Communication NBB_2021_24 / Evaluation of technical provisions for individual health insurance

Boulevard de Berlaimont 14 - BE-1000 Brussels tel. +32 2 221 38 12 - fax +32 2 221 31 04 enterprise number: 0203.201.340 RPM Brussels www.nbb.be

NATIONAL BANK OF BELGIUM
VAN BELGIE
Eurosystem

Communication
Brussels, 21 December 2021
Reference: NBB_2021_24
Your contact:
Frank Van Steen and Stany Zabinski tel. +32 2 221 21 23/3467 frank.vansteen@nbb.be / stany.zabinski@nbb.be

Evaluation of technical provisions for individual health insurance

Scope
Insurance or reinsurance companies under Belgian law that are subject to the Law of 13 March 2016 on the status and supervision of insurance or reinsurance companies.

Summary/Objective
This communication describes a reference scenario that the National Bank of Belgium will use as a lower limit to assess the prudence of hypotheses surrounding the modeling of medical inflation, and which will serve as a basis for identifying and quantifying structural imbalances in the pricing of health insurance.

Structure

1. Context
2. Verification and entry into force
3. Methodology of the reference scenario
4. Description of the reference scenario

NBB_2021_24 - 21 December 2021 Communication - Bus. 1/6

Madam, Sir,

1. Context
   The Verwilghen Law provides specific provisions for individual health insurance. Thus, a health insurer is required to offer lifetime contracts, and the possibilities to modify the technical foundations of premiums and coverage conditions are legally limited. Under the legal framework, policies can only be adapted in the following cases:
   1) by mutual agreement and in the interest of the insured;
   2) in the event of a change in the insured's personal situation (profession and social status);
   3) based on the consumer price index or a specific index (the medical index); or
   4) by an intervention of the National Bank of Belgium (hereinafter "the Bank").

With the entry into force of the Law of 13 March 2016 on the status and supervision of insurance or reinsurance companies (the "Insurance Supervision Law"), the pricing adaptation referred to in point 4 above has become a specific prerogative of the Bank and falls within the framework of possible recovery measures available to the Bank.

Health insurers offering individual health insurance policies face complex and sensitive choices in terms of assessment under Solvency II. Thus, the very long projection horizon makes the assessment of corresponding technical provisions particularly sensitive to the underlying model parameters. It is also necessary to make adequate projections of the evolution of medical costs over these potentially (very) distant deadlines. Objectivity, stability, and prudence are therefore the key words for the assessment of the best estimate for individual health insurance policies.

In order to examine the sensitivities surrounding the assessment of the best estimate and the mutual level playing field, the Bank decided to conduct a broad horizontal analysis focused on the modeling of hypotheses concerning the evolution of medical inflation. The results confirmed, in addition to market heterogeneity, the enormous sensitivity of the best estimate assessment to these hypotheses and, consequently, the need for clear guidelines for the modeling of this type of product. Based on the results of the analysis, the Bank decided to develop a scenario that will be used as a lower limit to assess the prudence of the medical inflation modeling hypotheses used for the calculation of technical provisions. Based on the principle of proportionality, the insurance company may derogate from this provided that it does not result in an underestimation of technical provisions. The Bank will also use this scenario as a basis for quantifying potential pricing imbalances.

2. Verification and entry into force
   Pursuant to Article 272 of Delegated Regulation (EU) 2015/35, the actuarial function must ensure that the most appropriate approximations for the purpose of calculating the best estimate are used, and, regarding individual health insurance, this amounts to verifying that any deviations from the reference scenario do not lead to an underestimation of technical provisions.

This verification must be carried out annually.
The communication applies for the first time to figures as of the reference date of 31/12/2021.

1 See Article 204 of the Law of 4 April 2014 on insurance.
Communication - Bus. 2/6 NBB_2021_24 - 21 December 2021

3. Methodology of the reference scenario
   The reference scenario is based on consumer price inflation increased by a wedge. Indeed, medical costs should grow more vigorously than the HICP since they follow prosperity and are therefore at least in phase with real growth. However, they should continue to grow in the short term due to technological innovation, which continues to push them upward. The wedge therefore represents the sum of real growth increased by this technological innovation.

