B.5. LSRPs

Question 1

Advantages of LSRPs to insureds

Answer 1

• Financial incentive for loss control
• Opportunity to save money in the 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 2

Disadvantages of LSRPs to insureds

Answer 2

• Uncertain costs compared to a traditional insurance plan
• Loss of immediate tax deductibility of traditional insurance premium
• Possibility of high costs in the short-term with bad experience
• Impact on future financial statements as losses develop
• Ongoing administrative costs as losses develop
• The need to post security as collateral against credit risk (for
  some plans)
• Additional complexity compared to a traditional insurance plan

Question 3

Advantages of LSRPs to insurers

Answer 3

• 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 the risk

Question 4

Disadvantages of LSRPs to insurers

Answer 4

• 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 a traditional policy
• Insured’s tendency to second-guess claims handling and ALAE costs
• Insured’s tendency to question the profit provisions since insured is taking on significant risk

Question 5

Typical timeframe for recalculating premiums for paid or incurred retro plans

Answer 5

Incurred basis: Cumulative incurred losses are typically
evaluated starting 6 months after the policy expires and
every 12 months thereafter.

Paid basis: Cumulative paid losses are typically evaluated
monthly starting the first month of the policy term. Paid
plans are often converted to an incurred basis after a
pre-determined amount of time (e.g., 5 years).

Question 6

General retrospective rating formula and component descriptions

Answer 6

R = (B + cL)T

L is the actual limited loss (with or without ALAE)

c includes loss-related charges like LAE and loss-based
assessments

T includes premium taxes and costs proportional to R

B includes profit and UW expenses not in T, expected
per-occurrence excess losses, and the net insurance charge

Question 7

Why an iterative procedure may be needed to obtain the net insurance charge

Answer 7

If maximum and/or minimum premiums are explicitly
selected, then the net insurance charge in B depends on
the aggregate limits implied by the max/min premiums,
but since the max/min premiums depend on B, an iterative
procedure is needed to obtain the correct net insurance
charge.

Question 8

Brief description of the balance principle

Answer 8

That expected retro premium equals guaranteed-cost
premium. It is flawed since there is a difference in risk
transfer between the 2 cases, as the insured takes on more
risk with a retro policy.

Question 9

Description of the Large Risk Alternative Rating Option (LRARO)

Answer 9

It allows for flexibility in retro plan design for very large
risks. This option assumes large risks are knowledgeable
consumers that can negotiate parameters with insurers
directly. Common LRARO customizations include allowing
for the NCCI plan to be on a paid basis (it is normally on an
incurred basis) and allowing maximum and minimum ratable
loss amounts to be set directly (instead of indirectly through
maximum and minimum premiums).

Question 10

Key differences between large deductible and SIR/excess plans

Answer 10

• For required coverages, regulator approval is required for SIR.
• Insured (using TPA perhaps) responsible for adjusting claims with SIR/excess, resulting in lower ALAE, ULAE, and premium taxes for insurer.
• Insurer has no credit risk on SIR, but does have it on large deductible plans.
• Since limits are generally not reduced by retentions but are reduced by deductibles, the specification of these plans will often be slightly different than large deductible plans in order to provide the same loss coverage.

Question 11

List 4 variations on loss-sensitive rating plans (besides dividend plans)

Answer 11

• Clash coverage
• Basket Aggregate coverage
• Multi-Year Plans
• Captives

Question 12

Briefly define dividend plans

Answer 12

Dividend plans are policies that allow for some profit to be
returned to insureds if losses are lower than expected, subject
to approval by the insurer’s board of directors.

Question 13

Briefly define clash coverage

Answer 13

Clash coverage protects insureds from single occurrences that
impact multiple of their loss-sensitive policies, each with a
separate per-occurrence retention. A single Clash Deductible
(aka Clash Aggregate) will represent the aggregate amount
the insured will need to retain from the occurrence, and an
insurer will cover the loss above that amount.

Question 14

Briefly define basket aggregate coverage

Answer 14

Basket Aggregate (aka Account Aggregate) policies cap
insured aggregate reimbursable or ratable losses across
multiple loss-sensitive policies at a single aggregate retention,
up to a specified limit. The insured will be reimbursed for
losses above the aggregate retention up to the limit.

Question 15

Discuss adjustments required for multi-year plans

Answer 15

• Reduce insurance charge since losses more stable over longer period.
• The per-occurrence and aggregate excess charges need to account for the longer loss trend.
• Contract wording should allow for significant changes in exposures during the policy term.
• Credit risk increases since the insured financial condition can deteriorate over a longer period.

Question 16

Three ways insurers protect themselves from credit risk

Answer 16

1. Security: The insurer can hold collateral for expected future
   insured payments.
2. Loss Development Factors: For incurred retrospective
   rating plans and dividend plans, insurers can use LDFs to
   estimate ultimate losses, instead of basing the retrospective
   premium or dividend formula on actual losses to date.
3. Holdbacks: Insurers and insureds can delay retrospective
   premium adjustments (usually for incurred plans) or
   dividend payments until a later maturity.

Question 17

Four considerations in setting retention levels

Answer 17

1. The insured should retain the higher frequency predictable “working layer” of occurrence losses, and the insurer should cover the less predictable losses above that level.
2. The insured should be comfortable with the risk implied by their retention.
3. The insurer should be comfortable with the credit risk implied by the retention level.
4. Retentions (especially per-occurrence retentions) should increase over time due to loss trend.

Question 18

How profit provisions on an LSRP compares to a guaranteed-cost policy

Answer 18

Since with loss-sensitive plans (other than dividend plans)
the insured is retaining most of the risk for their primary
losses, the capital needed by insurers to support these plans is
lower than needed for guaranteed-cost plans. However, since
the insurer is keeping the riskier portion of losses, the profit
provision will be larger as a percent of insured loss.

Question 19

How LSRPs are closed

Answer 19

Retrospective rating plans are closed by closeouts, which
generally 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 an insurer or reinsurer assuming responsibility for the
insured’s remaining loss obligations. Self-insured retentions
are closed using loss portfolio transfers.