S&P explains volatility in Vitality Re ILS, but pandemic remains the tail

Rating agency Standard & Poor’s has now published its pre-sale report and preliminary rating for the recently launched $200m Vitality Re VI Ltd. (Series 2015-1) health insurance-linked securities (ILS) deal from life and health insurer Aetna.

The Vitality Re VI Series 2015-1 ILS deal was launched to the investor community late last week, see our article on the deals launch here. More details are now available thanks to S&P’s publication of its pre-sale report and rating commentary.

As ever, the analysis from S&P provides some additional insight on where the risks lie in a transaction such as Vitality Re. In this case there is potential volatility due to factors outside of the number of claims that Aetna receives, with cost fluctuation and expenses also a key factor.

The Vitality Re series of health-linked ILS deals feature a trigger based on a medical benefit ratio (MBR). This is effectively an indemnity trigger, based on the ratio of claims costs to premium income in Aetna’s health and medical benefit insurance business. When the MBR reaches a pre-defined trigger percentage, over the course of an aggregate year, the Vitality Re ILS would pay out.

As a result of the MBR trigger the Vitality Re ILS deals are not solely at risk of large increases in the rate of health insurance claims at Aetna. They are also exposed to claims cost inflation, volatility, expenses, and also the insurers own response to changing claims trends.

S&P explains that the primary cause of volatility is nothing to do with the rate of claims coming in; “According to the risk analysis provided by Milliman, the primary driver of historical financial fluctuations has been the volatility in per-capita claim cost trends and lags in insurers’ reactions to these trend changes in their premium rating increases.”

So the fluctuating costs of claims and how insurers respond to changing health insurance claim trends are key risks which have the potential to move Aetna’s MBR and could ultimately affect the Vitality Re ILS deals.

“Other volatility factors include changes in expenses and target profit margins,” S&P continued.

Interestingly, the MBR for the first nine months of 2014 was 81.4%, up from 80.7% in the same period of 2013, S&P explains. The rating agency explains that this increase was driven by; “A percentage increase in per-member health-care costs that outpaced the percentage increase in per-member premiums.”

A number of factors drove this increase in per-member health care costs, S&P said. “Substantial growth in certain higher MBR businesses and costs associated with new hepatitis C treatments, and partially offset by pricing actions designed to recover fees and taxes mandated by health-care reform,” according to S&P.

These factors that cause the cost of claims to increase are the main source of claims volatility, S&P explains, however the major tail-risk for the Vitality Re ILS transactions remains the occurrence of a major pandemic which caused the number of claims made to escalate dramatically.

So it’s interesting to note that investors in the Vitality Re ILS deals are effectively taking on risks related to health care efficiency factors, claims cost inflation, changes in treatment and other areas which are perhaps not the typical catastrophic risk that ILS investors are used to assuming.

Of course, where indemnity trigger catastrophe bonds are concerned, ILS investors are also taking on some similar risks in cat bond deals with indemnity triggers where there is an exposure to the ceding companies claims practices as well as the potential for claims cost inflation.

S&P said that it assigned preliminary ratings of ‘BBB+'(sf) and ‘BB+'(sf) to the $140m Class A and $60m Class B notes, respectively, that are being issued by Vitality Re VI Ltd. in this Series 2015-1 transaction.

S&P notes:

“The ‘bbb+’ and ‘bb+’ MBR risk factors are derived from the model (Vitality Re VI escrow model) developed by Milliman Inc. Milliman constructed a model based on independently collected data and assumptions that could be used to assess the probability of attachment on the rated notes. The statistical data, methodology, modeling estimates, and explanations included in the information presented to us were prepared by experts in the actuarial analysis of health-care cost and utilization trends and MBR risk.”

In assessing the transaction S&P said that it reviewed the sensitivity tests from the risk model and relied on the results of stress tests that adjusted the premium and claims trends.

S&P notes a number of concerns, including the fact that the model has been constructed using industry-wide data and assumptions, that legislation such as Patient Protection and Affordable Care Act (PPACA) which is still undergoing changes could have the potential to negatively impact the Vitality Re VI notes and that any “New product or significant modification of reimbursement structure, medical management, or underwriting, or a significant change in rating methods on an existing product” could change S&P’s views on the deal.

Mitigating this is the fact that Milliman Inc., as risk modeller, is a widely recognised expert in health-care actuarial consulting. That this is the sixth Vitality Re ILS deal and the MBR’s have never come anywhere near the attachment points to date.

