modest Acquisition – Breakeven Scenario 2: Modest Acquisition – Breakeven Pricing, 10% increase on renewals (Max of 3)Pricing, 10% increase on renewals (Max of 3)Scenario 2: Modest Acquisition – Breakeven Scenario 2: Modest Acquisition – Breakeven

Pricing, 10% increase on renewals (Max of 3)Pricing, 10% increase on renewals (Max of 3)

YearClose Ratio Persist Gain Premium Growth 1-Persistency

1 7.9% -0.9% 3,619K2 7.3% 91.7% 1.9% 6,778K 87.3% 8.3%3 7.3% 83.7% 4.3% 9,546K 40.8% 16.3%4 7.5% 86.4% 6.6% 12,865K 34.8% 13.6%5 7.5% 81.4% 7.9% 14,222K 10.5% 18.6%6 7.6% 79.1% 8.0% 15,738K 10.7% 20.9%7 7.4% 77.9% 8.3% 16,192K 2.9% 22.1%8 7.4% 75.4% 7.7% 16,696K 3.1% 24.6%9 7.4% 80.7% 7.9% 18,101K 8.4% 19.3%

10 7.6% 81.5% 8.1% 18,910K 4.5% 18.5%

-5%

0%

5%

10%

15%

20%

25%

30%

1 2 3 4 5 6 7 8 9 10

Year

0M

5M

10M

15M

20M

25M

Close Ratio1-PersistencyGainPremium

Model Variance: 1000 simulationsModel Variance: 1000 simulationsModel Variance: 1000 simulationsModel Variance: 1000 simulations

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

60M 80M 100M 120M 140M

Premium

Gai

n

Gain: Standard Deviation = 15.8%

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

-40% -30% -20% -10% 0% 10% 20% 30% 40%

Premium: Standard Deviation = 4.9%

0

0.05

0.1

0.15

0.2

0.25

-40% -30% -20% -10% 0% 10% 20% 30% 40%

Scenario 3: Aggressive Acquisition – Priced at Scenario 3: Aggressive Acquisition – Priced at a Loss, 20% increase on renewals (Max of 2)a Loss, 20% increase on renewals (Max of 2)

Scenario 3: Aggressive Acquisition – Priced at Scenario 3: Aggressive Acquisition – Priced at a Loss, 20% increase on renewals (Max of 2)a Loss, 20% increase on renewals (Max of 2)

YearClose Ratio Persist Gain Premium Growth 1-Persistency

1 10.4% -5.7% 4,558K2 10.1% 85.6% -2.2% 8,191K 79.7% 14.4%3 10.2% 74.2% 0.4% 10,853K 32.5% 25.8%4 10.2% 73.3% 2.1% 13,223K 21.8% 26.7%5 9.8% 69.3% 2.6% 13,741K 3.9% 30.7%6 10.2% 72.8% 2.9% 14,666K 6.7% 27.2%7 10.0% 71.5% 3.1% 15,787K 7.6% 28.5%8 10.2% 70.1% 2.3% 16,309K 3.3% 29.9%9 10.2% 70.9% 1.9% 16,830K 3.2% 29.1%

10 10.0% 72.0% 1.5% 17,663K 5.0% 28.0%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

1 2 3 4 5 6 7 8 9 10

Year

0M

5M

10M

15M

20M

25M

Close Ratio1-PersistencyGainPremium

Scenario 4: Moderate Acquisition Pricing – Scenario 4: Moderate Acquisition Pricing – Two rate increases limited to 5%Two rate increases limited to 5%

Scenario 4: Moderate Acquisition Pricing – Scenario 4: Moderate Acquisition Pricing – Two rate increases limited to 5%Two rate increases limited to 5%

YearClose Ratio Persist Gain Premium Growth 1-Persistency

1 7.0% 2.3% 3,533K2 6.5% 94.9% 3.7% 6,608K 87.0% 5.1%3 6.6% 93.5% 5.0% 10,095K 52.8% 6.5%4 6.3% 88.8% 6.3% 13,194K 30.7% 11.2%5 6.5% 90.9% 7.3% 15,552K 17.9% 9.1%6 5.6% 88.9% 8.5% 17,450K 12.2% 11.1%7 5.0% 86.5% 9.3% 18,485K 5.9% 13.5%8 5.2% 88.4% 9.9% 19,914K 7.7% 11.6%9 5.2% 86.6% 10.4% 21,002K 5.5% 13.4%

10 5.0% 89.0% 10.8% 22,226K 5.8% 11.0%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1 2 3 4 5 6 7 8 9 10

Year

0M

5M

10M

15M

20M

25M

Close Ratio1-PersistencyGainPremium

Scenario 5: Classic Underwriting CycleScenario 5: Classic Underwriting CycleScenario 5: Classic Underwriting CycleScenario 5: Classic Underwriting Cycle

YearClose Ratio Persist Gain Premium Growth 1-Persistency

1 10.4% -5.1% 4,437K2 10.0% 94.1% -5.9% 8,171K 84.1% 5.9%3 9.9% 95.5% -3.5% 12,587K 54.0% 4.5%4 3.3% 87.3% 5.8% 12,792K 1.6% 12.7%5 3.2% 76.1% 12.2% 11,461K -10.4% 23.9%6 3.3% 72.7% 14.9% 10,059K -12.2% 27.3%7 8.7% 75.2% 7.0% 11,975K 19.0% 24.8%8 8.6% 85.3% 4.4% 15,157K 26.6% 14.7%9 8.5% 88.5% 3.8% 17,957K 18.5% 11.5%

