Recession Threatens Profit Cycle: A weak economy can shorten the time health insurers enjoy gains, but insurers can take measures to protect themselves. (Life/Health).

After three years of playing catch-up, health carriers are once again enjoying a return to profitability. Historical studies have consistently demonstrated a six-year cycle in health insurer profitability: three years of depressed earnings followed by three years of strong gains. The cycle is generally attributed to carriers' inability to accurately forecast changes in trend.

Typically, carriers will base their ratings on current loss ratios and past trends on their block of business. Without reliable leading trend indicators, the rationale is that the current trend levels demonstrated on their in-force block will continue indefinitely.

Unfortunately, the trend studies are all based on past experience.

Trend is measured as change in manual loss ratio relationships over time. Typically, a carrier will measure this change in its rolling three--and 12-month manual loss ratios (i.e. trend).The problem with this is that the trend being measured is what was experienced in the past. For example, to include the most current experience period as possible in a trend calculation, you must estimate the incurred--but unreported or unpaid--claim liability to complete the most current month. Doing this kind of estimate introduces an element of risk, because you're trying to predict changes in claims-payment backlog or reflect seasonal variations in claims.

This trend, calculated by looking at past experience, is then used in pricing new cases and renewals that won't be effective for several months into the future, and then they often are guaranteed for 12 months. Once a carrier realizes that the trend has changed, it takes at least 12 months to fully reflect the new trend in the in-force block when it renews.

Essentially, the carrier realizes that the trend, which has been used in setting the prices for its block of business, has been wrong. The trend used in pricing new business can be changed immediately. But the carrier must wait up to 12 months to change the pricing on accounts just written or renewed at rates now known to be inaccurate. This delay in recognizing trend changes, and then correcting the pricing in every policy, is what causes the underwriting profit cycle.

Carriers frequently deepen the underwriting cycle by actions they take. For example, when carriers are ahead of trend, they are tempted to rely on the favorable loss ratios and reduce rates further to write additional business. But they may be lowering rates exactly as trend is beginning to move back up, and they won't recognize their mistake for six to 12 months.

When the economy weakens, employers respond with layoffs, hiring freezes or cutbacks on benefits as they attempt to maintain profitability. As they do, underwriters must be more diligent to monitor participation levels. They must be aware of several factors:

* When employers reduce contribution levels, the younger, healthier employees may not see value in enrolling in the medical plan.

* For employers who fall under reform, a carrier's only protection against adverse selection is to monitor and enforce minimum contribution and participation levels.

* As employers downsize staff, carriers need to be alert for changes to the demographic mix of their insured population. Older, less healthy employees who are downsized may elect to continue coverage through the Consolidated Omnibus Reconciliation Act of 1985 (COBRA) or state continuation plans.

* As younger employees leave the plan--either because they are downsized first or are the first to drop coverage when their employer cuts back on contribution--the insurer is left with an older demographic mix. This shift will accelerate the claims trend experienced by the carriers.

Another catalyst that accelerates trend in a weak economy is the pressure faced by health-care providers to maintain earnings targets. As investment-income results diminish, health-care providers are more likely to raise their prices quickly to offset reduced earnings.

Underwriters should take the following steps:

* Closely monitor changes in the demographic mix of insureds.

* Diligently enforce contribution and participation levels.

* Avoid the temptation to lower rates below sustainable levels based on emerging improved loss ratios.

* Closely track changes in health-care provider charge levels for both fee-for-service and contracted PPO network fee schedules.

The bottom line? Be on guard for a shortened underwriting cycle during weak economic' cycles.

Gary Cain, a Best's Review columnist, is senior vice president, Group Life and Health, at Principal Financial Group, Des Moines, Iowa.