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Chapter 11: financial plans.

Introduction

Workers compensation programs have what are called front and back ends. The front end is the cost at the start of the policy term. The back end is the way in which claims affect the ultimate cost. Both the front and back ends must be considered when choosing a financial plan.

The standard premium was discussed in previous chapters. It is the starting point in determining the cost of a workers compensation policy. The standard premium is amended by application of the experience modification factor, which was discussed in Chapter 10. (Some states also may tax the standard premium.) The result is called the modified standard premium, which is displayed on the policy declarations page and is considered the front end cost. The modified standard premium may be paid in a lump sum (annual premium) or in installments over the term of the policy.

Some workers compensation programs start and end with the modified standard premium. In these, there is no back end. The insured merely pays the premium, the policy is issued, claims are turned into the insurance company, and no more money changes hands between the insured and insurer unless audited payrolls differ from the estimated payrolls used at policy inception. The entire risk of the workers compensation exposure is transferred to the insurance company. Such programs are called fully insured or guaranteed cost plans. Only a change in payrolls or a revision in the experience modifier can generate a premium change.

The far extreme from guaranteed cost workers compensation is selfinsurance. With self-insurance, the standard premium also is the starting point. The insured self finances the workers compensation exposure instead of buying a policy. In other words, the insured takes on the entire risk of worker injuries. Some insureds who elect self insurance do cap their exposure through the use of excess loss or stop loss insurance. Excess or stop loss insurance limits the dollar value of claims for which the self-insured business is responsible. Claim costs above the excess or stop loss point are paid by the insurance company that provides the excess loss coverage. However, for practical purposes, the exposure remains with the client. Most states require that businesses either purchase a workers compensation insurance policy or become qualified self-insurers. They cannot choose to be uninsured. In selfinsured plans, the experience modifier does not affect the cost.

Another way to view this is to look at fixed costs versus variable costs. Fixed costs are those costs that do not change unless the payroll changes. Under a guaranteed cost program, the entire premium is fixed; there is no variable cost. The insured pays the premium and does not risk having to pay more if claims are worse than expected. Conversely, the insured does not have the opportunity to receive a premium return from the insurance company if claims are better than expected. After the premium is paid, the only exchange of money comes at the time of the payroll audit. If payrolls are higher than estimated at policy inception, the insured is billed for additional premium. If payrolls are lower than estimated at policy inception, the insured receives a return premium.

In a self-insured program, the fixed costs are much lower than in a guaranteed cost program. They are comprised of items such as excess premium for stop loss coverage, assessments, premium for a self-insurance bond, taxes, and service fees. They may be as low as 10 percent of the standard premium. The bulk of the costs are variable. Variable costs are comprised mainly of the cost of claims--both adjusting and paying them. The ultimate cost of a self-insured program can be much different than predicted at inception because of the impact of claims.

Market conditions, account size, and account claims history affect the type of financial plans available. When the market is soft, a greater variety of financial plans are offered even when individual account loss history is poor. When the market hardens, however, fewer options are offered and an individual company's loss history may have a greater impact on the type of financial plan available. In addition, smaller companies may not be eligible for certain financial plans. They may only be eligible for a fully insured, or guaranteed cost, program.

Between the two extremes of guaranteed cost and self insurance are a number of other methods of financing the workers compensation exposure.

This chapter examines them in terms of:

* amount of insurance purchased;

* cash flow arrangements;

* amount of fixed costs;

* amount of risk transferred to insurance company; and

* amount of collateral required.

Types of Financial Plans

The types of financial plans that will be discussed in this chapter are guaranteed cost, standard dividend, sliding scale dividend, incurred loss retrospective rating, paid loss retrospective rating, and deductibles. Selfinsurance and captive plans will not be discussed because they are individually designed and beyond the scope of this book.

Figure 4 at the end of this chapter highlights some of the major differences among seven types of financial plans.

Many workers compensation experts use premium size guidelines when deciding what type of financial plan a business should seek. Very small businesses with workers compensation premiums of $25,000 or less may not be offered any choice other than a guaranteed cost or dividend plan. Since there is no down side to a dividend plan for the insured, it is attractive to small businesses. Adverse market conditions may cause insurers to refrain from offering dividend plans to all but the best accounts, however, so businesses may be forced to purchase a guaranteed cost program.

NCCI regulations do permit companies to offer incurred loss retrospective plans to companies with premiums of $25,000 or more. Since there is the risk of paying more with a retro plan, businesses need to be sure they can financially assume that risk.

As businesses grow in size and sophistication, the types of financial plans they are offered also become more complex. Figure 1 illustrates the relative trade-off between risk and cash flow that are features of various types of plans. Larger businesses should be sure that they have adequate safety and claims management systems in place before choosing a plan that requires them to take on substantial risk. Financial stability also is considered by insurers when when they offer a workers compensation plan that has attractive cash flow.