10 5.1% 84.6% 7.1% 18,966K 5.6% 15.4%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

1 2 3 4 5 6 7 8 9 10

Year

0M

5M

10M

15M

20M

25M

Close Ratio1-PersistencyGainPremium

Scenario ComparisonScenario ComparisonScenario ComparisonScenario Comparison

Annual Premium

0M

1M

1M

2M

2M

3M

1 2 3 4 5 6 7 8 9 10Years

TargetBreakevenAggressiveModerate AcquisitionUnderwriting Cycle

Sold Margin

-6%

-1%

4%

9%

14%

19%

1 2 3 4 5 6 7 8 9 10Years

TargetBreakevenAggressiveModerate AcquisitionUnderwriting Cycle

Scenario Comparison: Results from Years 6-10Scenario Comparison: Results from Years 6-10Scenario Comparison: Results from Years 6-10Scenario Comparison: Results from Years 6-10

1 Priced at Target: No increase on renewal 5 Underwriting Cycle2 Priced at break even: 10% increase on renewal 6 Increasing Rates3 Priced at a loss: 20% increase on renewal 7 Decreasing Rates4 Initially priced below target: 5% increase on renewal 8 Low rates

0%

2%

4%

6%

8%

10%

12%

70M 75M 80M 85M 90M 95M 100M 105M 110M 115M 120M

5 Yr Premium

5 Y

r G

ain

4

6

3

2

5

17

8

Impact of Rate GuaranteeImpact of Rate GuaranteeImpact of Rate GuaranteeImpact of Rate Guarantee

Annual Premium

0M

5M

10M

15M

20M

25M

1 2 3 4 5 6 7 8 9 10Years

1 Yr Guarantees

2 Yr Guarantees

Sold Margin

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

1 2 3 4 5 6 7 8 9 10Years

1 Yr Guarantees

2 Yr Guarantees

ObservationsObservationsObservationsObservations

Caveat: Model is simple and may not reflect actual Caveat: Model is simple and may not reflect actual marketplace dynamicsmarketplace dynamics

Adequate stable pricing produces better long-term resultsAdequate stable pricing produces better long-term results

Acquisition Pricing: Lower persistency keeps long-term Acquisition Pricing: Lower persistency keeps long-term premium growth low, especially after more than one premium growth low, especially after more than one increaseincrease

Best results from slightly low prices followed by modest Best results from slightly low prices followed by modest increases (if early below-target profit can be afforded!)increases (if early below-target profit can be afforded!)

Discussion PointsDiscussion Points

Model Assumptions vs. Today’s LTD Model Assumptions vs. Today’s LTD MarketplaceMarketplace

How Best To Operate In This Environment?How Best To Operate In This Environment?

Discussion Points -- MarketplaceDiscussion Points -- Marketplace

Start-Up Blocks vs. Ongoing BlocksStart-Up Blocks vs. Ongoing Blocks

Expense RatiosExpense RatiosGrowth TargetsGrowth TargetsCurrent Year Results vs. Rolling AveragesCurrent Year Results vs. Rolling AveragesTrends in ResultsTrends in Results

Discussion Points -- MarketplaceDiscussion Points -- Marketplace

Constant Risk Dynamics vs. Constant Risk Dynamics vs. Trends in Claim CostsTrends in Claim Costs

Aging Population Aging Population Leveraging of Social Security OffsetsLeveraging of Social Security OffsetsObesityObesityEconomic FactorsEconomic Factors

Discussion Points -- MarketplaceDiscussion Points -- Marketplace

Other Carriers’ PhilosophiesOther Carriers’ Philosophies

Stable and Rational?Stable and Rational?Throw in a New Entrant?Throw in a New Entrant?Aggressive Growth Goals?Aggressive Growth Goals?

Discussion Points -- ExecutionDiscussion Points -- Execution

New Business Pricing ProcessNew Business Pricing Process

Underwriter DiscretionUnderwriter DiscretionSales Office Pricing PoolsSales Office Pricing PoolsUpdating Manual Rate BasisUpdating Manual Rate BasisGrey Areas in Manual RatesGrey Areas in Manual RatesCredibility and Experience RatingCredibility and Experience Rating

Discussion Points -- ExecutionDiscussion Points -- Execution

Implementing Rate IncreasesImplementing Rate Increases

Developing the Renewal StrategyDeveloping the Renewal StrategyRate Increases Targeted at Block Level or Case Rate Increases Targeted at Block Level or Case

Level?Level?Segmenting the BusinessSegmenting the Business

• Differences By Case Size?Differences By Case Size?• SIC Categories?SIC Categories?• Voluntary vs. Non-Contributory? Voluntary vs. Non-Contributory?

What to do with Rate Decreases? What to do with Rate Decreases?

Discussion Points -- Execution Discussion Points -- Execution

Aligning The OrganizationAligning The Organization

UnderwritingUnderwriting• Objectives at Department or Employee Level?Objectives at Department or Employee Level?• Which Metrics to Use?Which Metrics to Use?

SalesSales• Compensated Based on Persistency?Compensated Based on Persistency?• Compensated Based on Profitability?Compensated Based on Profitability?

ActuarialActuarial

Discussion Points -- Execution Discussion Points -- Execution

Measuring The ResultsMeasuring The Results

What Types of Experience Reports?What Types of Experience Reports?Beware of the Vanishing Rate Increase!Beware of the Vanishing Rate Increase!What if Rate Increases Achieved But What if Rate Increases Achieved But

Earnings Objectives Not Met?Earnings Objectives Not Met?