Group Health Insurance Premiums

If you are a small business owner or operator and want to get an explanation of the way premiums are priced for the company, then please read on. There are basically two ways these premiums can be calculated.

Group Insurance Pricing

The pricing (rate making) process in group insurance is essentially the same as pricing in other industries. The insurance company must generate enough revenue to cover the cost of its claims and expenses and contribute to the surplus of the company. It differs in that the price of a group insurance product is initially determined on the basis of expected future events and may also be subject to experience rating so that the final price to the contract holder can be determined only after the coverage period has ended. Group insurance pricing consist of two steps.

(1) The determination of a unit price, referred to as a rate or premium rate for each unit of benefit (e.g., $1,000.00 of life insurance, $1 of daily hospital benefit, or $1 of monthly income disability benefit)

(2) The determination of the total price or premium that will be paid by the contract holder for all of the coverage purchased.

The approach to group insurance rate making differs depending on whether manual rating or experience rating is used. In the case of manual rating, the premium rate is determined independently of a particular groups claim experience. When experience rating is used, the past claims experience of a group is considered in determining future premiums for the group and/or adjusting past premiums after a coverage period has ended. As in all rate making, the primary objective for all types of group insurance is to develop premium rates that are adequate, reasonable, and equitable.

Manual Rating

In the manual rating process, premium rates are established for broad classes of group insurance business. Manual rating is used with small groups for which no credible individual loss experience is available. This lack of credibility exist because the size of the group is such that it is impossible to determine whether the experience is due to random chance or is truly reflective of the risk exposure. Manual rating is also used to establish the initial premiums for larger groups that are subject to experience rating, particularly when a group is being written for the first time. In all but the largest groups, experience rating is used to combine manual rates and the actual experience of a given group to determine the final premium. The relative weights depend on the credibility of the groups own experience. Manual premium rates (also called tabular rates) are quoted in a company’s rate manual. As pointed out earlier, these manual rates are applied to a specific group insurance case in order to determine the average premium rate for the case that will then be multiplied by the number of benefit units to obtain a premium for the group. The rating process involves the determination of the net premium rate, which is the amount necessary to meet the cost of expected claims. For any given classification, this is calculated by multiplying the probability (frequency) of a claim occurring by the expected amount (severity) of the claim.

The second step in the development of manual premium rates is the adjustment of the net premium rates for expenses, a risk charge, and a contribution to profit or surplus. The term retention, frequently used in connection with group insurance, usually is defined as the excess of premiums over claim payments and dividends. It consists of charges for (1) the stop-loss coverage, (2) expenses, (3) a risk charge, and (4) a contribution to the insurer’s surplus. The sum of these changes usually is reduced by the interest credited to certain reserves (e.g., the claim reserve and any contingency reserves) the insurer holds to pay future claims under the group contract. For large groups, a formula is usually applied that is based on the insurers average claim experience. The formula varies by the size of a group and the type of coverage involved. Insurance companies that write a large volume of any given type of group insurance rely on their own experience in determining the frequency and severity of future claims. Where the benefit is a fixed sum, as in life insurance, the expected claim is the amount of insurance. For most group health benefits, the expected claim is a variable that depends on such factors as the expected length of disability, the expected duration of a hospital confinement, or the expected amount of reimbursable expenses. Companies that do not have enough past data for reliable future projections can use industry wide sources. The major source for such U.S. industry wide data is the Society of Actuaries. Insurers must also consider whether to establish a single manual rate level or develop select or substandard rate classifications on objective standards related to risk characteristics of the group such as occupation and type of industry. These standards are largely independent of the groups past experience.

The adjustment of the net premium rate to provide reasonable equity is complex. Some factors such as premium taxes and commissions vary with the premium charge. At the same time, the premium tax rate is not affected by the size of the group, whereas commission rates decrease as the size of a group increases. Claim expenses tend to vary with the number, not the size of claims. Allocating indirect expenses is always a difficult process as is the determination of the risk charge. Community-rating systems, developed originally by Blue Cross Blue Shield, are often defined to limit the demographic and other risk factors being recognized. They typically ignore most or all of the factors necessary for rate equity and may be as simple as one rate applicable to those with families. There is little actuarial rationale for charging all groups the same rate regardless of the expected morbidity. Community rating has been mandated in some jurisdictions. This makes it a matter of public policy rather than an actuarial pricing question.

Experience Rating

Experience rating is the process whereby a contract holder is given the financial benefit or held financially accountable for its past claims experience in insurance-rating calculations. Probably the major reason for using experience rating is competition. Charging identical rates for all groups regardless of their experience would lead to adverse selection with employers with good experience seeking out insurance companies that offered lower rates, or they would turn to self funding as a way to reduce cost. The insurance company that did not consider claims experience would, therefore, be left with only the poor risk. This is why Blue Cross Blue Shield had to abandon community rating for group insurance cases above a certain size. The starting point for prospective experience rating is the past claim experience for a group. The incurred claims for a given period include those claims that have been paid and those in process of being paid. In evaluating the amount of incurred claims, provision is usually made for catastrophic claim pooling. Both individual and aggregate stop loss limits are established in which exceptionally large claims (above these limits) are not charged to the group’s experience. The “excess” portions of claims are pooled for all groups and an average charge is accounted for in the pricing process. The approach is to give weight to the individual groups own experience to the extent that it is credible. In determining the claims charge, a credibility factor, usually based on the size of the group (determined by the number of insured lives insured) and the type of coverage involved, is used. This factor can vary from zero to one depending on the actuarial estimates of experience credibility and other considerations such as the adequacy of the contingency reserve developed by the group.

In effect, the claims charge is a weighted average of (1) the incurred claims subject to experience rating and (2) the expected claims, with the incurred claims being assigned a weight equal to the credibility factor and the expected claims being assigned to a weight equal to one minus the credibility factor. The incurred claims subject to experience rating are after consideration of any stop loss provisions. Where the credibility factor is one, the incurred claims subject to experience rating will be the same as the claims charge. In such cases, the expected claims underlying the prospective rates will not be considered. Thus, when companies insure a group of substantial size, experience rating reflects the claim levels resulting from that group’s own unique risk characteristics. It has become common practice to give to the group the financial benefit of good experience and hold them financially responsible for bad experience at the end of each policy period. When experience turns out to be better than was expected in prospective rating assumptions, the excess can either be accumulated in an account called a premium stabilization reserve, claim fluctuation reserve, or contingency reserve or the excess can simply be refunded. The refund is either called a dividend (mutual company) or an experience rating refund (stock company).

The net result of the experience rating process is usually called the contract holder account balance, representing the final balance attributed to the individual contract holder. As pointed out earlier this balance or a portion of the balance can be refunded to the contract holder. The adequacy of the group’s premium stabilization reserve influences dividend or rate adjustment decisions.