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Understanding the Disability Insurance Model

In essence, insurers sell “paper,” a promise to pay in the future in exchange for cash now. Insurance is designed to protect against risk, because individuals who buy insurance are financially compensated in case of loss. For protection against loss, individuals pay insurance companies for specific types of risk. Individuals pay premiums to an insurer as part of an insurance contract in exchange for transferring the risk of loss to a large group of individuals who then share the financial loss.

Disability insurance is designed for income replacement for all or part of a person’s income if he or she becomes unable to work or can only earn a reduced income as a result of disability. Group disability coverage includes high and law risk people grouped together in the plan.

The underwriting for disability policies tends to be substandard to that of life policies as it involves consideration of many physical conditions and impairments which can result in long term disability. Many of these conditions and impairments will not affect a person’s life span and play no role in life insurance underwriting. This is made even worse by a lack of claims experience studies on disability risk. Underlying this is the subjective nature of disability claims which makes such studies difficult to undertake. Even underwriting manuals only set forth suggestions actions for impairment risks rather than objective and precise standards. Therefore, disability underwriting remains more of an art than a science.

Exclusion riders represent a negative approach to underwriting and an “admission of defeat” of sorts. Rather than determine the risk of impairment, the underwriter chooses to exclude the particular impairment in its entirety. Since it is difficult to exclude entire impairments, many underwriters choose to implement limited exclusion riders in which reduce certain impairment benefit periods.

The most significant responsibility of underwriters is to determine premium that factors in the likelihood of a claim and enables the insurer to earn a profit. http://www.ftpress.com/articles.aspx?p=19038886&seqNum=2) Premium rates are also determined in response to insurer losses.

Occupation in disability claims plays a critical role, especially its physical requirements. It is far more common for a physical laborer who must use his body to become disabled and for a longer period than a professional worker who mostly undertakes mental work. In general, education and income result in more favorable morbidity. Consequently, lower premiums are offered for white collar workers. With less physical labor being undertaken in the workplace, underwriting has gone toward evaluation of stability, motivation, and responsibility in one occupation as opposed to another.

Group disability policies can be marketed quite profitably at a relatively lower cost in comparison with individual contracts. These contracts are generally more restrictive and can be price adjusted as needed. Group contracts tend to have more limited benefit pay periods and will make deduction for other benefits received. Minimal underwriting is required. An insurance company may need to match other companies’ offers which include enhanced coverage or lower pricing in order to prevent losing market share.

The claims processing function determines the cost of a loss and pays the claims to the insured. http://www.ftpress.com/articles.aspx?p=19038886&seqNum=2)Claims handling requires a greater level of expense, activity and training than a life insurance claims examiner possesses. The training and position responsibilities of a disability claims examiner rivals that of an underwriter. As many disability claims examiners are required to perform necessary review, this requires an efficient, accurate and responsive administrative and examination process. The contract language and will only resolve some potential problems, where the claims examiner must rely on his experience and professional judgement to resolve most others.

The specific procedures to be utilized for claims review should be spelled out in the disability insurance contract. Problem claims such as those involving younger individuals with higher earnings can cost the insurer large sums of money of the course of a period of disability. For this reason, claims department must have training procedures and claims guidelines for its examiners which include lay medicine, claim investigation, field handling, etc. Claims investigation is of paramount importance and include weighing factors such as the age and occupation of the claimant, severity of the disability, subjectivity of the disability, and projected length of disability. Medical examinations are not routinely requested, but are reserved for disability claims of potentially long duration and degree of recovery is in question.

Insurance companies make money in two ways: from investments and by generating underwriting profit (collecting premiums that exceed insured losses and related expenses). Money is made by investing assets set aside for claims during the interval period between receiving the premium and payment of claims, known as “the float” (also known as the “reserves”). The float, in turn, becomes an important source of investment income.http://www.ftpress.com/articles.aspx?p=19038886&seqNum=2)

Insurance can lose money on their investments or on the insurance contracts they have written. These losses can stem from investment (losses from float (reserve) money investments), claims losses (claims paid are greater than premiums received due to mispricing insurance by underestimating the risk). Incorrect calculation of risks can turn the insurance business ugly. For example, investment in subprime mortgage-backed securities during the financial crisis of 2008 caused large losses.http://www.ftpress.com/articles.aspx?p=19038886&seqNum=2) http://www.ftpress.com/articles.aspx?p=19038886&seqNum=2)

There have been many instances of improper conduct resulting in insurer insolvency:

  • On September 16, 2008, the American International Group (AIG) received an $85M initial bailout payment from the U.S. Government before it became insolvent. This amount eventually was increased to $150B. In exchange, the Government received nearly 80% of AIG’s equity. The near insolvency resulted from bad investments in collateralized debt obligations (CDOs) comprised of tranches of subprime mortgage loans in addition to accounting problems. AIG faced an $11B shortfall to cover potential claims in 2009 while it paid $218M in executive bonus pay following posting a $61.7B loss in 2008.
  • The Mission Insurance Company was hit with $1.5B in losses when it only held $240M in capital surplus. Much of this deficit resulted from increasing workers compensation and automobile insurance business through deep discounting of premiums. When it was first investigated, the company had a $169M reserve deficiency and $900M in unpaid claims. It was liquidated in 1987.
  • The Transit Casualty Company racked up $4B in losses with its liquidation taking until 2012 to complete. It began as a small company with a manual claims processing system which grew rapidly, growing from 800 to 37,000 policies sold during 1982 – 1983 without underwriting guidelines. For example, it issued an 18 state Wal-Mart policy for half the reasonable cost of such coverage with a guaranteed no increase in rate charged.   It was ordered to stop writing policies by 1985 and quickly went into liquidation with investigation finding swapping of policies by a multitude of different insurance and resinsurance companies while not paying 200,000 claims
  • The Integrity Insurance Company was started in 1957 and provided insurance for banking loan collateral and principals taking loans. In the late 1970’s, it diversified into many coverage areas including commercial property and casualty, umbrella policies, hospital professional liability, personal and commercial automobile, commercial fire, inland marine, commercial special multiperil, geneal liability, and others while passing the risk of to reinsurers and retaining as little as 1% of coverage in exchange for commissions for policy sales. It was placed into liquidation in 1987 with $1B in losses and $2B in unpaid claims
  • The Maryland Indemnity Insurance Company collapsed in 1977 after creating a vast network of national and international companies writing insurance for medical malpractice in addition to liability insurance for various purposes including nurses, hearing aid installers, lounge owners, trucker, underground storage tanks, guides and outfitters, marine hull coverage, among others. It had no reinsurance protection while holding a potential claims liability of $50M. When it shut down, the company had just over $2M in assets and nearly $6M in liabilities.

Economy Effects

Economic recessions and unemployment tend to cause in increase in disability claims frequency and move in direct proportion to the severity of the recession. It is at such times, that claims examiners must be aware of the potential for claims abuse due to malingering and increase their investigative efforts. This presents increased problems for the claims examiner in the degree of length of disability in claims involving subjective factors and understanding that these factors themselves may be escalated in time of economic recession.

Insurance companies owned by stockholders have to answer to stockholders. If management’s investment strategy are carried out with shareholder expectations, seizing opportunities for growth and profit, then they may be acting at the expense of policyholders. Unfortunately, no ownership structure is a cure-all for poorly conceived or executed strategies.

The combined factors of the aging “Baby Boomers” (who have reached their peak of disability) along with a slumping economy have resulted in rising disability claims. Aged persons (over 50) with impairments have difficulty finding work. Even seasoned workers will be dropped if they cannot maintain a production rate for 40 to 50 hours per week. Older workers staying on the job often spend time at work on non-work responsibilities. Many employers choose to “do more with less” and seek to have older workers make disability claims in order to reduce the financial burden to the employer.

The effect on increased disability claims in insurers has been immediate. For example, Lincoln Financial experienced an 8.8% first quarter loss in 2015 as a result of increased long term disability claims.

When insurance companies issue policies, they are required to have undertaken proper underwriting in order to retain sufficient reserves to pay claims as they come due.

When insurance companies market policies in multiple areas to gain market share through underpriced offerings, often with insufficient underwriting and/or retention of capital reserves or sufficient reinsurance, they will eventually suffer losses. When premiums fall short and are insufficient to pay incoming claims, claims are denied. At this point, the claims department becomes the only area where an insurer can exercise loss control.

With the rapidly increasing number of disability claims stemming from an aging workforce, particularly from larger and cheaper group policies issued, insurers are forced to deny claims in order to prevent greater losses. This is made worse when insurers face investment losses due to poorly chosen stock market, real estate, or foreign investments.

For this reason, claims departments are subject to economic pressures which have bear consequence of payment of claims rather than determining payment in accordance with policy terms alone as required and expected from their insureds.

Posted in Economics, General Disability Issues | Tagged , , , |


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