Centre for Actuarial Research
(CARe)
A Research Unit of the University of Cape Town
The Effect of Risk-Based Capital Formulae on South African Medical Scheme Solvency
CARe Discussion Paper
prepared for the Council for Medical Schemes
by John Kendal, supervised and edited by Heather McLeod
May 2004
Centre for Actuarial Research
University of Cape Town
Private Bag
Rondebosch
7701 SOUTH AFRICA
Telephone: +27 (21) 650-2475
Telephone for Professor McLeod: +27 (28) 572-1933
Fax: +27 (21) 689-7580
E-mail:
E-mail for Professor McLeod :
Editor’s Note
John Kendal submitted this work as his Honours research project in the Actuarial Science Department at the University of Cape Town in 2003. John obtained a first for his project (a rarity in Actuarial Science) and his work was submitted as one of the best national actuarial projects in that year.
The purpose of his research was to ‘compare and explain’ the Australian and USA risk based capital (RBC) systems and investigate, using the 2000 statutory returns from the Office of the Registrar of Medical Schemes, the impact of application of these systems in South Africa.
The most valuable and long-lasting part of this work is the definition of the data items in the statutory returns to the Registrar that should be used in the RBC formulae from the USA and Australia. This mapping was no small feat and this diligent work will provide a valuable platform for the development of recommendations on a possible RBC formula for South Africa.
In areas where there was no equivalent data item in South Africa, the author has suggested an appropriate definition or indicated whether it is a meaningful omission. This work was placed in Appendices C, D and E but should probably have merited a chapter in its own right.
This is a very useful research report which will lay the foundations for RBC work in medical schemes in the years to come.
The most important research work now needed is to determine the required overall level of solvency for South African medical schemes. Work also needs to be done on how the solvency standard for healthcare funds differs from the standard for managed care organisations (the NAIC formula) in the USA and how this might be applied in South Africa.
Once agreement is reached on the overall solvency needed in South African medical schemes and managed care organisations, it will then be possible to undertake further research on the appropriate level of certain key parameters in the formulae, based on South African evidence.
Professor Heather McLeod
May 2004
Synopsis
Risk-based capital (RBC) is a level of capital that enables a medical scheme to withstand certain adverse fluctuations in results. It is determined by the risks facing a scheme. This report examines two foreign methods for calculating RBC requirements and estimates the impact a RBC system would have on South African medical scheme solvency.
The USA and Australian RBC systems
The USA RBC system for Managed Care Organisations (MCO’s) is incredibly detailed, but remarkably simple. It is based on a certain probability of ruin and determines the RBC for an MCO, known as risk-based capital after covariance, by multiplying its various balance sheet and income statement items by risk factors. A special feature of this system is its allowance for risk-transfer through managed care arrangements and reinsurance contracts.
The Australian system requires insurers to hold capital to meet certain circumstances. This system resembles the current RBC system for South African life insurers and would probably be similar to any RBC system developed for South African medical schemes. It requires insurers to hold an amount of capital (i.e. the solvency reserve) that will enable the fund to meet its current obligations if the fund was closed to new business and run-off. It also requires the fund to hold sufficient capital (i.e. the capital adequacy reserve) to meet its obligations as a going concern. Special features of this system are its interaction with the Australian risk-equalisation system and its specification of a method to estimate outstanding claims.
Impact of RBC on South African medical scheme solvency
Since no RBC system has been developed specifically for the South African medical scheme industry, the impact of RBC on South African medical scheme solvency was estimated by calculating the USA and Australian RBC requirements for South African medical schemes using 2000 statutory returns data.
At the industry level, it is unclear whether a RBC system would require the industry to hold more or less capital than the current 25% of gross contributions rule. The USA RBC after covariance is less than 25% of gross contributions, while the Australian solvency and capital adequacy reserves straddle the current requirement.
The figure below shows the USA and Australian RBC requirements as a percentage of gross contributions for individual schemes.
Under both systems, some schemes are allowed to hold less than 25% of gross contributions while others are required to hold significantly more. This implies that some schemes would be strongly against a RBC system while others (especially the larger schemes) would support it.
Conclusions
Despite the differences between the two foreign systems, they each have features that could be useful in the South African environment. They also suggest what changes should be made to the life insurance standards to make them applicable to medical schemes. In addition, it appears that each RBC system will have a unique effect on solvency at the industry level.
