A matter of time: exceptions made to preferred pricing may present life insurers with an unwelcome surprise: poor underwriting results.

Preferred pricing of life insurance policies, a marketing tool that boomed in the 1990s, might have a hidden time bomb that could affect life insurers' mortality experience and push reinsurers to raise costs even higher than recent experience has required.

While the best preferred classes are looking good, with mortality results as expected, exceptions made to the preferred underwriting guidelines for business reasons are shifting the results, said Tracy Choka, senior rice president of applied mortality research with Swiss Reinsurance Co.'s life and health reinsurance operations.

Swiss Re pulled about 2.5 million policies into the data set of a new survey, with the ability to "slice and dice" it very quickly to carve out and understand the trends, so the company can react, Choka said.

"What we've seen in the industry is people taking the preferred underwriting model that may apply to someone age 45 or 55, and extrapolating that forward to age 65 or age 75," Choka said. "But the risk factors at the older ages shift, and when you get to some of the extreme older ages some predictors--like cholesterol--aren't as predictive a determining factor as they are at age 45. The question becomes what are the key risk factors as the demographics change."

Also, preferred underwriting is complex, and it brings sales pressure to make exceptions for various business reasons, Choka said. The profit margin in term products especially is very narrow, and Swiss Re has seen a negative result with mortality when there is a high proportion of magnitude of material exceptions being made, she said.

Preferred underwriting includes individuals whose life expectancy--mortality--is expected to be above average based on medical history and other criteria chosen by each insurance company, according to information from the Society of Actuaries. When an insurance applicant qualifies under these more strict guidelines, the insurance company offers a lower premium for the coverage.

Initially, preferred coverage was limited to nonsmoker policies, but changes in companies' standards now have preferred coverage available to smokers, with a new "super-preferred" class available for nonsmokers, according to the society.

The poor mortality results vary dramatically according to the level of exceptions being made by each company, Choka said. For a company making few to no exceptions, the mortality results are coming in pretty much as expected, she said. Some companies, however, were making exceptions that added 9% of more additional mortality to their books of business, and for that risk group, there is a material deviation from expected to actual results, she said.

Reinsurer Influence

When preferred underwriting first came to the forefront, many reinsurers were willing to go to companies to guarantee their mortality, said Paul Graham, chief actuary for the American Council of Life Insurers. Reinsurers would offer a price for a block of business based on a rate of mortality, and if the direct insurance company saw a slightly higher mortality in that book, the company would take the offer, since it would make additional profit, he said.

"The insurer could reduce their premium rate in the marketplace and sell a lot of business, which made their agents happy, and they would gain on the difference between the two mortality rates," Graham said. "All the risk was on the reinsurer."

Of companies responding to a May 2003 study by the Society of Actuaries, 37% said it was too early to tell whether their preferred mortality was better or worse than expected, with 30% stating their experience was better than expected. An additional 22% stated their experience was about the same as expected, according to the society.

The Swiss Re study also showed there might be more substandard business included in the preferred risk class than was anticipated, Choka said. A clear definition of what is a "preferred" policy and clear alignment of pricing and underwriting are needed to make sure mortality pricing is consistent with thresholds put on the class of business, she said.

An additional trend, which is somewhat related to the mortality pricing, is for the tobacco class and the older-age applicants, Choka said. Much of the tobacco class experience is emerging worse than expected, but Swiss Re doesn't have as much credible experience, since only 7% of the exposure in this book of business comes from the tobacco class, she said.

Policies priced for tobacco use usually are sold to a lower average policy size, because the premium per thousand is larger, and that's coupled with more relaxed underwriting guidelines, which mean companies aren't doing as much traditional risk selection, she said. The trend is for increased incidence of cardiovascular disease and some cancers that additional underwriting requirements such as a chest x-ray of an attending physician's statement might have found, she said.

"We know the reinsurers have had some poor years recently, because they underestimated the mortality on some blocks of business," Graham said. "Now, they're starting to get a better knowledge base and they're doing one of two things. They can either adjust their rates according to their past mortality or they can offer a 'preferred-preferred' level with additional underwriting requirements to reach that level of mortality and a better profit margin."

Mitigating Factors

The most concerning trend coming out of the study is at the older ages--the age 55 band and the age 65 band--which indicate a relaxing of traditional underwriting requirements overall, Choka said. Companies have been focused on preferred underwriting itself, with a lot of competitive pressure--especially in the term marketplace--that has caused a relaxing of the use of those traditional requirements, she said.

"We believed that the mortality slope by issue age band was relatively flat," Choka said. "If a company was assuming 38% or 40% mortality of the 1975-1980 mortality table, they assume that level of mortality pretty much for ages 45 or 55 or 65.The experience we're seeing is the slope is dramatically steeper than that. Mortality rates for age 55 and 65 are not within plus or minus a percentage point or two of age 45 mortality, as was assumed."

"As far as the folks in the field--the agents and brokers--are concerned, the easier it is to issue a case, the more they're going to sell, with reduced requirements even a little more important to the agent than the very best price," Graham said.

Some carriers have gone the other way, however, and said they were going to seriously underwrite applications, and they're also going to have the lowest price on the street, Graham said. The companies believe their agents should be able to sell that combination no matter how difficult the underwriting is, he said.

"I don't think the whole marketplace is going to clamp down on underwriting; at least it won't happen immediately," Graham said. "We've swung a little bit too far to less requirements, and putting the clamps on it fast would be difficult."

The study didn't show anything yet on obesity of diabetes, which also is to be expected, since the underwriting process includes factors for body mass index, a factor in both of those diagnoses, Choka said. Underwriters are seeing a dramatic increase in the prevalence of both obesity and diabetes in general in the total group of applications coming through the doors, but these applications usually are excluded from the preferred class, she said.

Trying to predict future mortality gain is quite difficult now, Graham said. Over the past 30 years, mortality probably has improved about 1% a year. The key to making money in the super-preferred marketplace is to figure out whether the improvement still is going to be 1% a year in the future, of whether it will be half a percentage point or 2%, Graham said. "The folks that do that the best are the ones who will win," he said.