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Learning the pitfalls of casualty rating plans.

Learning the Pitfalls of Casualty Rating Plans

The risk manager is responsible for millions of dollars of expenses. Unlike other members of the management team, whose effectiveness is measured by such indices as size of staff and budget, the risk manager's performance is tied to his ability to control expenses. His cost containment tools include deductibles, aggregates, loss-sensitive rating plans and loss control procedures.

Because of his limited staff, he may need to depend on insurance company and broker technicians to monitor and control the various rating approaches he has undertaken. However, representatives of neither group share his interests in the company, and some are technicians more in name than in reality. As a result, they may overlook the dangers inherent in casualty rating plans, and after a loss, the risk manager may have trouble explaining why the company was not properly covered. Therefore, the risk manager must fully understand the risks associated with these plans before they are employed.

Manual Rating Plans

Today, many large insureds continue to accept manual rating subject to experience credits and premium discounts. The protection of the manual premium as a maximum is offset by the experience rating as well as the application of rate changes. When an experience debit is applied to both higher filed rates and increased exposure, the combined effect can be unexpected and financially harmful.

One problem with experience rating is that bad experience can extend into future years. Another problem is the potential loss of interest in loss control by an insurance company when there is a high maximum. However, a basic flaw may exist in manual rates when applied to an individual corporation. Many classes are extremely broad to provide credibility. However, by doing so, they fail to consider individual differences of geography, company size and age and experience of employees. For example, consider a large public entity pool under workers' compensation. The differences which occurred from risk to risk due to the factors cited above were not addressed by class rating and the application of experience rating. As a result, there was considerable disincentive for members to practice loss control because of the failure to have such concerns adequately recognized in rate inductions.

Retrospective Rating Plans

Retrospective rating plans have been applied for many years to various casualty lines, but the potential effect of different factors within such plans is still not fully understood. Take, for example, the minimum-maximum range. A major broker had introduced such a plan for risk generating premiums in excess of $1 million. Significant savings potential seemed likely because of the low minimum. However, a careful examination of actual historical losses indicated that even if loss control was aggressively practiced, only a minor reduction in losses in the current period could be expected. When an assessment of the most likely loss level was made by the client, the potential return was less than the time value of money, if invested at a modest rate of interest.

A maximum under a retrospective rating plan, when too high, can be potentially dangerous as well. In one case involving a manufacturing firm, the underwriter confirmed, at policy inception, that the 2.25 maximum would be collected by the insurance company. In another situation, a heavy equipment manufacturer was faced with a high maximum and a low minimum that required evaluation of the appropriateness of the plan. An examination of historical losses and a projection of an expected loss range showed the low minimum/high maximum plan to be extremely dangerous from a penalty rating standpoint.

One of the most one-sided provisions of an incurred-loss retrospective rating plan is the three-year plan. When an insured is written on a three-year" retro, the bound to it for three years because of stiff penalties for early withdrawal. Thus, good experience in the first year or two can lost or either changing the reserves or by bad experience in the third year. One heavy manufacturer willingly cancelled its retro plan and accepted a high penalty for withdrawal to take advantage of the benefits of a replacement fronting program.

The fundamental difficulty, however, of any incurred-loss plan is that the determination of reserves and incurred losses contractually rests with the insurance company. It is theoretically possible to face a situation in which loss reserves are maintained at a level above maximum requirements up to and one day beyond the last retrospective adjustment, thus barring any return. The day after the last calculation, the reserves could theoretically be dropped to zero and the insured and his agent would have no direct recourse under the language of the retrospective agreement or the policy.

The incurred-loss retro approach, with a high maximum and a satisfactory loss conversion charge, also offers no incentive for the insurance company to reduce loss. This becomes more apparent when the insured's historical loss ratio has fallen consistently well below the maximum afforded under the plan. Although the plan may have modest factors, it may also have a built-in predisposition for the insurer to provide minimum loss control.