Table of Contents
Editor’s Note ii
Synopsis iii
Table of Contents v
Glossary viii
1. Introduction 1
1.1 Background to Research Project 1
1.2 Statement of Research Project 1
1.3 Objectives of Research Project 1
1.4 Sources of Information 1
1.5 Scope and Limitations of Project 2
1.6 Plan of Development 2
1.7 Acknowledgements 2
2. Risk-Based Capital 3
2.1 Introduction to Risk-Based Capital 3
2.2 Medical Scheme Risk 4
2.3 Calculation of RBC Requirements 5
2.4 Desirable Features of a RBC System 6
3. The USA RBC system for Managed Care Organisations 8
3.1 Introduction to the USA RBC System 8
3.2 Asset Risk – Affiliates 9
3.3 Asset Risk – Other 10
3.3.1 Fixed income assets 11
3.3.2 Replication transactions 11
3.3.3 Equity 12
3.3.4 Property and equipment assets 12
3.3.5 Asset concentration 13
3.4 Underwriting Risk 15
3.4.1 Base Underwriting risk RBC 15
3.4.2 Underwriting risk RBC after managed care discount 15
3.4.3 Alternative risk charge 17
3.5 Credit Risk 18
3.6 Business Risk 21
3.7 Risk-Based Capital After Covariance 23
3.8 Transitional Arrangements 25
4. The Australian RBC System for Private Health Insurers 27
4.1 Introduction to the Australian RBC System 27
4.2 Solvency Liability 29
4.3 Expense Reserve 31
4.4 Inadmissible Assets Reserve 32
4.5 Resilience Reserve 34
4.6 Management Capital Amount 35
4.7 Capital Adequacy Liability 36
4.8 Renewal Option Reserve 39
4.9 Business Funding Reserve 40
4.10 Subordinated Debt Allowance 40
4.11 Solvency and Capital Adequacy Reserves 42
4.12 Transitional Arrangements 42
5. The effect of RBC on South African Medical Scheme Solvency 44
5.1 Methodology 44
5.2 Industry Level 44
5.2.1 Aggregate solvency 44
5.2.2 Aggregate solvency by scheme type 45
5.2.3 Aggregate solvency by scheme size 47
5.3 Individual Scheme Level 48
5.3.1 Range of individual scheme capital requirements 48
5.3.2 Individual scheme solvency by scheme type 49
5.3.3 Individual scheme solvency by scheme size 49
5.4 Summary 50
6. A Comparison of the Australian and USA RBC Systems 52
6.1 Conceptual Framework 52
6.1.1 Probability of ruin 52
6.1.2 Capital to meet specific circumstances 52
6.1.3 Suitable conceptual framework for a South African RBC system 53
6.2 Components of Each Formula 53
6.2.1 Omissions from the USA formula 54
6.2.2 Omissions from the Australian formulae 54
6.2.3 Relative sizes of the different components 54
6.3 Special features of each formula 55
6.3.1 Special features of the USA formula 55
6.3.2 Special features of the Australian formulae 57
6.4 Meeting the requirements 57
6.5 Basis for intervention 57
7. Conclusions and Further Research 58
8. References and Bibliography 59
8.1 Australia 59
8.2 United States of America 60
8.3 South Africa 61
8.4 General 62
Appendix A: Data Files Submitted to the Council for Medical Schemes 63
Appendix B: RBC Theory 64
B1. Calculation of RBC requirements using the EPD and probability of ruin approaches 64
B1.1 Ruin Approach 64
B1.2 Expected policyholder deficit (EPD) approach 65
B1.3 More complicated situations 66
B2. Estimating factors by simulation 66
B3. Solvency liability margin 67
Appendix C: Method used to calculate the USA RBC Requirement 69
C1. Statutory returns data used in the calculation 69
C2. Treatment of the different types of guarantee 71
C3. Assumptions and adjustments to the formula 72
C3.1 Premium tiers 72
C3.2 Alternative risk charge 73
Appendix D: Method used to calculate the Australian Solvency Reserve 74
D1. Statutory returns data used in the calculation 74
D2. Assumptions and adjustments to the formula 75
D2.1 Asset concentration risk 75
D2.2 Resilience reserve 75
D2.3 Management capital amount 77
Appendix E: Method used to calculate the Australian Capital Adequacy Reserve 78
E1. Statutory returns data used in the calculation 78
E2. Assumptions and adjustments to the formula 79
E2.1 General 79
E2.2 Capital adequacy margin 79
E2.3 Renewal option reserve 81
Glossary
Accumulated funds
The net asset value of a medical scheme, excluding funds set aside for specific purposes and unrealised non-distributable reserves.