Some professionals use a premium of $300,000 as the threshold for businesses that desire to self-insure. This is only a rule of thumb, but it is wise to remember that a certain premium size is necessary to support the management programs that are required with self insurance.

Both the qualitative and quantitative aspects of a program should be studied when choosing a plan. The quantitative aspects are the actual dollars that are expected to be spent in covering worker injuries. Qualitatively, a company may desire a specific financial program because it provides a greater opportunity for the company to influence loss control and claims adjusting. An insurer usually is more likely to coordinate these activities with the insured that is retaining more risk. It is important to remember, however, that an insurance company always retains the final decision-making authority on claims in any type of insured workers compensation program.

The way in which worker injuries are managed can greatly impact both current and future workers compensation costs. Because of this, close attention to cost and program management must be paid when trying to understand and select an appropriate workers compensation program. The various types of plans can be placed on a continuum of insurance options. This continuum places the program factors on a relative scale of amount of insurance, cash flow, fixed costs, risk, and collateral requirements. As illustrated in the chart below, guaranteed cost programs generally include the most insurance and least risk. Cash flow management is low or non-existent. At the other end of the continuum is self-insurance, which features the least insurance, best cash flow management, and lowest fixed costs. In exchange for these pluses, a self-insured company takes on the most risk and highest collateral requirement. Of course, the fixed cost structures of each program vary depending upon market conditions.

[FIGURE 1 OMITTED]

Guaranteed Cost Plans

A workers compensation policy with a fixed or guaranteed cost premium is the most conservative and the easiest to understand. Such programs are stable in regard to cost. A company that chooses a guaranteed cost plan knows what worker injuries will cost at policy inception because the policy premium is the cost. The premium varies only as a factor of payroll and experience modifier, if applicable. It does not vary directly as the result of loss experience and cannot be increased retrospectively.

The guaranteed cost premium is the manual, or standard, premium. If an account qualifies for an experience modifier, it is applied to the standard premium. The standard premium calculation is discussed in Chapter 9. The experience modifier is discussed in Chapter 10. The guaranteed cost program is the starting point for all workers compensation programs and can be reduced by discounts, dividends, and deductibles or increased by loss or expense constants. Even though it is the easiest to understand, it may not be the most desirable--or even available in the marketplace.

Dividend Plans

These plans are designed so that an insured may receive a dividend if worker injuries are less expensive than anticipated. They are designed to reward companies that do a good job in preventing and managing worker injuries. The dividend may be based on the loss experience of a particular group to which the insured belongs or of the individual insured. In group dividend plans, the claims experience of the entire group is compiled. If the insurer has made a profit on the group, a dividend may be declared. In like fashion, individual dividends are determined based on the amount of losses the individual company incurs.

Dividends are never guaranteed. They are payable only upon declaration of the insurer's board of directors. If declared, they are paid at various intervals after the policy expires, sometimes in a lump sum and sometimes in a series of payments. Dividends usually are not computed earlier than twelve months or more after policy expiration. The details on how and when the dividend is due should be provided before policy inception.

In addition, policies with back-end dividend plans are subject to experience rating. Therefore, if a company qualifies for an experience modifier, it is used to develop the standard premium. Stock and/or mutual company discounts also are applied to policies that offer a back-end dividend.

Standard Dividend Plans

A standard or flat dividend, if declared, is paid a year or more after a policy expires. They are most often used with affinity or group programs. Affinity programs are designed around a type of business. For example, a trade group of manufacturers, grocery stores, schools, or other business type may develop a workers compensation group program that is open to association members. Since the group represents a large amount of premium, insurers may be willing to offer a dividend plan to its members. Even though an insured receives the benefit of a possible dividend, the insured will not have to pay additional premium--aside from additional premium that may be developed in the payroll audit. An exception exists for assessable insurance policies issued by an assessable mutual insurance company or reciprocal.

Dividend plans work because insureds are rewarded when the insurer makes an underwriting profit on a homogeneous group of accounts. Since the insured does not risk having to pay more premium in the event of bad losses, the potential return is lower than in riskier plans. There is a trade-off between risk and potential benefit.

For example, an association of manufacturers may go to one carrier to purchase workers compensation insurance. Individual group members are underwritten separately, and the amount of premium for each is reviewed as a whole to provide the insurer with an incentive to write the coverage. Individual workers compensation policies are issued to each group member, and each pays its own premium. After the policies expire, the claims experience of all members is combined to determine whether an underwriting profit was made. If so, the insurer may declare a dividend. However, if claims costs are higher than a predetermined amount, a dividend is not possible.

Group or affinity programs often are used when coverage is hard to obtain, especially when the workers compensation premium of individual group members is relatively low. An insurance company may not be interested in taking the risk of insuring a small manufacturer, which generates only $15,000 of premium but has the potential of thousands of dollars of losses. However, if a number of small companies solicit coverage as a group, the combined premium often is large enough to interest several insurers. Small companies may join the group so that they can qualify for a potential dividend.

