Many life insurance companies have expanded their fully underwritten standard risk class to include marginally substandard risks as well. The intent of these “expanded standard” programs is to increase the placement of marginally substandard risks by avoiding the stigma associated with the term “substandard” or “rated.” This article foregoes discussion of the relative merits of these programs and instead focuses on mortality adjustments needed to maintain an actuarially sound standard class.
A typical example of a company’s expanded standard program might be for applicants initially rated Table A (or 25 percent additional mortality) through Table D (or 100 percent additional mortality) to be reclassified as standard. We also assume the company has preferred classes, in which case rated applicants would be placed into the non-preferred (residual) standard class — therefore increasing the standard class mortality. We further simplify our discussion by ignoring the distinction between smokers and nonsmokers.
Gathering the Data
To begin our assessment of the above standard class expansion, we would need to collect the following data from the company’s policy administration and/or underwriting systems on recently underwritten risks: face amount of insurance by underwriting class (e.g., super-preferred, preferred, residual-standard or substandard table rating). This information will be used to calculate (1) the relative distribution of risks among the various classes and (2) the average relative mortality that the new expanded standard class will exhibit. Assuming that the company has not had an expanded standard program in the past, it would be appropriate to review the historic class distribution, because the company may start placing more substandard business by now offering these risks at a standard rating.
At this point, it is necessary to understand how underwriters and actuaries view substandard table ratings. On average, an applicant rated Table B, for example, is expected to exhibit mortality that is 150 percent of the mortality of a corresponding non-rated applicant. This non-rated applicant represents an average of risks from all the non-rated underwriting classes (super-preferred, preferred, etc.), not just risks from the residual-standard class. Underwriting manuals typically show ratings (and therefore expected mortality) consistent with this all-class view of an average risk rather than the residual-standard class view.
Before we begin our calculations, we still need one final piece of information, which can be obtained from the company’s pricing actuary: the mortality of the risks in the current residual-standard class relative to the mortality of all classes combined. If there were no preferred classes, we would expect this to be 100 percent (since there is only one class). However, as the preferred and super-preferred risks are carved out, the relative mortality of those remaining in the residual-standard class increases. This mortality may be arrived at empirically using the company’s actual mortality experience by underwriting class (if credible values exist) or theoretically using a “conservation of deaths” approach.
We are now ready to calculate the mortality adjustment for our example above. (See Figure 1 on page 2.)
Based upon a combination of recent mortality experience and a theoretical model, the company’s pricing actuary has calculated that residual-standard class relative mortality is approximately 120 percent. This percentage was calculated by taking the ratio of the residual-class mortality to the overall mortality for all classes combined. The pricing actuary has realized that the company’s placed business tends to skew towards the super-preferred class (due to higher not-taken rates in the preferred and residual-standard classes) and has adjusted the overall mortality accordingly. The actuary also concluded that the introduction of an expanded standard program will increase the placement of substandard risks and has suggested an appropriate adjustment in the distribution of placed risks.
Here is our final calculation:
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The average relative mortality of the Table A through Table D risks we want to include in our expanded residual-standard class is 172.5 percent.
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Relative mortality for the current residual-standard class is 120 percent.
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Residual-standard risks represent 15 percent of all business (super- preferred through Table D).
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Table A through Table D risks currently represent 10 percent of all business and would therefore represent 40 percent of our new expanded standard class [(10% / (10% + 15%)]. However, we have increased this to 50 percent based upon the pricing actuary’s suggestion.
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We calculate a mortality adjustment factor to account for the expanded standard class such as (172.5% x 50%) + (120% x 50%) = 1.4625
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We multiply the current mortality assumption for the residual-standard class by 1.4625 to account for the Table A through Table D risks now placed in the class.
Maintaining the Assumptions
While the above development is rather straight-forward, the assumptions used in the calculations have some amount of uncertainty. To preserve the integrity of the expanded standard class, the pricing actuary should monitor the assumptions that went into its creation. The original table rating should be retained in the system in order to review the actual table ratings of the risks placed in the new class, and the actuary should proactively manage significant deviations from the assumptions. The actuary should also be sure that the underwriting staff understands the marketing implications of the expanded class. Note that there may be increased field pressure to rate the borderline Table E or Table F risks as Table D so that they can be placed as standard.
As with all changes in underwriting practices or plan design, it is important to inform the company’s reinsurers of the features of the new expanded standard class well in advance of its implementation. Expect the reinsurers to request a copy of the data that was collected when the company made its mortality adjustment. The reinsurers will want to make their own mortality assessment and then analyze any impact on reinsurance pricing.
Editor's Note: For the underwriting perspectice to expanded standard underwriting programs, please see Andrea Moody's article.