In fact, S&P notes that the highest MBR seen for the covered business since 2007 was an MBR percentage of 88.5% in 2009. The two tranches of notes being issued by Vitality Re VI have attachment MBR’s of 100% for Class A and 94% for the riskier Class B notes.

Since 2009, Aetna’s MBR for the covered business has more typically been around the 82% mark, with an MBR of 82.9% in 2012, 81.9% in 2013 and 81.4% for the first nine months of September. Even the highest MBR seen during any of the Vitality Re ILS deals were outstanding was 11.2% lower than the Class B attachment point, S&P notes.

On the subject of the PPACA legislation, S&P explains:

“In 2014, major provisions of PPACA became operational but were largely limited to individual business, which is not included in the covered block. Provisions applying to small-group insurance will take effect this year but are applicable only to plans with 100 or more members. Although the inclusion of plans in excess of 50 members in 2016 creates some additional uncertainty and complexity, this is partially mitigated by the fact that small group business constitutes approximately 28% of the covered block in 2014 and the possibility of various offsetting factors (e.g., reinsurance) included in PPACA. In addition, any rebates contemplated by PPACA will not be removed from the total premium calculation.”

Finally, S&P notes that the primary driver of risk, under the modelled scenarios, for Vitality Re VI Ltd. will be pandemics, despite the potential volatility from other sources.

Other details that are available thanks to S&P’s pre-sale report include the underlying transaction structure, which sees Aetna using its Vermont domiciled self-reinsurance captive Health Re to effect the deal.

At the time of issuance, Health Re will be capitalized in respect of the risk associated with the quota share reinsurance agreement (QSRA) that relates to the Series 2015 notes issued by Vitality Re VI. Health Re’s existing capitalization will be at least $[110] million.

Under the terms of the QSRA, ALIC will cede on a quota share basis annually $[1,000] million of covered business premiums to Health Re, and ALIC will receive an annual ceding commission thereon of 8.0%. ALIC will retain at least 10% of all medical benefit claims obligations with respect to the covered business net and unreinsured. To ensure that ALIC receives capital and reinsurance credit for the QSRA, the cession of such premium by ALIC to Health Re is effected on a “funds withheld” basis.

Quarterly ceding commission payments of 8.0% per annum and recoveries of medical benefit claims from Health Re on the covered business are a subset of those reported by ALIC in its statutory statements.

Health Re pays dividends to Aetna as permitted by the Vermont Department of Financial Regulation in its licensing order. Health Re may only pay dividends when Health Re’s total adjusted capital is no less than 150% of its company action level risk-based capital, after giving effect to the dividend.

In terms of the covered business, S&P explains:

The covered business ceded under this transaction is the commercial insured accident and health business (namely preferred provider organization [PPO], point of service [POS], and indemnity lines [traditional choice]) directly written by ALIC and reported in its annual statutory statements as “Accident and Health-Group,” except for the excluded risks. The following risks will be excluded from the covered business: all business written through Aetna’s group insurance business (including accidental death and dismemberment; life products, including term life, group universal life, and paid-up life; long-term disability, short-term disability, temporary disability, leave management, and long-term care products); all dental and limited dental products; all Medicare and Medicaid products; all stop loss products; all individual medical products; all limited medical products, including all limited benefit plans (commonly referred to as “mini-med” plans) and all student health plans; all stand-alone vision products; all stand-alone employee assistance program products; all AARP products; all domestic expatriate products; and all products where an insured pays 100% of the premium.

For the nine months ended Sept. 30, 2014, ALIC wrote approximately $7.4 billion of premiums on 2.1 million members for the covered business. This compares to $6.0 billion of premiums and 1.7 million members as of the nine months ended Sept. 30, 2013.

From 2007 to 2013, the premiums for the covered business were $5.3 billion, $6.2 billion, $7.1 billion, $6.9 billion, $6.8 billion, $7.3 billion, and $8.1 billion, respectively.

Aetna will cede annually, in each of three years, $[1.0] billion or approximately [12]% of the covered business premium and risk to Health Re through the QSRA related to the Series 2015 notes.

Finally, S&P explains that as a result the initial (and preliminary until the deal is finished) MBR attachment points can be considered as $1 billion for the Class A notes and $940 million for the Class B notes.

We will keep you updated as new information emerges and Vitality Re VI Ltd. (Series 2015-1) progresses to market. You can read all about this and every other Vitality Re ILS deal from Aetna in the Artemis Deal Directory.