Medical Trend and Medicare Supplement Insurance Profitability - What’s Safe to Assume?
Medical trend has been in the spotlight lately because it drives healthcare costs. Higher trend means higher medical costs, which translates to more expensive health insurance. But what does higher trend mean for Medicare Supplement insurance and profitability?
Recently we attempted to answer this question during a presentation we delivered at the annual Medicare Supplement Conference. We used profit modeling to find out what happens to profit margin when the trend is different than expected. We began by modeling an 8% expected annual trend, then modeled a 4% actual trend to see the impact on profit margin. What we wanted to find out was whether the margin would be higher or lower. Lower trend leads to lower claims, so that must mean higher profit margin, right?
Wrong! It turns out that profit margin is much LOWER when trend is lower. In our example above where we expected 8% trend but experienced 4% trend, profit margin fell from 5.8% of premium to 2.9%. Why? The margin drop was driven by commissions, which jumped from 10.5% to 13.4% of premium on a net present value basis. But why did that happen?
Medicare Supplement commissions are typically paid on original premium, so rate increases are not commissionable. Rate increases that are filed and approved are usually about the same level as medical trend. So annual rate increases cause policyholders’ premiums to go up, but agents’ commissions don’t change. Over time, higher trend means that a lower total percentage of premium is subject to commissions, which reduces the effective commission rate as a percentage of premium. And if trend is lower than expected, the reverse is true - commissions are higher as a percent of premium, pushing profit margin down.
The green line in the chart below is the difference in commissions, which is essentially the difference in profit margin.
So how would insurers fix a profit problem like the above, where there is lower than expected trend?
There’s no easy answer because this is an expense problem. If claims are higher than expected, then the loss ratio is higher than what was priced, and rate increase approvals can usually be secured to address this. But it is difficult, if not impossible, to get rate increases approved to fix an expense problem.
In our example, we only looked at the impact of changing trend, but in reality trend and lapse rates are connected. When trend is lower, rate increases will be smaller, which means fewer existing customers will shop around for lower rates, and therefore an insurer’s lapse rates are going to be lower.
Is it possible that when trend is lower, lower lapse rates boost profitability enough to offset the commission impact? In our example, lapse rates would have to drop 42% in order for profit margin to stay unchanged. You can judge whether that is realistic, but it seems unlikely to me.
Given the profit shortfall that occurs when trend is lower than expected, you might think it’s a good pricing strategy to lowball the trend assumption, leaving you a better chance for profit margin to be higher than expected. The problem is that it will be harder to sell your product. In today’s very compressed and competitive Medicare Supplement market, launching a product with rates that are too high is a great way to ensure disappointing sales. It’s important to strike a balance between reasonable pricing assumptions and marketability.
What our modeling work demonstrates is how important it is to get the trend assumption right, and to evaluate and reset your trend assumptions with each new pricing analysis. Assuming higher medical trend turns out not to be conservative - in fact, it’s just the opposite.