As the best estimate is based on market-conform principles, it is appropriate in this case to use as much information as possible from liquid markets. For the increase in the HICP, there are liquid inflation-indexed swaps (inflation swaps) that provide an estimate at the Eurozone level. At the national level, there are sometimes also inflation-linked bonds, which, however, generally present higher expectations regarding HICP due to illiquidity premiums contained in the assessment. These instruments therefore seem less appropriate. For the calibration of the wedge, there are no financial instruments: historical calibration must be used. GDP-linked bonds are, however, already available, but they are still in the design stage.

Regarding the long term, the inflation curve is inspired by the risk-free interest rate curve as produced by EIOPA. In this case, a Smith-Wilson extrapolation will also be used from a maturity of 20 to 60 years up to an Ultimate Forward Medical Inflation Rate (hereinafter "UFMIR"). The coherence of the extrapolation is important to ensure that no additional volatility results from the inconsistency between the risk-free interest rate curve and the medical inflation curves. In addition, the UFMIR is based on the long-term expectations used by the Study Committee on Aging and the European Commission for the projection of public health expenditures. Indeed, it was observed, in the 1960s to 1980s, a income elasticity of 1.2 to 1.5 during different years and in different countries. This observation is explained by the establishment of social security after the Second World War and did not constitute a long-term effect. The income elasticity has recently converged to 1. This convergence indicates that in the long term, the real increase in public health expenditures is consistent with the real growth of GDP per capita, which corresponds to 1.5%. In addition, it is assumed that the growth of medical costs for the insurance sector is in phase with the growth of public expenditures. Indeed, it is based on the stability of policy in the best estimate projection. Moreover, it is assumed that the increase in the HICP is in phase with the 2% target of the European Central Bank's monetary policy. The long-term nominal growth of private medical costs is therefore 3.5% (= 1.5% x 1 + 2%).

4. Description of the reference scenario
   4.1 - General provisions
   The reference scenario concerns exclusively hypotheses concerning the expected evolution of the inflation of claims of companies and the expected evolution of general medical inflation at the market level for individual health insurance such as hospitalization, outpatient care, and dental care. It combines the use of observed developments in premiums and claim costs in the short term with macroeconomic elements in the long term.

Concretely, the scenario has the following characteristics regarding the modeling of the evolution of medical inflations:

• Short-term evolution of medical inflations: based on a European inflation curve increased by an inflation wedge.
  o European inflation curve: constructed using zero-coupon inflation-indexed swaps (ZCIIS) based on the Harmonised Index of Consumer Prices excluding Tobacco (HICPxT) of the Eurozone. o Inflation wedge: differential between European inflation and Belgian claim inflation.
  • Specific medical inflation (important for the evolution of claim payments): calibration based on a sufficiently large set of historical observations specific to companies. The wedge is defined as the average differential between specific claim inflation and Eurozone HICPxT inflation.
    The medical inflation curve for claims does not apply to indemnity-type insurance, but only to insurance covering expenses. The projection for indemnity insurance is not linked to medical inflation.
  • General medical inflation (at the market level, therefore important for the evolution of premium revenues via the medical index): based on historical observations of the base indices of Article 7 of the Royal Decree of 18 March 2016 determining specific indices, possibly supplemented by expert judgment if the available data are not deemed sufficiently significant. The wedge is defined as the average differential between general claim inflation and Eurozone HICPxT inflation. Given the volatility of recent observations, it is requested to limit oneself to the overall medical index without taking into account age categories.

By analogy with the "liquid" part of the EIOPA risk-free interest rate curve, the short term would reach a Last Liquid Point of 20 years.

• Long-term evolution of medical inflation: forecasts of medium and long-term medical inflation can be very diverse and are surrounded by a very high degree of uncertainty. That said, this uncertainty does not prejudice the obligation to formulate, for the long term as well, well-founded and objective hypotheses. For the long-term part, macroeconomic principles are therefore taken into account, resulting in a long-term medical inflation that is equal, according to the following formula, to an ultimate forward medical inflation rate of 3.5%:

UFMIR = income growth (1.5%) x elasticity (1) + base inflation (2%) = 3.5%.

where the long-term estimate of GDP growth by the Federal Planning Bureau (1.5%) and the inflation target of the European Central Bank (2%) are taken into account. By fixing income elasticity at 1, it is assumed that the evolution of medical costs, on a real per capita basis, follows general income growth.

