Loss-sensitive rating plans1

Question 1

Loss-Sensitive Rating Plans

Answer 1

-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 2

due to significant amount of risk retained

Answer 2

these plans are usually only available to large commercial risks

Question 3

retrospective rating plans

Answer 3

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

Question 4

large deductible plans

Answer 4

• 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 5

self-insured retentions with excess policy

Answer 5

• 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 6

Advantages to insureds

Question 7

Disadvantages to insureds

Question 8

Advantages to insurer

Question 9

Disadvantages to insurer

Answer 9

• 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 10

cash flows for a retrospectively rated policy are:

Answer 10

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 11

retro rating: initial premium

Answer 11

• initial premium can be determined in various ways, though premium as if the policy was prospectively rated is common choice
• choice of initial is important because it can lead to cash flow advantages for either insured or insurer

Question 12

retro plans can be either

Answer 12

paid loss or incurred loss basis

• incurred basis: cumulative incurred losses are typically evaluated starting 6 months after policy expires and every 12 months thereafter
• paid bases: cumulative paid losses are typically evaluated monthly starting 1st month of policy term; paid plans are often converted to incurred basis after a pre-determined amount of time

Question 13

-retrospectively rated policies will have ratable limits on

Answer 13

actual aggregate losses and/or per-occurrence losses entering the retrospective premium formula

helps stabilize the premium from being too high (and too low if there is explicit aggregate minimum) regardless of actual losses sustained

Question 14

retro: charges are included in premium formula to account for

Answer 14

capping created by these ratable limits

• there is some overlap between occurrence limit and aggregate limit
• we will need to consider potential overlap between charge for occurrence limit and charge for aggregate limit
• note these limits being discussed are not coverage limits that apply to actual claims
• these limits refer to how much of losses will be used in retrospective premium calculation

Question 15

general prem formula for retro: L will be subject to ratable limits

Answer 15

1. if there is per-occurrence ratable limit in plan, then individual occurrences will be capped by this limit when determining L
2. aggregate (limited) losses may be capped by an aggregated ratable limit LG directly or indirectly by capping R at a maximum premium G
   - if limit is specified in terms of losses, it usually is set as multiple of expected losses for policy
   - if limit is specified in terms of max, usually set as a multiple of guaranteed cost premium (prospective premium)
   - in either case, aggregate limit will usually be made to update due premium audit
3. aggregate (limited) losses may be capped by an aggregate minimum ratable amount LH directly or indirectly capping R at a minimum premium H
   - like aggregate limit case, minimum ratable amount will be determined as multiple of expected loss or guaranteed cost premium and will be updated after audit
   - if explicit minimum ratable amount isn’t specified, policy still has implicit minimum premium when L=0 of H=BT

Question 16

LCF

Answer 16

• LCF covers costs that are assumed to be proportional to actual losses
• costs include any LAE not included in L and any loss-based assessments

Question 17

Tax rate

Answer 17

includes premium taxes and any other non tax-related items that are proportional to R; T is fixed at policy inception

Question 18

basic premium

Answer 18

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 19

combo of insurance charge and insurance savings is called

Answer 19

net insurance charge

Question 20

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

Answer 20

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 21

Balance Principle

Answer 21

• 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 22

Large Risk Alternative Rating Option, LRARO

Answer 22

• 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