Group Pricing in a Highly Competitive Market

Lyndon F. Fadri, FASP, ASA




(While this is entitled Group Pricing, the discussion is limited to the pricing of Group Yearly Renewable Term Life plan. The ideas presented however should also apply to other group renewable term products such as accident and hospitalization.)



Business Condition


Over the past few years, competition in the group insurance business has tightened at a very rapid pace. Last year was extra tight as most companies posted minimal, if not negative growths. The group life business of the industry grew by only 7% in terms of premium compared to previous year's growth rate of 26%. There could be three major reasons: entry of new players in the group business, the financial currency crisis that prompted companies to tighten their budgets and the saturation of the market. These may have triggered the reduction of premium rates so that it counterbalanced the natural growth expected of the business (as salaries of employees increase, more individuals add to the covered groups, benefits improve, additional groups purchase coverage, etc.) and the results of developing other group markets.


As a result, profit margins have generally shrunk as loss ratios went up (due to rate reductions and underwriting liberalization) and as increases in operational costs are not matched by corresponding increase in premium income. Table 1 presents the facts.


The Actuarial Society of the Philippines (ASP) has taken some steps to slow down this pace or avert the trend towards cut-throat competition that could threaten the health of the group line of business. It has drafted the Standards of Actuarial Practice in Group Insurance. How effective it will be remains to be seen. After all, in many insurance companies, the group insurance business is controlled by non- actuaries.


From the looks of it, competition is here to stay. The very nature of the business itself spells competition - the renewable and flexible nature of product, the client base, and the presence of professional shoppers (the brokers). As management continues to set high premium goals in a nearly saturated market, the trend will continue.



Pricing Strategies


Pricing strategies may be classified according to their sensitivity to market conditions. An extreme case is one that does not consider the prevailing market levels. Pricing factors including margins and profit targets are imputed in the premium formula. For actuaries, these should be the ideal strategy. In a highly competitive market, however, this may not be viable if margins and profits are high enough such that the premium formula produces non-competitive premium rates. Given that operational expenses are expected to go up, the bottom line will suffer as premium income diminishes.


On the opposite end is a market-driven pricing strategy. This strategy may be based on the belief that the top line takes care of the bottom line. Pricing should result to a level below prevailing market rates to be effective. Depending on the margins in the current level of rates, this may be viable or not in the short term. In the long term, however, this won't be viable. Other players are expected to react to the situation and the chain reaction will continuously bring the rates down. Once the rates hit inadequate levels, no matter how big the business becomes, the bottom line will remain negative. In fact, the bigger the business, the bigger would be the loss.


Of course, players in the industry today do not absolutely adopt one or the other. Some may be heavily sensitive and some are less. This largely depends on who ultimately controls pricing.


The industry's loss ratio could be around 55% presently. The market-driven strategy may still be successful in the aggregate. Though for some accounts the rates have gone down below adequate levels, gains from other accounts could still offset the losses. Those who are less sensitive to market conditions have lost some grounds but as they felt the strain in the top line cascading to the bottom line, may have reacted and this should explain the continuing rate reduction. The market has imposed.


These discussions lead us to conclude that a long-term viable pricing strategy should be one that is sensitive to the market yet it should not produce rates below what are adequate. Sensitivity should then be confined to the margins and profit targets.


The challenge then as far as pricing is concerned is to be able to determine accurately the adequate rates at a competitive profit margin. With pricing accuracy, the company should be able to capture the profitable business and would be ready to lose the unprofitable ones with the expectation that the takers would eventually feel the strain in their profits. Once they raise their rates, there's an opportunity for takeover.



Accurate Determination of Rates


Accurate determination of rates is a lot easier said than done. In fact, nobody knows precisely what really is the least price that is adequate. Applications of the principles and methodologies of Actuarial Science should however enable us to determine rates more accurately.


Pricing can be segmented into two tasks: setting the general basis for pricing and the implementation of the actual pricing. In the first task, we set the pricing formula, establish the mortality bases, expense assumptions and margins and write the general underwriting guidelines. In the implementation, we apply the pricing formulas and guidelines to the case on hand.


