loss sensitive

Question 1

describe the balance principle for retrospective rating, and why it is flawed

Answer 1

The balance principle states that the premium for a guaranteed-cost plan should equal the expected premium for a retrospectively rated plan. It is flawed because there is a difference in risk transfer in the 2 cases, specifically, the insured retains more risk with a retrospective rating plan

Question 2

Loss-Sensitive Rating Plans

Answer 2

-LSRPs are plans in which 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 3

due to significant amount of risk retained

Answer 3

these plans are usually only available to large commercial risks

Question 4

retrospective rating plans

Answer 4

insured’s premium will develop based on their losses during policy term

Question 5

large deductible plans

Answer 5

• insured will have a very large per-occurrence deductible with an optional aggregate limit on losses retained below per-occurrence deductible
• insurer indemnifies all losses in excess of per-occurrence deductible and all primary losses in excess of optional aggregate deductible limit
• insurer provides services equivalent to full coverage policy including adjusting all claims regardless of whether they exceed deductible
• plans have become more common than retrospectively rated plans

Question 6

self-insured retentions with excess policy

Answer 6

• insured retains a very high per-occurrence retention with optional aggregate limit or losses retained below per-occurrence retention
• insurer indemnifies all losses in excess of per-occurrence retention and all primary losses in excess of optional aggregate retained limit
• insurer only becomes involved with claims that may exceed the retention so while insured may adjust claims themselves insured will usually contract with a TPA to adjust claims
• these polices are usually purchased by insureds that want to retain a greater portion of risk compared with large deductible plans or retrospectively rated policies

Question 7

Advantages to insureds

Answer 7

• financial incentive for loss control
• opportunity to save money in short-term with good experience
• possible cash-flow benefits compared to a traditional insurance policy
• possible savings from reduced premium-based taxes and assessments

Question 8

Disadvantages to insureds

Answer 8

• uncertain costs compared to traditional policy
• loss of immediate tax deductibility of traditional premium
• possibility of high costs in short-term with bad experience
• impact on future financial statements as losses develop
• ongoing administrative costs as losses develop
• need to post security as collateral against credit risk
• additional complexity compared to traditional plan

Question 9

Advantages to insurer

Answer 9

• insured’s immediate financial incentive for loss control
• greater willingness to write risks that insurer wouldn’t otherwise write on a traditional policy
• less capital required to write policies under which insured shares risk

Question 10

Disadvantages to insurer

Answer 10

• higher administrative costs compared to a traditional policy
• existence of credit risk for some plans when need to collect from insured
• possible cash flow disadvantages compared to traditional policy
• insured’s tendency to second guess claims handling and alae costs
• insured’s tendency to question profit provisions since insured is taking on significant risk

Question 11

cash flows for a retrospectively rated policy are:

Answer 11

1. insured pays an initial premium at start of policy term
2. just like with a prospectively rated policy, sometime within a few months after policy expires, exposures will be audited and premium will be recalculated based on auditee exposures
   - insured will be billed or refunded for any resulting premium differences
3. premium is also recalculated multiple times using actual loss experience of individual policy as it develops
   - after each of these recalculations of premium, insured will pay or receive the difference between newly calculated premium and previously paid premium

Question 12

basic premium

Answer 12

covers costs that are not variable with actual losses L or actual retrospective premium R

1. profit and UW expenses not included in T
2. expected per-occurrence excess loss if per-occurrence ratable limit is selected
3. expected aggregate excess losses (aka insurance charge) if an aggregate ratable limit is selected
4. credit (aka insurance savings) if a minimum aggregate ratable loss amount is selected

Question 13

if max and/or min premiums are explicitly selected then net insurance charge in B depends on

Answer 13

aggregate limits implied by max/min premiums but since max/min premiums depend on B, iterative procedure is needed to obtain the correct net insurance charge

Question 14

Balance Principle

Answer 14

• aside from extra incentive for loss control under retro plan, expected losses for a retro rated policy would be equal to expected losses from insured for a guaranteed-cost policy
• as such, for some retro rating plans in US, it is a requirement that expected premium for a retro plan = prem under guaranteed cost plan
• this matching requirement is called balance principle
• since there is a difference in risk transfer between 2 cases, balance principle is actually flawed

Question 15

Large Risk Alternative Rating Option, LRARO

Answer 15

• plans such as NCCI and ISO in US include a provision called LRARO that allows for flexibility in plan design for very large risks
• option assumes large risks are knowledgeable consumers can negotiate parameters with insures directly
• common LRARO customizations include allowing for NCCI plan to be on a paid basis and allowing max and min ratable loss amounts to be set directly instead of indirectly through max and min premiums

Question 16

large deductible plans

Answer 16

• often just written as full coverage policies with an extra endorsement specifying that insured will reimburse the insurer for losses below per-occurrence deductible possibly up to an aggregate limit
• deductible may or may not include alae

