B5. Loss-sensitive rating plans

Question 1

loss-sensitive rating plans

Answer 1

Loss-sensitive rating plans are only available for large commercial risks ( due to significant amount of risk retained)

insured retains a greater portion of risk compared to a typically policy and as such insured’s costs (policy premium or retained losses) are * significantly dependent on actual losses* of insured during policy term

Question 2

Reason for increased interest in loss-sensitive rating plans by insureds

Answer 2

Trend toward self-insurance since insured hopes to keep expenses and profits that would be paid to insurer

Question 3

Advantages/disadvantages of loss-sensitive rating plans for the insured

Answer 3

Advantages:

1. financial incentive for loss control due to reflection of bad loss experience in premium
2. *opportunity to save money in short term with good experience due to immediate reflection of good loss experience without lag or credibility
3. possible cashflow benefits due to payment of total premium later than a traditional policy ( Retro)
4. possible savings due to lower premium taxes and assessments (LDD and SIR policy only)
5. tax savings to employer due the unpaid deductible of a LDD policy being tax deductible, but the unpaid claims of a traditional policy is not

Disadvantages:

1. insured retains a greater portion of risk due to higher uncertainty in total costs than a traditional policy with a fixed premium
2. possibility of high costs in short term with bad experience
3. ongoing impacts on future financial statements and ongoing administrative costs due to payment of bills as losses develop
4. need to post collaterals against credit risk of paying future bills as losses develop
5. more complex than a traditional policy

Question 4

Advantages/disadvantages of loss-sensitive rating plans for the insurer

Answer 4

Advantages:

1. immediate financial incentive for loss control for the insured
2. less capital required to write policies due to greater portion of risk retained by insured
3. **greater willingness to write risks that the insurer would not write on a traditional policy

Disadvantages:

1. tendency of insured to challenge the profit provisions due to insured retaining greater portion of risk
2. tendency of insured to challenge the claims handling and ALAE costs* due to insured paying* high costs for bad experience*
3. credit risk due to collection of retained losses from insured later than a traditional policy
4. higher administrative costs due to higher complexity

Question 5

What is the Large Risk Alternative Rating Option of retrospective plan (LRARO)

Answer 5

Description:

• allows more flexibility ( use losses on paid basis)
• for knowledgeable/sophisticated large insureds
• by negotiating directly with the insurer

Example of negociations/customizations:

• calculation based on paid plan instead of incurred plan
• agg limits based on min/max ratable loss instead of min/max total retro premiums

Question 6

Timeframe for recalculating retrospective premiums for paid vs incurred plans

Answer 6

Paid plan particularities (for LRARO only):

• first recalculation of premium at 1st month after inception (t=1/12)
• subsequent recalculations of premium every 1 month (t=2/12, 3/12, 4/12, etc)
• generally converted to an incurred plan after a pre-determined amount of time (ex: 5 years)

Incurred plan particularities (default):

• first recalculation of premium at 6th month after expiration (t=18/12)
• subsequent recalculatons of premium every 12 months (t=30/12, 42/12, 54/12, etc)

Question 7

Differences between loss-sensitive rating plans and a guaranteed-cost (traditional) policy

Answer 7

Loss-sensitive rating plans:
-insurer retains a smaller portion of the risk => insurer required to held less capital => $ of profit provision is lower

• insurer retains the riskier portion of the losses => % of profit provision is higher
• expenses higher since:
  
  • cost in issuing endorsement
  • additional data reporting
  • cost in computer system upgrade
  • cost in seeking reimbursement if LDD

Question 8

Why an interative procedure is needed to calculate the net insurance charges of retrospective premiums

Answer 8

• net insurance charges in the basic premium depend on the min/max total retrospective premiums
• however the min/max total retrospective premiums depend on the basic premium
• therefore iterations are needed to converge to the correct net ins charges

Question 9

What is the balance principle of retrospective premiums

Answer 9

Principle:
-the expected retrospective premium must equal the guaranteed-cost premium (which is the premium of traditional policy)

Flaw of principle:
-the expected retrospective premium should be slightly lower because the insured retains a greater portion of risk (as compared to a traditional policy)

Question 10

Why must a retrospective plan absolutely have a per occurrence limit and a maximum ratable loss

Answer 10

If there is no per occ limit or max ratable loss:

• insured pays exactly all of the actual losses during the policy term
• and also pays the expense and profit provisions for the insurer
• therefore it would be cheaper to buy no insurance

If there is only a per occ limit:
-insured potentially pays an unlimited amount of exposure

If there is only a max ratable loss:

• if low agg limit => insured has no incentive for loss control
• if high agg limit => insured pays premium mostly driven by volatility of large losses

Question 11

List 5 variations on loss-sensitive rating plans

Answer 11

1. dividends plans
   - Allow for some profit to be returned to insureds if losses are lower than expected subject to approval by insurer’s board of directors
   - if loss>expected => no additional money collected from insured
   - money returned is considered to be expense for insurer not premium
   - since profit returned is not in premium increase/decrease => no tax savings
   - since dividends may be recouped if losses develop => additional credit risk
2. clash coverage
   -protects insureds from single occurrences that impact multiple of their loss sensitive policies each with separate per-occurrence retention
   -insured will retain up to the clash deductible
   -therefore the insured pays only 1 deductible instead of x deductibles on the x loss-sensitive policies
   grosso modo : clash deductible < sum (individual deductibles)
3. basket aggregate coverage
   policies cap insured aggregate reimbursable or ratable losses across multiple loss-sensitive policies at single aggregate retention up to specified limit; insured will be reimbursed for losses above aggregate retention up to limit
   -if insured has x loss-sensitive policies
   -insured pays up to the basket aggregate retention, up to a basket aggregate limit
   -therefore the insured pays up to 1 aggregate limit instead of the x aggregate limits on the x loss-sensitive policies
4. multi-year plans
   - lower insurance charges: because more stable on longer period
   - higher per occ deductible and aggregate limit: because more trend on longer period
   - higher credit risk: since insured financial condition can deteriorate over time
   - contrat wording more flexible to allow significant changes in exposures
   - get popular during soft markets since insureds want to lock in lower rates
   - Loss trends must be built in
5. captives
   - large insureds create their own reinsurance company
   - to insure their own exposure

Question 12

3 sources of credit risk for loss-sensitive rating plan

Answer 12

1. retro policy
   - insured pays premium as losses develop instead of inception
2. LDD policy
   - insured reimburses the deductible max to aggregate limit
3. dividends plans
   - insured reimburses the dividends if lossexpected

Question 13

3 ways an insurer can protect himself from credit risk

Answer 13

1. loss development factors
   - insurers can use LDFs to estimate ultimate loss instead of using actual loss to calculate retro premium or dividends
2. security
   - insured needs to post collaterals for expected future payments
3. holdbacks
   - insurer can delay retro adjustments or dividends payments until a later maturity

Question 14

4 considerations for insureds and insurers in agreeing on retention levels

Answer 14

1. insured should be comfortable with the retained risk implied
2. insurer should be comfortable with the credit risk implied
3. insured should retain the higher predictable frequency (working layer), and insurer should retain the less predictable loss
4. retentions should increase over time to reflect the loss trend

Question 15

Assumption for Discount calculation in Deductible plans

Answer 15

Discount is based on assumption that acquisition expenses, taxes and profit are reduced proportional to premium; while other expenses and LAE are not reduced => so we use (E-a)

Question 16

Why is Excess loss coverage risky?

Answer 16

1. insurer has no control over underlying claim
2. interest rate risk is significant due to CF differences. avg loss and expense payout period is longer.
3. claim notification is longer, since insurer must rely on notice from TPA.

Question 17

Reason to buy LDD contract even if higher premium than Retro

Answer 17

1. Company might be willing to pay more for the certainty of fixed prm
2. Insured may not have the capabilityy to handle and process claims and may wish the insurance company to do that work which happends in a LDD policy

Question 18

Reason to buy retro contract even if higher premium than LDD

Answer 18

Insured may have made changes to their safety procedures , meaning that they would have lower losses in future periods, and the higher retrospective premiun will eventually adjust downward , saving the company money

The insured may be in the type of business that generates a large number of very small losses, so a LDD policy would require the insured to pay most of their losses

Question 19

if new risk ( experience rating impratical) what should we do

Answer 19

1. retro rating : can allow adjustement to premium based on current period experience. For the insured, may have cash flow advantage if initial prm is set to low. For insurer , one advantagee is a lower capital requirement
2. Coud use LDD plan : loss sensitive rating option where the insured is responsivle for claims below the deductible.
   Benefit to insured : would see a more immediate reflection of good loss experience.
   Benefit for insurer : insured has a financial incentive for loss control
3. use NCCI method of splitting primary and xs loss so that premium is not inappropriately impacted by large losses with less credibility. Avantage for insured : their prm will not see large swings yrs to yrs from large loss experience.advantage for insurer : experience mods from a split plan for WC are generally shown to be more accurate in estimating expected costs so they are less likely to underprice risk .