There are times when insurance companies will offer a group dividend to an entire group, which is computed based on the experience of the group as a whole, as well as individual dividends to members, which are computed on the experience of the member. In these types of programs, a group member is eligible to receive two dividends.

Sliding Scale Dividends

The next type of dividend plan is tied directly to the underwriting results of individual insureds. Instead of relying on group experience, an individual company stands on its own claims experience for purposes of dividend calculation. These are called sliding scale dividend plans. They start with the expectations of a particular loss ratio. Insureds who develop a lower loss ratio may be rewarded with a dividend. Those who develop a higher than expected loss ratio lose the dividend opportunity.

For example, a plan might assume that the incurred loss ratio for a manufacturer will be 65 percent. The incurred loss ratio is determined by dividing incurred losses by the earned premium. Incurred losses include both paid and reserved claim amounts. If the loss ratio is less than 65 percent, a dividend may be declared. If the loss ratio is higher than 65 percent, the insured is not responsible to pay more premium; the insurance company has to absorb the excess losses. However, the company forfeits the dividend. This type of plan provides a financial incentive to prevent worker injuries and to manage the claims that do occur.

Sliding scale dividend plans are usually written for either one or three years. A three-year plan can be written in either of two ways. Under the first approach, a computation is made at the end of the first, second, third, and succeeding years. Partial dividends may be paid at each computation. However, starting with the second year, the computation includes all prior years up to a maximum of three years. With the second approach, the computation is not made until the end of the third year. Some three-year plans may include a recapture provision, which requires the insured to pay back prior-year dividends if, at subsequent valuations during the three years of losses, claims deteriorate.

In a one-year plan, losses are valued as of a predetermined date, such as at twelve or eighteen months after policy expiration. If the loss ratio is less than a predetermined percentage, a dividend may be paid. The amount of the dividend slides with the loss ratio, subject to a maximum possible dividend. For example, a sliding scale plan could be written so that the insured gets 75 percent of the savings if the account's loss ratio is less than the expected 60 percent but greater than or equal to 35 percent. If the loss ratio is less than 35 percent, it is treated as if the loss ratio were 35 percent.

The formula for this plan would be

Dividend = .75 x (.60--actual loss ratio) x Premium

The actual loss ratio used can be no lower than 35 percent.

Consider three cases. All three are based on the following assumptions:

1. A one-year sliding scale dividend plan is used.

2. The audited premium is $100,000.

3. The expected loss ratio is 60 percent (the insurer expects $60,000 in losses).

4. The dividend is based on 75 percent of the savings subject to a minimum usable loss ratio of 35 percent.

In the first example, ABC Company has $50,000 of losses, which translates into a 50 percent loss ratio ($50,000 of incurred losses divided by $100,000 premium). ABC earns a dividend of $7,500, which is 75 percent times the difference between the expected loss ratio of 60 percent and the actual loss ratio of 50 percent, times the premium. The formula is 75 percent x (60 percent--50 percent) x $100,000, which equals a dividend of $7,500.

In the second example, ABC has $65,000 in losses or a 65 percent loss ratio. Since the loss ratio is more than 60 percent, no dividend is earned.

In the third example, ABC has $30,000 in losses, which is a 30 percent loss ratio. The formula for ABC's dividend would be

Dividend = 75 percent x (60 percent--30 percent) x $100,000

Dividend = $22,500

However, since the lowest loss ratio that can be used in this plan is 35 percent, ABC only receives a dividend of $18,750. The 35 percent loss ratio must be used in place of the actual 30 percent earned, for a calculation as follows:

Dividend = 75 percent x (60 percent--35 percent) x $100,000

Dividend = $18,750

This sliding scale dividend plan also can be illustrated as:
Estimated Dividend Display

Audited Premium of $100,000

Loss Ratio      Losses              Dividend     Net Premium

60% +           $60,000 +           $0           $100,000
55%             $55,000             $3,750       $96,250
50%             $50,000             $7,500       $92,500
45%             $45,000             $11,250      $88,750
40%             $40,000             $15,000      $85,000
35%             $35,000             $18,750      $81,250
Less than 35%   Less than $35,000   $18,750      $81,250


As shown, the maximum dividend possible with a $100,000 premium is $18,750.

Sliding scale plans are popular because the account can benefit from better than expected losses without the threat of additional premium if losses are worse than expected. These plans are not often available to insureds with poor or fluctuating loss histories because no risk, and only an opportunity to gain, is transferred to the insured. Keep Figure 1 in mind. A sliding scale dividend plan is to the right of a guaranteed cost plan because the insured is beginning to take on financial responsibility for preventing and managing its own claims.

Retrospective Rating Plans

Retrospective rating rewards companies that have below average losses and penalizes those with above average losses in the policy year in which the claims occurred. The premium for expired policies is adjusted as claims develop and mature. Workers compensation claims often have long tails. An accident may occur during the policy term and remain open for several years--until the worker is completely healed and back to work or she is placed in some type of permanent disability program. Claims experience--both good and bad--affects the ultimate cost of the policy during which the claims occurred.