Paid-Loss Retrospective Rating

This relatively new approach allows the insured to retain the interest earnings on loss reserves until payments have been made and is considered by many to be the most desirable rating plan from the purchaser's standpoint. Unfortunately, in a paid-loss retrospective rating plan, all may not be well.

Consider the safety and loss prevention mentioned under the incurred-loss retro plan. If the insurer receives an attractive loss adjustment percentage for adjusting losses, it has no incentive to reduce those losses through effective loss control. This situation was demonstrated when a major utility with millions of dollars in annual loss payments was on a paid-loss retro plan and found that losses continued to rise. The insurer had only a token approach to loss control because of the problem.

Another concern from the perspective of the insured is that paid-loss retrospective rating plans may result in inadequate or low estimates of reserves from the insurance company. This is understandable, particularly if the insurance company is adequately protected under a high loss conversion factor and has no reason to establish adequate reserves on outstanding losses.

Certain insurance companies, pointing out that paid-loss retrospective programs prevent them from earning interest on reserves, seek to convert the programs to incurred-loss plans after a certain number of years. The argument given by these insurance companies is that they need this opportunity to recoup lost investment income. In a recent renewal for a large wholesaler, however, a major insurance company agreed to a compromise and accepted "T-bill" interest on outstanding reserves after a specified period of time with individual reserves subject to a form of arbitration. In this manner, both the insured and the insurer were protected.

In addition, if the loss adjustment charge increases with the amount of payment, no incentive exists for the insurer to constrain loss costs with a paid-loss retro plan. Unless the risk manager is actively involved in looking at loss handling, he may find no control being exhibited for handling or constraining loss cost.

Retention and Fronting Programs

Retention and fronting programs represent the final group of so-called quasi-insurance programs. As with self-insurance, the costs can be measured on a cost-benefit basis. The handling of workers' compensation, however, may vary because the insurance company's paper covers the entire risk and the insurer can be very zealous of its good name in loss settlement. As a result, any requests from the insured to avoid payment in a specific case may be ignored by the insurer. On the other hand, when it comes to liability, the insurer may retain only a small layer over the self-insurance level with further coverage being protected through excess policies. In these situations, when an insured refuses to have a particular claim paid, such refusal may be accepted by the insurer so long as any subsequent court action obligating a payment above the retention will be the sole responsibility of the insured. As a result, the insured becomes his own excess carrier when a settlement could have been affected with this retention level. This possibility that excess coverage may be eliminated is not always understood by risk managers and certainly not by senior executives.

Sometimes, the fronting company will seek to convert its letter of credit or other reserve support to cash and provide for this contractually in the funding agreement. In other situations, there may be questions by the insured as to the true reserve level which should be carried. In the first instance, working with a major broker and a large manufacturer eliminates the cash requirement as long as the insured continues the program with the insurance company. In the second instance, studies have been conducted for large manufacturers to confirm the appropriateness of reserve levels established by insurance companies.

Where permitted, self-insurance programs supplemented by excess coverage may be as good as or perhaps slightly better than paid-loss or fronting programs. However, other questions may arise regarding claims settlement, claims cost, reserving levels, funding requirements and overall claims management. While certain activities can be properly addressed in-house, for some insureds, a third-party administrator may be needed in addition to a qualified broker.


There is no best approach to addressing the specific needs of an individual business and handling the requirements imposed on the risk manager. The risk manager must be fully versed in the intricacies of various approaches. He must recognize potential pitfalls and provide appropriate constraints to limit his company's loss costs. The risk manager must not assume that insurance underwriters, brokers or third-party administrators understand the problem and act in the best interests of his company. If a consultant is brought in, he should be evaluated carefully to confirm competence, professionalism and the absence of any potential conflict of interest.

Ultimately, accountability for loss containment rests with the risk manager. He cannot delegate that accountability to anyone else. In the final analysis, it is his responsibility to mind the store.

Arthur E. Parry, CPCU, is manager of risk management services for The Wyatt Company.
COPYRIGHT 1989 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989 Gale, Cengage Learning. All rights reserved.

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Author:Parry, Arthur E.
Publication:Risk Management
Date:May 1, 1989
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