describe the balance principle for retrospective rating, and why it is flawed
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
Loss-Sensitive Rating Plans
-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
due to significant amount of risk retained
these plans are usually only available to large commercial risks
retrospective rating plans
insured’s premium will develop based on their losses during policy term
large deductible plans
- 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
self-insured retentions with excess policy
- 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
Advantages to insureds
- 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
Disadvantages to insureds
- 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
Advantages to insurer
- 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
Disadvantages to insurer
- 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
cash flows for a retrospectively rated policy are:
- insured pays an initial premium at start of policy term
- 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 - 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
basic premium
covers costs that are not variable with actual losses L or actual retrospective premium R
- profit and UW expenses not included in T
- expected per-occurrence excess loss if per-occurrence ratable limit is selected
- expected aggregate excess losses (aka insurance charge) if an aggregate ratable limit is selected
- credit (aka insurance savings) if a minimum aggregate ratable loss amount is selected
if max and/or min premiums are explicitly selected then net insurance charge in B depends on
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
Balance Principle
- 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
Large Risk Alternative Rating Option, LRARO
- 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
large deductible plans
- 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
large deductible plans: policy premium vs full coverage
- 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
from loss standpoint, self-insured retention with excess policy is similar to
large deductible plan
key differences between self insured retention and large deductible plan
- for required coverages, regulator approval is required for self-insurance with excess policy
- 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 - 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
- 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
dividend plans
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
clash coverage
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
class coverage- estimating expected losses
-can be difficult and may require simulations and assumptions about frequencies, severities, and correlations between LOBs
basket aggregate coverage
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
multi-year plans
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