Under a retrospectively rated plan, an insured is affected by losses in two ways. First, its current retrospective policy premium is adjusted upward or downward based on claims that occur in that policy year. Second, its future experience modifier is reduced if losses are lower than expected. The future modifier is increased if losses are higher than expected. This double benefit or penalty occurs because experience rating is used in conjunction with retro rating. However, the impact of the experience modifier is less with a retro policy than with a guaranteed cost policy. The effect of the modifier is included only in the fixed cost portion of the premium and not in its variable costs.

There are two basic types of retro plans:

* Incurred loss retrospective rating plans

* Paid loss retrospective rating plans

There are any number of hybrid combinations of plans. However, only these two types are discussed in this book. The information on incurred loss retro rating is based on the National Council on Compensation Insurance (NCCI) retro rating system. States that do not belong to the NCCI issue their own retro regulations. However, for practical purposes, the NCCI program provides a general context that may be applied to non-NCCI states. In addition, the discussion will focus on the NCCI one-year incurred loss retro plan, even though three-year and multiple lines plans also are available.

A retro plan utilizes a simple concept. Insureds pay in premium during the policy term. The premium is used to issue the policy and operate the program, as well as to pay for claims adjusting and payment. Starting at six months after policy expiration, claims are reviewed. If the program operating (fixed) costs and claims (variable) costs are lower than the amount paid in, the insured receives a retrospective return premium. If they are higher than the amount paid in, the insured is billed a retrospective additional premium. Retro plans are evaluated six months after the end of the policy period (eighteen months from inception) and in twelve-month intervals thereafter. For an annual policy, the evaluation dates would be eighteen, thirty, forty-two, fiftyfour months, etc., after policy inception.

In an incurred loss plan, both paid and reserved claims are included when the retro premium is calculated. Because of this, the insured is ultimately responsible for its own claims. This can lead to better loss prevention and claims management, which usually means lower total costs. Insureds may seek an incurred loss plan because it offers an opportunity to lower the ultimate premium substantially when claim costs are controlled.

Conversely, insurers may be willing to offer only a retro plan to insureds with poor claims experience for the same reason: the insured ultimately is charged for its losses. The possible gain of a lower premium is balanced against the risk that claims will be bad, which would result in a higher premium.

Companies qualify for a one-year retrospective rating plan if their estimated modified standard premium is at least $25,000. This estimated standard premium may include workers compensation and other casualty insurance lines. However, when a combined lines retro is used, the Insurance Services Office (ISO) retrospective rating plan should be consulted.

Even though a minimum $25,000 of modified standard premium is the NCCI threshold, many companies require a higher premium.

Retrospective Rating Formula

The retrospective rating premium formula is as follows:

Retrospective Premium = [(Basic Factor x Standard Premium) + (Losses x Loss Conversion Factor)] x Tax Multiplier

The retro premium is limited by minimum and maximum premiums.

The basic factor (BF) is the percentage standard premium that is needed to issue the policy and operate the program. It includes insurer underwriting expenses; producer commission, if applicable; insurance charges; and profit. The basic factor usually ranges from .15 to .35, depending upon the size of the risk, the amount of insurance being provided, and other factors in the plan. The basic factor multiplied by the standard premium develops the basic premium.

The loss conversion factor (LCF) is a percentage that represents the cost to adjust claims. It usually ranges from .08 to .15 of losses. At times, adjusting costs are represented by a dollar figure per type of claim instead of a percentage. For purposes of this discussion, a percentage LCF is used. The LCF is added to the total value of claims, which then are referred to as converted losses.The LCF reflects general claims adjusting costs. Unusual adjusting costs--such as special surveillance and expert witness testimony--may be allocated to specific claims. These are called allocated loss adjusting expenses (ALAE). ALAE are added to the converted losses, but they are not subject to the LCF.

The tax multiplier (TM) is the average of the taxes, fees, and assessments that apply to the account. In general, tax multipliers fall in the range of 1.04 to 1.06.

Retrospective premiums are limited by minimum and maximum premiums. The retro premium can never fall below the minimum premium, regardless of how good the loss experience is. This is because the insurance company must be able to recover its program costs. The maximum premium ensures that the risk is not subject to unlimited losses. The insured may choose to buy coverage that limits individual losses in addition to the overall premium limit provided by the maximum. This is called purchasing loss limitations or loss limits.

Retro plans are not eligible for insurer premium discounts. This is because premium discounts are used to lower the expense portion of the guaranteed cost premium. Since retro plan operating expenses are covered by the basic premium, operating costs are, in theory, already minimized.