The suggested actions are not exhaustive but this should clearly provide the pricing direction:



General Pricing


Recognize the detailed factors affecting the premium. Interest, often disregarded, should be considered. A breakdown of expense to per policy, per member, percentage of premium and so on is advisable. Reinsurance is another very important factor. This literally calls for a shift from traditional gross premium formula simply expressed as GP = NP/ (1 - %Expense - %RiskCharge - %Commission) where the expense and risk provisions are based on tables or on gut-feel estimate to a more complex formula.


Actually, asset shares pricing may be used to consider future scenarios especially if expenses or taxes are amortized or a change in demographics is expected.


Margins in each pricing factor should be properly identified. The mortality table being used may already contain margin. For example, if reinsurer's table is used, it is more likely that the rates already contain margins for reinsurer's expense and profit. The interest assumption may contain margins itself.


Identifying these margins properly need a lot of studies: mortality study, expense study and the like. In the absence of such studies, comparing actual experience against the pricing bases should provide us an idea.


In the resulting gross premium, the consolidated margins should also be identified to verify if it is consistent with the set overall margin. There is a tendency that margins overlap so that the resulting margins are compounded.


Rationalize margins. Margins are set basically to account for deviations of experience from the pricing basis. It's a basic knowledge that the larger the sample the lower the deviation, and the higher the probability, the lower is the relative deviation. A margin formula should be developed to account for these deviations consistently. The term volume discount is what we often hear and such discount is just often estimated.


In many cases, a different mortality table is used for refunding or non-refunding account. It may be more accurate to use just one table but taking into account the experience refund provision in the margin formula.


Examine the profitability of the expected total portfolio to test the profitability in light of market conditions. How does your margins affect the expected premium income is the basic consideration.


Properly set credibility factors for experience rating. How credible is the mortality table being used compared to the experience is the basic question that the credibility formula should address.



Actual Pricing


Underwrite prudently. Gather the needed information especially the previous experience and the group's demographics. In many cases only average age is furnished. A study of the age and salary mix of comparable groups will help us make more accurate pricing.


Strive to consistently apply the set pricing guidelines. Deviating from the pricing guidelines consistently will result to a less controllable bottom line. It will also distort the experience relative to the pricing bases. As such, it will be useless in the regular evaluation of the general pricing guidelines.


Avoid the concept of cost subsidies. Price accordingly each type of risk. In many cases, we continue to retain the rates for Group Hospitalization in spite of bad experience because anyway there's Life. Why not reduce the life rates and increase the medical rates accordingly?



Sample Risk Theory Applications


As we strive to develop accurate pricing formulas, application of actuarial science is necessary - construction of mortality tables, graduation, expense studies, life contingencies, etc. Of the many subjects, Risk Theory is less popular. As such some simple samples on the application of this theory are presented to provide an insight on its usefulness in group pricing.


A margin formula:


a) The individual claims distribution can be approximated by the binomial distribution with E[S] = np and Var[S] = npq where n is the number of lives, p is the average mortality rate, and q, the complement of p.


b) The aggregate distribution of claim can be approximated by the normal distribution, in accordance with the central limit theorem.


c) Introduce a relative security loading factor (L) such that Pr(S<=(1+L)E[S]) > F(x), using the normal distribution, Pr( (S - E[S]) / SD[S] <= (L)E[S] / SD[S] ) > F(x) or L = x SD[S] / E[S] = (x)(npq)(.5) / np


d) Using the above assumptions and using the relative security loading L, assigning full credibility (c = 1) for an exposure of N lives, Ls = (x)(Npq)(.5) / Np.


e) The credibility factor may be set as the inverse proportion of the relative security loadings, c = Ls/L or c = (n/N).5. The choice of N is critical.


To come up with better formulas, the simplifying assumptions used may be improved.





Conservatism should be put in a proper perspective. In light of the business condition, ultra-conservative pricing could work against the viability of the business. What makes us extra-conservative is because we do not know exactly what's going to happen. In this issue of uncertainty, the actuary is expected to be the master. Application of his knowledge is what is needed.


It is not suggested however that we totally do away with the traditional conservatism especially in other areas like reserving.


Of course, while pricing is significant, it's not all that matters in maintaining the viability of group business. We can reduce administrative costs or improve administrative efficiency, align organizational setup with the requirements of the business, seek better reinsurance terms, develop other products immune to this stiff competition, develop other group markets and improve marketing strategies. A total approach would make the biggest difference in this highly competitive market.