• The Smith-Wilson extrapolation method is prescribed for the convergence of short-term results to the ultimate forward medical inflation rate prescribed above. As mentioned above, this method is already well known in the context of constructing the EIOPA risk-free interest rate curve. It will therefore be used to allow the curve to converge, from the Last Liquid Point of 20 years, to 3.5% at a maturity of 60 years. The technical specifications of this method can be consulted on the EIOPA website.
  https://www.eiopa.europa.eu/tools-and-data/risk-free-interest-rate-term-structures_en - Risk-free rates previous releases and preparatory phase.
  Communication - Bus. 4/6 NBB_2021_24 - 21 December 2021

4.2. Specific points of attention

• Point of attention 1: Calibration of wedges - Historical data
  Specific medical inflation wedge: Here, precision prevails. If a large history of detailed and reliable data is available, a history as long as possible should be used.
  General medical inflation wedge: Here, stability prevails. The number of medical indices calculated and published by the Federal Public Service Economy in accordance with the Royal Decree of 18 March 2016 is quite limited. Whenever possible, these data should be supplemented by more relevant older statistics that are also available, for example, statistics published by Assuralia. It is important to approach these data with caution (cf. point 3).

• Point of attention 2: Calibration of wedges - Data granularity
  Specific medical inflation wedge: Without prejudice to the principle of proportionality, claim profiles must be established by product and sex, with product granularity conforming to that used for the medical index.
  General medical inflation wedge: The estimate at the product level is sufficient in this case, with product granularity conforming to that used for the medical index.

• Point of attention 3: Calibration of wedges - Representativeness of data
  If, due to changes in regulation and legislation or developments in underwriting policy and product assortment, the evolution of medical costs in the past is not representative of the future, this must be remedied. If, furthermore, the data used regarding medical inflation represent only part of the companies subject to the medical index, these data must be adapted so that they are representative of the entire market. Finally, expert judgments can also be applied to data related to health crises that have a strong short-term impact but whose long-term impact is considered less significant.

• Point of attention 4: Calculation of the wedge
  The calculation of the wedge must be carried out according to one of the following methods:
  1) The wedge can be calculated on the one hand as an average differential between specific claim inflation and Eurozone HICPxT inflation.
  2) In that case, the company can also use a specific model to establish a rate curve for the wedge.

• Point of attention 5: Construction of the inflation curve
  Since convergence depends on the short-term curve, this means that the Smith-Wilson methodology convergence must be calibrated to ensure that the UFMIR is reached at 60 years. In case of inadequate calibration, it would indeed be reached earlier or later.

NBB_2021 24 - 21 December 2021 Communication - Bus. 5/6

• Point of attention 6: Coherence with the Verwilghen Law
  The inflation curve based on general inflation is an estimate of future base indices. It can therefore, in accordance with Article 7 of the Royal Decree of 18 March 2016, be used to construct future specific indices for the calculation of the evolution of future premium revenues.

• Point 7: Possibility of stochastic valuation
  The communication presents the modalities for a deterministic calculation. If the company has future management activity that depends on the specific value of the HICP relative to the medical index, the company may, for the calculation of the Best Estimate, deviate from this deterministic calculation and use a stochastic model for the HICP, the wedge, and the medical index. The company applies the management activity for each individual simulation based on the concrete value of the HICP, the wedge, and the medical index at the time in the simulation.

The verification by the actuarial function that any deviations from the reference scenario do not lead to an underestimation of technical provisions, in the case of a stochastic valuation model, must be done based on the central Best Estimate, in line with a single central scenario.
The final Best Estimate, after verification that technical provisions are not underestimated relative to the reference scenario, is thus equal to:

BE > max(BE_ref, BE_central) + TVOG

With:

• BE_ref the deterministic Best Estimate based on medical inflation from the reference scenario;
• BE_central the central Best Estimate according to the company's own medical inflation hypothesis based on a single central scenario;
• TVOG the time value of options and financial guarantees calculated as the difference between the stochastic Best Estimate and the central Best Estimate BE_stoch - BE_central
• BE_stoch the stochastic Best Estimate according to the company's own medical inflation hypothesis based on a complete set of stochastic scenarios,

A copy of this communication is sent to the approved commissioner(s) of your company.

Sincere regards.

Pierre Wunsch
Governor

Communication - Bus. 6/6 NBB_2021_24 - 21 December 2021