Affiliates
“A person or entity that directly, or indirectly through one or more other persons or entities, controls, is controlled by, or is under common control with the reporting entity.” (NAIC, 2001, 33)
Capital (also equity or net asset value)
For the purposes of this report, capital is defined to be total assets minus total liabilities. Therefore, the terms capital, equity and net asset value will be used interchangeably throughout this report.
Gross contributions
“Gross contributions are amounts (premiums) payable by members and/or employers, in terms of the rules of the medical scheme, for the purchase of healthcare benefits. Gross contributions include, savings plan contributions.” (SAICA, 2003, p.53)
Healthcare receivables
“Fee-for-service, coordination of benefits and subrogations, co-payments, and other health balances.” (NAIC, 2001, p.34)
IBNR claims liability
This is the liability for future payments in respect of claims that have already been incurred by the medical scheme but not yet reported in the scheme’s records, as well as the expected future development on reported claims (ASSA, 2003).
Managed care
Refers to the use of management techniques to deliver appropriate healthcare in a cost-effective manner, through the use of risk-sharing contractual arrangements with healthcare providers and various other healthcare expenditure management techniques.
Managed care healthcare benefits
This is the cost of healthcare services under payment systems such as capitations and other contractual arrangements (SAICA, 2003)
Managed care management services expenses
This is the cost to the medical scheme of healthcare expenditure management services such as disease and case management, pre-authorisation and bill review. This does not include the cost of any healthcare services. (SAICA, 2003)
Managed care organisation
“Any person, corporation or other entity which enters into arrangements or agreements with licensed medical providers or intermediaries for the purpose of providing, or offering to provide, a plan of health benefits directly to individuals or employer groups in consideration for an advance periodic charge (premium) per member covered.” (NAIC, 2001, p.34)
National Association of Insurance Commissioners
The regulator of, inter alia, USA MCO’s
Net contributions
“Net contributions represent contributions for which the medical scheme is at risk, and are calculated as gross contributions less savings contributions, during the accounting period.” (SAICA, 2003, p.54)
Outstanding claims
Outstanding claims consist of claims that have been:
· Incurred but not reported (IBNR);
· Reported but not yet settled or approved for payment;
· Reported and administratively finalised but which may be reopened. (ASSA, 2002).
Private Health Insurance Administration Council
The regulator of Australian private health insurers
Probability of ruin
The probability of insolvency
Registered medical scheme
Any medical scheme that is or will be in full compliance with the Medical Schemes Act of 1998, and is registered with the Council for Medical Schemes (Dreyer, 2001).
The Registrar
The Registrar of medical schemes, appointed under section 18 of the Medical Schemes Act of 1998
Reinsurance
A contractual arrangement under which some of the risk of the medical scheme is transferred to a reinsurer in return for some consideration (ASSA, 2002)
Risk
Risk is the possibility of adverse deviations in results.
Risk-Based Capital
Risk-based capital is the minimum amount of capital a medical scheme must hold to ensure that the danger of insolvency is acceptably low. It is an amount of capital that enables an entity to survive certain adverse fluctuations in results.
Risk charge
The amount of risk-based capital required by a risk element or collection of risk elements.
Risk element
Distinct, quantifiable elements that differ in their level of risk are known as different risk elements (Butsic, 1994). For example, bonds, equities and property are three different risk elements.
Risk factor (also RBC factor)
The risk factor for a certain risk element is the ratio of its risk charge to the value of that risk element. They are related to risk charges and the value of a risk element by the following equation:
Risk charge = Value of Risk element Risk factor.
Technical insolvency (also insolvency or ruin)
Technical insolvency occurs when a scheme’s liabilities exceed its assets.
Abbreviations
ASC Administrative services contract
ASO Administrative services only
ASSA Actuarial Society of South Africa
HBFCAR Health benefits fund capital adequacy requirement
HBFSR Health benefits fund solvency requirement
IBNR Incurred But Not Received
MCO Managed Care Organisation
NAIC National Association of Insurance Commissioners
PHIAC Private Health Insurance Administration Council