The basic and loss conversion factors, as well as the minimum and maximum premiums, are set through negotiation between the insured and insurer. Therefore, there can be major differences in the final amount of the retro premium among insurance companies. It is important to monitor the financial implications of a retro plan through the entire time it remains open.

Excess Loss Premium

If the standard premium that is subject to retro rating is at least $100,000, insureds may elect to purchase excess loss coverage. Excess loss coverage limits the amount of incurred loss arising from one accident that will be included in the retro premium calculation. Excess loss coverage also is referred to as buying a loss limit or limitation.

For example, a retro plan may incorporate only the first $100,000 in cost of each worker accident in the claims portion of the retro formula. This type of plan caps losses at $100,000 per accident. Only the first $100,000 of incurred loss from each accident is used in the retro premium formula. The premium for the statutory coverage above the loss limit of $100,000 is not subject to retrospective rating. It is called the excess loss premium or nonsubject premium. The nonsubject premium does not fluctuate with losses; it is simply added to the retro premium at the end of the calculation. The workers compensation retrospective rating endorsement, which is attached to the policy, shows the subject and nonsubject premiums separately.

How a Retro Works

The following illustrates the way in which a retro works by discussing four policies, all of which are written on one-year retrospective plans. Each of the policies has:

* modified standard premium of $100,000;

* maximum premium of $140,000; and

* minimum premium of $70,000.

Figure 2 illustrates how the first adjustment of each policy, made at six months after expiration, generates different results for each policy.

[FIGURE 2 OMITTED]

In these policies, the entire modified standard premium of $100,000 was paid to the insurance company during the policy term. Thus, retro adjustments were made on the basis of a premium pay-in of $100,000.

As discussed previously, workers compensation claims often take a significant amount of time to mature and develop to maximum potential. Over a period of years a claim may increase or decrease in value as the worker undergoes continuing treatment or goes back to work. Consequently, the losses that are used in annual retro calculations may differ significantly from those used at the first adjustment.

As shown in Figure 2, the first adjustment for Policy 1 resulted in a retro premium of $80,000. Therefore, $20,000 was returned to the insured. The first adjustment for Policy 2 produced a retro premium of $110,000, so the insured was billed $10,000 additional premium. Policy 3 generated a premium of $166,000 at the first adjustment because of several large claims. Since the program includes a maximum premium of $140,000, the insured was billed only $40,000. Policy 4 would generate a return premium of $45,000 if there were no minimum premium. Lower than expected claims produced a retrospectively adjusted premium of only $55,000. The insured only received a return premium of $30,000 because $70,000 is the minimum premium.

However, the premium for each of these policies continues to be adjusted annually based in the development of losses. To illustrate this refer to Figure 3, which charts the first four retro adjustments, which are issued at intervals of eighteen, thirty, forty-two, and fifty-four months after policy inception.

Policy 1 generated a $20,000 return premium at the first adjustment. At the end of thirty months (second adjustment), the retro premium was recalculated at $115,000 because several claims deteriorated. The insured is not only required to pay the difference between the standard premium ($100,000) and the retro premium ($115,000), but it also must repay the $20,000 return it received at the first adjustment. Thus, the premium billing at thirty months is for $35,000. At the end of forty-two months, claims continue to deteriorate, and the retro premium increases to $165,000. The insured is billed $25,000 because the $165,000 exceeds the maximum $140,000 premium. The fourth computation produces a retro premium of $125,000, because several claims were resolved at costs lower than anticipated. The insured therefore is returned $15,000 ($125,000 less $140,000 paid to date).

These adjustments continue until all claims are closed or the insured and insurer mutually agree to close the plan. It is not unusual for retro programs to remain open for five or more years, especially in long-term exposures such as workers compensation.

[FIGURE 3 OMITTED]

Optional Retro Premium Components

The basic retrospective premium formula discussed previously does not include two optional elements that may be added separately to a retro plan. They are excess loss premiums and retrospective development factors. The excess loss premium pays for stop loss or loss limitation insurance, which was mentioned. The excess loss premium may be included within the basic premium. However, it also may be shown as a separate charge, which is outside the retro adjustment.

If a plan is written with a per accident loss limit of $100,000, only the first $100,000 in claim costs arising from each accident is used in the retro premium calculation. Such excess loss coverage stabilizes retro plans by dampening the effect of large losses. For example, three employees might be seriously injured in an industrial accident. The total cost of all three injuries might run into the hundreds of thousands of dollars. If a $100,000 per accident loss limit were purchased, only the first $100,000 of all claims arising from the one accident would be included in the retro adjustment. If a $100,000 per claim loss limit had been chosen, the first $100,000 cost of each worker's injuries, or $300,000, would be included in losses used in the retro adjustment.

The purpose of the retrospective development premium is to smooth out some of the fluctuations that often occur between the first and subsequent retro adjustments; it stabilizes the retro premium over time. The retrospective development premium reduces the likelihood that the insured will receive a large premium return at the first calculation, which likely will have to be repaid to the insurer at subsequent calculations.

