Question

What's the major reason why Penn Treaty company failed to fulfill LTC liability obligations?

Answer 1

1.incorrect assumptions are made in pricing new insurance products

2.Underpricing a new product was the major cause of the insolvency of Penn Treaty.

Explanation 1

Insurance companies need to make many assumptions in order to determine how much to charge for LTC insurance. For LTC insurance, one key assumption is the lapse rate, or the frequency at which policyholders voluntarily discontinue their policies while they are still healthy. As we mentioned, LTC insurance is significantly prefunded. This feature, combined with the lack of surrender value, means LTC policyholders who let their policies lapse or who die early reduce the cost for those who continue on with their policies. LTC insurers must also make assumptions about the likelihood of a policyholder needing LTC— such as the probability that someone will become disabled and require LTC and how much money that individual will use while in care relative to the policy limit. Assumptions must also be made about how long a person will require care, which in turn involves assumptions about whether the individual will get better or die. Insurers base these assumptions on some combination of their own experience and the broader insurance industry’s experience. Because LTC claim payments can be made many years in the future, interest rate assumptions are used to derive the present value of claims, as well as that of premiums paid to fund these claims. Insurers typically use the rates of interest they expect to earn on assets they own (or plan to invest in) to derive the interest rate assumptions. When possible, insurers seek to buy assets to match the expected timing of liability payments. However, it is hard to find bonds with long-enough maturities to match payments for very long-term liabilities, such as LTC insurance policies.

Which of the LTC insurance pricing assumptions wound up missing the mark? Many of the pricing assumptions LTC insurers made were off—and off in the wrong direction, which means that LTC insurance was underpriced. One reason for this was that LTC insurance was a relatively new product and, therefore, insurance companies did not have sufficient experience on which to base their assumptions.9 This led many companies to use their experience with other products to price LTC insurance. In addition, companies arguably used less margin of safety than prudent, given the paucity of data on which to base their assumptions about how LTC insurance would perform. We now discuss some of the issues with the assumptions made by insurers

Lapse-rate assumptions for LTC insurance— which were mostly based on the history of lapses on annuities—turned out to be too high. As discussed previously, LTC insurance is a “lapsesupported” product. Insurers expected a decent percentage of policyholders to discontinue their policies early without making any claims. It was anticipated that the premiums collected from exiting policyholders would subsidize those remaining as well as provide a source of profit for the insurers. The expected “lapse support” did not materialize. Morbidity (claim incidence, benefit utilization, and claim termination) and mortality assumptions were based on general population data or on non-LTC insurance data. People choosing private insurance can have different characteristics than the general population.LTC insurance was priced with the expectation that future premiums could be invested at the then-prevailing interest rates before they were used to pay claims. This assumption turned out to be too optimistic given the low-rate environment that has existed since the most recent financial crisis. As we mentioned before, life insurers have difficulty buying assets with maturities long enough to match liabilities whose payments extend many years into the future (such as LTC policies). This situation was exacerbated when the maturity of liabilities was longer than originally assumed on account of low lapse and mortality rates. The result was that assets matured sooner than liabilities and had to be reinvested at significantly lower interest rates than were needed to fund those liabilities.

Explanation 2-

Underpricing a new product was the major cause of the insolvency of Penn Treaty. Penn Treaty, at the time the tenth-largest LTC insurer, was placed into rehabilitation (the first stage of the receivership process for insurers) in January 2009.When an insurer is in rehabilitation, it continues to operate, collecting premiums and paying claims. This can put policyholders in a bind. When Penn Treaty went into rehabilitation, its LTC policyholders were faced with two choices. First, they could terminate their policies, thereby losing the value of prefunding from the premiums already paid (discussed in more detail later). Terminating their policies would also leave them uninsured. And replacement policies would most likely cost more. Alternatively, they could keep paying premiums in the hope that the insurer emerged from rehabilitation healthy or was acquired (either option could involve large premium increases). However, if policyholders continued paying premiums and rehabilitation failed, the insurer might be liquidated and they might get only a fraction of the amount owed from the assets remaining plus any payments from state guaranty funds. Penn Treaty’s assets were substantially depleted, and it ended up being ordered to liquidate in March 2017. During the eight-year rehabilitation period, many policyholders’ claims were paid at their contracted rates. However, other policyholders, who were not yet disabled when the liquidation process began, lost out because the insurer did not have money left to pay them and state guaranty funds have caps on the payout per policy.

Penn Treaty failed because it used assumptions that turned out to be incorrect to price LTC insurance. LTC insurance was particularly susceptible to incorrect forecasting assumptions because it was a relatively new product, with limited actuarial data and with potential payments occurring as many as 50 years in the future.