Question 17

large deductible plans: policy premium vs full coverage

Answer 17

• since deductible is in place, policy premium will be much lower than premium for full coverage policy including expected premium for retro rated policies
• this means that employer is taking on more of insurance risk so it is possible that their total costs in given year would be higher than purchasing full coverage
• since some expenses are variable to lower net premium, expenses will be lower in amount compared to full coverage but expected excess loss can be relative to expenses so expense ratios can be quite high

Question 18

from loss standpoint, self-insured retention with excess policy is similar to

Answer 18

large deductible plan

Question 19

key differences between self insured retention and large deductible plan

Answer 19

1. for required coverages, regulator approval is required for self-insurance with excess policy
2. since with self-insurance and excess policy, the insured is responsible for adjusting claims; insure only incurs alae for claims that exceed retention
   - usually retention applies to loss only and alae is shared pro-rata
   - ulae is much lower since insurer doesn’t handle claims below retention which reduces premium and amount of premium related expenses
3. on these plans, insurer pays insured for loss amounts above retention instead of paying ground-up loss and seeking reimbursement from insured like on large deductible plans; insurer does not have credit risk on these plans
4. since limits are generally not reduced by retentions but are reduced by deductibles, specification of these plans will often be slightly different than large deductible plans in order to provide same loss coverage

Question 20

dividend plans

Answer 20

basically regular policies that allow for some profit to be returned to insureds if losses are lower than expected subject to approval by insurer’s board of directors

• money returned is considered to be expense for insurer not premium
• if insured losses develop upward after dividend paid, some of that dividend may need to be paid back to insurer

Question 21

clash coverage

Answer 21

protects insureds from single occurrences that impact multiple of their loss sensitive policies each with separate per-occurrence retention

• single clash deductible aka clash aggregate will represent the aggregate amount the insured will need to retain from occurrence and insurer will cover loss above that amount
• example: employee car accident triggers both WC and AL could cause insured to retain full per-occurrence deductible from both lines but clash coverage can cap this at single aggregate amount retained

Question 22

class coverage- estimating expected losses

Answer 22

-can be difficult and may require simulations and assumptions about frequencies, severities, and correlations between LOBs

Question 23

basket aggregate coverage

Answer 23

aka account aggregate; 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

-with this, underlying loss-sensitive insured policies are usually written without aggregate limits on deductible losses or maximum ratable loss amounts so coverage provides main source of aggregate loss protection

Question 24

multi-year plans

Answer 24

some loss-sensitive plans can be written on multi year basis instead if single year; longer time period is thought to result in more stable expected losses thus reducing the insurance charge for aggregate losses being too high

-get popular during soft markets since insureds want to lock in lower rates

Question 25

captives

Answer 25

very large insureds can create their own insurance companies called captives to insure their own exposures;

often accomplished by typical insurer providing a policy to insured and then ceding most of exposure to captive

Question 26

credit risk

Answer 26

-loss sensitive plans in which insured may need to further pay or reimburse insurer subject insurers to credit risk

Premiums for retro rating

Deductible amounts for large deductible plans

Return of dividends on dividend plans

Question 27

credit risk is especially relevant for

Answer 27

for longer tailed lines and when higher amounts are involved since credit risk will involve greater amounts of risk over longer period of time

Question 28

-insurers can protect themselves from credit risk with

Answer 28

security

ldfs

holdbacks

Question 29

security

Answer 29

insurer can hold collateral for expected future insured payments

Question 30

LDFs

Answer 30

for incurred retro rating plans and dividend plans, insurers can use LDFs to estimate ultimate losses instead of basing retro premium or dividend formula on actual losses to date

Question 31

holdbacks

Answer 31

insurers and insureds can delay retro premium adjustments or dividend payments until a later maturity

Question 32

there are 4 considerations when deciding upon retention levels for a loss-sensitive plan

Answer 32

1. insured should retain higher frequency predictable working layer of occurrence losses and insurer should cover less predictable losses about that level
2. insured should be comfortable with risk implied by their retention
3. insurer should be comfortable with credit risk implied by retention level
4. retentions should increase over time due to loss trend

Question 33

capital for loss sensitive plans v guaranteed cost plans

Answer 33

• since with loss sensitive plans other than dividend plans insured is retaining most of risk for primary losses, capital needed by insurers to support these plans is lower than needed for guaranteed cost plans
• since insurer is keeping riskier portion of losses, profit provision will be larger as % of insured loss

Question 34

since loss-sensitive plan can continue to develop over many years

Answer 34

at some point insurer and insured will agree to close plan

• retro rating plans are closed by closeouts which means applying LDFs to losses to determine a final premium amount
• large deductible plans can be closed using a buyout or loss portfolio transfer which in either case results in insurer or reinsurer assuming responsibility for insured’s remaining loss obligations
• self-insured retentions are closed using loss portfolio transfers