Audit vs. Retro Calculation

The terms premium audit and premium calculation and adjustment often are confused, but they are decidedly different calculations. The premium audit always precedes the retro premium computation and adjustment. Assume that a workers compensation risk is being retrospectively rated. The rate is applied to each $100 of payroll. The standard premium is equal to payroll divided by 100, multiplied by the manual rate and experience modification factor. The initial premium is merely an estimate, but it is the amount paid to the insurer before or during the policy term. The actual modified standard premium is determined at the premium audit. At policy expiration, the insurance company audits the payrolls. If the payroll is more than estimated, an additional premium is charged. If less, a refund is made. This audited modified standard premium then is used as the pay-in amount at the first retro adjustment.

Retro Policy Cancellation

If an insured goes out of business, a one-year retro plan is cancelled as follows:

1. the modified standard premium is calculated on a pro rata basis; and

2. the retrospective premium then is calculated using the pro rata modified standard premium.

The minimum and maximum premium factors are applied to the pro rata modified standard premium. If the minimum and maximum factors were .50 and 1.5 respectively, they would be multiplied against the modified standard premium to develop the dollar amount of the minimum and maximum on the pro rata cancellation.

However, insureds who cancel a retro plan for reasons other than going out of business are penalized to discourage them from bailing out of a retro plan that is not going well. The process in this case is:

1. the premium for the policy is calculated on a short-rate basis; and

2. the retrospective premium is calculated using the short-rate premium.

The short-rate is calculated by taking the partial premium for the period the plan was in effect, extending it for a full year, and then multiplying the result times the short-rate factor. The short-rate premium is used as the minimum premium. In addition, the annualized standard premium, rather than the short-rate premium, is used as the basis for computing the maximum premium. This serves as an additional deterrent to canceling the policy under adverse loss conditions.

Retrospective Rating Forms

Insureds must sign an election form indicating that they are aware of selecting a retro rating plan. An election form usually contains the following information: name of insured; date plan takes effect; formula factors (basic premium factor, minimum premium factor, maximum premium factor, loss conversion factor, tax multiplier, and retrospective development factor if applicable); loss limitations and excess loss premium factor if applicable; signature of insured; date election form signed; and policies covered under the plan. Retrospective rating is included in a policy by attaching a retrospective endorsement. These are described in Chapter 6.

Incurred Loss vs. Paid Loss Plans

The main difference between an incurred loss and paid loss plan is the type of claims included in the calculations. The major benefit with a paid loss plan lies in cash flow; the money that is paid in to the insurer is based on the amount of paid claims.

In a paid loss plan, the insured pays the insurer a deposit premium and sets up a claims fund at the beginning of the year. The deposit premium is similar to the basic premium in an incurred loss plan; it is designed to cover insurer expenses and profit. The claims fund is established so that the insurer can pay claims as they come due. The insured is required to replenish the claims fund as the insurance company uses it to pay claims. The difference between this pay-in amount and the estimated standard premium usually must be posted in collateral.

It can take many years for a paid loss plan to close. Therefore, the insured is expected to pay claims long after a policy has expired. Collateral is required as a financial guarantee that future claims will be funded. The collateral often is in the form of a letter of credit or cash escrow account, but some insurers will accept other types of assets as collateral.

At regular intervals, incurred losses are reviewed and an incurred loss retrospective premium is calculated. The paid-in premium and paid losses are subtracted from the incurred loss premium. This difference is used to determine whether the required collateral should be adjusted to guarantee the payment of future claim bills. Thus, the collateral may be adjusted at the date of the annual retrospective rating calculations.

Deductible Plans

Deductibles are used in some states for workers compensation and employers liability policies. The NCCI deductible endorsement is described in Chapter 6. Deductibles may be applicable to medical payments, indemnity payments, or both. Exhaustive credit checks usually are conducted before an insured is offered a deductible plan. This is because, under a deductible plan, the insurance company usually pays claims and then seeks reimbursement from the insured. The insured's credit worthiness thus becomes very important.

There are state-specific guidelines for deductible programs, so individual state regulations should be reviewed for specific information.

Deductibles can serve two purposes. Small deductibles are used to eliminate nuisance claims. Large deductibles are designed to offer the insured a method for increasing its retention without incurring unlimited liability and without having to handle claims, as it would under a self-insured retention. However, many insureds do negotiate with insurers to have independent companies adjust their claims under a large deductible program. One of the original incentives for large deductible programs was in the area of taxation. Since the deductible amount of claims is not actually premium, premium taxes and assessments were not levied against it. This offered some tax relief to insureds. However, some states have revised their taxation so that this incentive may no longer apply.

Many insurers sell large deductible plans to large companies. The deductible usually ranges from $100,000 to $1,000,000 per accident. Aggregate coverage for losses falling within the deductible layer usually is available.

The set-up of a large deductible plan is similar to the paid loss retrospective rating plan discussed previously. The insured pays a deductible premium and sets up an escrow account with funds adequate to pay the deductible portion of expected claims for a sixty to ninety-day period. Additionally, the insured is billed every month for actual payments that fall within the deductible layer. The amount of collateral required is based on estimated losses and the insured's financial condition.

As with the paid loss retro plan, the initial pay-in is substantially less than the full estimated standard premium, which is collected up-front in an incurred loss retro program. Even though the insured may have to post collateral with both paid loss and incurred loss plans, cash flow is superior to other programs.

Among the various advantages of a large deductible program are the following:

* In some states the insured's premium and other expenses are lower because, as the deductible increases, the corresponding premium falls, along with the taxes, fees, and assessments that are a function of premium.

* The insured may retain the investment income on the collateral and claims escrow funds.

* The insured realizes immediate benefits from favorable loss experience with some protection against catastrophic losses.

* A large deductible plan offers superior cash flow.

* Fixed costs (deposit premium) usually are lower than with other plans.

* The insured often retains the insurance company's administrative and claims services.

* Many insurance companies permit insureds to have a say in loss control and claims management. Some may permit the insured to hire independent loss control and claims management companies, rather than using the insurance company's personnel.

There also are negative features to large deductible plans. These include:

* A large deductible plan creates an additional administrative burden for the insured.

* The insurer still has ultimate control of claims management unless arrangements are made so that an outside firm--third party adjuster--is used to handle claims.

* The insured is limited to the services offered by the insurer unless it agrees to unbundle claims management.

* Letters of credit may be difficult to obtain or expensive for highly leveraged companies.

* Unfavorable loss experience can have a great impact on costs, and ultimate costs may be difficult to calculate unless an aggregate is purchased.

* Reserves for future loss payments are not tax deductible until the losses actually are paid, while premiums are deductible when paid.
Figure 4

Option Evaluation Form

                                                               Sliding
                                    Guaranteed    Standard      Scale
                                       Cost       Dividend     Dividend
Evaluation Questions                   Plan         Plan         Plan

 1 Is this type of plan                Yes          Yes          Yes
   auditable?

Cash Flow

 2 Can costs other than audit          Yes          Yes          Yes
   results be fixed in advance?
 3 If losses are good, do I get         No          Yes          Yes
   money back?
 4 If losses are bad, do I have         No           No           No
   to pay more money?
 5 Are all program costs paid in       Yes          Yes          Yes
   the first year of the program?
 6 Are calculations made on an         N/A        Incurred     Incurred
   incurred loss or paid loss
   basis?
 7 Who earns interest income?        Insurer      Insurer      Insurer
 8 Can any of the program costs      Possible     Possible     Possible
   be deferred?
 9 Is additional up-front cash          No           No           No
   required to set up program?

Rating

10 Is there potential for a             No          Yes          Yes
   dividend payment?
11 Is price subject to                  No           No           No
   negotiation?
12 Is program easy to understand?      Yes          Yes          Yes

13 Does an expense discount            Yes          Yes          Yes
   apply?
14 Is composite rating possible?       Yes          Yes          Yes
15 Is a compensating balance           N/A          N/A          N/A
   arrangement possible?

Taxes & Assessments

16 Does insured pay full premium       Yes          Yes          Yes
   taxes?
17 Are costs tax deductible?           Yes          Yes          Yes
18 Are residual market loadings         No           No           No
   avoided?
19 Are there other assessments?             Included in premium

Losses

20 Does insured share risk with         No           No           No
   insurer?
21 Are loss limitations                N/A          N/A          N/A
   available?
22 How important is loss               Not        Somewhat     Somewhat
   reserving?                       important    important    important

Services

23 How much control do I have       No control   No control   No control
   over how the program is
   managed?
24 Who has the final say on how      Insurer      Insurer      Insurer
   claims are managed?
25 How easy will it be for me to    Difficult    Difficult    Difficult
   customize loss control
   efforts?
26 Can services be unbundled?           No           No           No
27 Will I need all internal staff       No           No           No
   to manage the program?
28 Is additional record keeping         No           No           No
   needed?

General Considerations

29 How much do market conditions                 Great impact
   impact this progiam?
30 Does the program provide a          Yes          Yes          Yes
   buffer between my company and
   third parties?
31 In general, how flexible is      Inflexible   Inflexible   Inflexible
   the plan?
32 Does tbe plan encourage loss         No       Minimally    Minimally
   control?
33 Is firms credit worthiness all       No           No           No
   important factor?
34 How hard is it to move away         Easy         Easy         Easy
   from this type of program?

                                    Incurred Loss     Paid Loss
                                    Retrospective   Retrospective
Evaluation Questions                 Rating Plan     Rating Plan

 1 Is this type of plan                  Yes             Yes
   auditable?

Cash Flow

 2 Can costs other than audit            No              No
   results be fixed in advance?
 3 If losses are good, do I get          Yes          Possible/
   money back?                                       Collateral
 4 If losses are bad, do I have          Yes             Yes
   to pay more money?
 5 Are all program costs paid in         No              No
   the first year of the program?
 6 Are calculations made on an        Incurred          Paid
   incurred loss or paid loss
   basis?
 7 Who earns interest income?          Insurer       Negotiable
 8 Can any of the program costs          Yes             Yes
   be deferred?
 9 Is additional up-front cash           No          Yes, loss
   required to set up program?                          fund

Rating

10 Is there potential for a              N/A             N/A
   dividend payment?
11 Is price subject to                   Yes             Yes
   negotiation?
12 Is program easy to understand?      May be          May be
                                      difficult       difficult
13 Does an expense discount              No              No
   apply?
14 Is composite rating possible?         Yes             Yes
15 Is a compensating balance             N/A             Yes
   arrangement possible?

Taxes & Assessments

16 Does insured pay full premium         Yes             Yes
   taxes?
17 Are costs tax deductible?             Yes           Yes/STR
18 Are residual market loadings          No              No
   avoided?
19 Are there other assessments?                  Included in premium

Losses

20 Does insured share risk with          Yes             Yes
   insurer?
21 Are loss limitations                  Yes             Yes
   available?
22 How important is loss              Extremely         Very
   reserving?                         important       important

Services

23 How much control do I have       Fair control    Fair control
   over how the program is
   managed?
24 Who has the final say on how         Consultative/Insurer
   claims are managed?
25 How easy will it be for me to     Negotiable      Negotiable
   customize loss control
   efforts?
26 Can services be unbundled?         Sometimes       Sometimes
27 Will I need all internal staff     Possibly        Possibly
   to manage the program?
28 Is additional record keeping          Yes             Yes
   needed?

General Considerations

29 How much do market conditions           Minimal impact
   impact this progiam?
30 Does the program provide a            Yes             Yes
   buffer between my company and
   third parties?
31 In general, how flexible is        Minimally        Fairly
   the plan?                          flexible        flexible
32 Does tbe plan encourage loss          Yes             Yes
   control?
33 Is firms credit worthiness all     Possibly           Yes
   important factor?
34 How hard is it to move away        Difficult       Difficult
   from this type of program?

                                                   Self-
                                      Large       insured
                                    Deductible   Retention
Evaluation Questions                   Plan        Plan

 1 Is this type of plan                Yes          Yes
   auditable?

Cash Flow

 2 Can costs other than audit           No          No
   results be fixed in advance?
 3 If losses are good, do I get      Possible/Collateral
   money back?
 4 If losses are bad, do I have        Yes          Yes
   to pay more money?
 5 Are all program costs paid in        No          No
   the first year of the program?
 6 Are calculations made on an       Variable    Variable
   incurred loss or paid loss
   basis?
 7 Who earns interest income?       Negotiable   Negotiable
 8 Can any of the program costs        Yes          Yes
   be deferred?
 9 Is additional up-front cash      Yes, loss    Yes, loss
   required to set up program?         fund        fund

Rating

10 Is there potential for a            N/A          N/A
   dividend payment?
11 Is price subject to                 Yes          Yes
   negotiation?
12 Is program easy to understand?    May be       May be
                                    difficult    difficult
13 Does an expense discount            Yes          Yes
   apply?
14 Is composite rating possible?       Yes          Yes
15 Is a compensating balance           Yes          Yes
   arrangement possible?

Taxes & Assessments

16 Does insured pay full premium     Yes/STR      Yes/STR
   taxes?
17 Are costs tax deductible?         Yes/STR      Yes/STR
18 Are residual market loadings         May be reduced
   avoided?
19 Are there other assessments?         May be reduced

Losses

20 Does insured share risk with        Yes          Yes
   insurer?
21 Are loss limitations                Yes          Yes
   available?
22 How important is loss               Very        Very
   reserving?                       important    important

Services

23 How much control do I have          Good        Good
   over how the program is           control      control
   managed?
24 Who has the final say on how      Consultative/Insurer
   claims are managed?
25 How easy will it be for me to    Negotiable   Negotiable
   customize loss control
   efforts?
26 Can services be unbundled?       Sometimes     Usually
27 Will I need all internal staff    Possibly    Possibly
   to manage the program?
28 Is additional record keeping        Yes          Yes
   needed?

General Considerations

29 How much do market conditions        Minimal impact
   impact this progiam?
30 Does the program provide a          Yes          Yes
   buffer between my company and
   third parties?
31 In general, how flexible is        Fairly      Fairly
   the plan?                         flexible    flexible
32 Does tbe plan encourage loss        Yes          Yes
   control?
33 Is firms credit worthiness all      Yes          Yes
   important factor?
34 How hard is it to move away      Difficult    Difficult
   from this type of program?
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Publication:Workers Compensation Coverage Guide
Date:Jan 1, 2006
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