In another blogs, I discussed the topics of large deductibles, and self-insured retentions. But there is another method clients can utilize to retain risk, retrospective rating plans.
In the 1990’s, large deductible programs began to appear with greater frequency. This was in part due to the deterioration of the workers’ compensation market in the earlier part of the decade. Due to unsustainable competition in the voluntary market, insufficient rate adjustments in the assigned risk and other markets of last resort, and unanticipated expansion of benefits workers’ compensation turned from having a marginal profit potential to a no-win line of coverage, even in the voluntary market for good long term profitable risks. Assigned risk surcharges grew to consume a large portion of the workers’ compensation premiums in several states. In some cases, over 50% of the voluntary premium went to prop up the assigned risk market causing some carriers to exit entire states for workers’ compensation.
Large deductible plans were a good solution for insurance carriers and many clients who wanted to stay out of the assigned risk. They even allowed carriers to take advantage of attractive take-out credits to reduce their assigned risk surcharges. Middle market and national accounts benefited from reduced costs and better services. If clients wanted to retain risk, large deductibles were the way to go as they offered a mechanism to reduce costs and provided cash flow advantages.
Retrospective rating plans have been existence going back before the 1970’s. Unlike deductible programs, they were considered as more of a defensive mechanism by underwriters than as a method for insureds to retain risk or reduce their net insurance costs. Yet they were an effective method to reduce costs for those clients wanted to take risk.
Deductible or self-insured retention plans which carves out a primary layer of losses to be paid by the insured, while insurance carriers charge a highly discounted premium in consideration for not covering claims within the working layer. In contrast, retrospective rating plans create a flexible premium schedule which increases or decreases based upon the insured’s actual loss experience.
Retrospective rating plans (aka retros) set parameters of potential premium fluctuations using minimum and maximum factors expressed as a percentage of the standard premium (aka first dollar premium). Furthermore, retros have a formula dictating how the ultimate premium will. The formula is:
Retro Premium = ((Incurred losses x LCF) + (BPF x Standard Premium)) x Tax Multiplier
The term incurred losses seems self-explanatory. However, it is important to explain it can include or exclude allocated loss adjustment expenses (ALAE). If the insured selects to exclude ALAE from incurred losses, they are built back in by increasing the Loss Conversion Factor (LCF) of the Basic Premium Factor (BPF). Which option is better? It is about an even wash.
The LCF is a factor used to represent the cost of adjusting claims. It always includes unallocated loss adjustment expenses (ULAE) but may include ALAE if the insured opt for that route. ULAE are expense that cannot be specifically tied to a single claim, such as overhead and adjuster salaries.
The BPF is akin to the large deductible premium. Like the deductible premium it represents the insurance company’s risk premium, underwriting expenses, profit. It is expressed as a percent of the standard premium so a BPF of .35 means the carrier will collect 35% of the standard premium to cover expenses and make a little bit of profit.
I think it is also worthwhile to clarify the term Standard Premium. Standard Premium is a workers’ compensation term. Standard Premium is the final premium which includes both experience, and scheduled modifiers along with ancillary charges for terrorism and increased employer’s liability limits. It does not include the premium discount which is a discount akin to a volume discount policyholders received based upon the size of their premium. In the case of commercial auto and general liability programs, the standard premium would simply be the final modified premium.
Insureds can limit the impact of any single loss by purchasing a loss limit. In doing so, they limit how much risk they take on a per loss basis. For example, if they select a $100,000 loss limit, the amount of any single loss is limited to $100,000. Hence, only the first $100,000 of a $250,000 will be included within the incurred losses. Yes, the loss limit is akin to the per occurrence deductible. The cost of the loss limitation is built into the basic premium.
The insured’s aggregate annual risk is limited by application of a maximum retro factor which is expressed as a percentage of the standard premium. For example, a maximum retro factor of 150% with a standard premium of $1,000,000 would limit the ultimate retro premium to $1,500,000 (150% of $1,000,000).
Retros waive application of the premium discount. Therefore, even a max of 100% (1.00) presents some risk over a guaranteed cost program as the insured forgoes the premium discount.
Retros include a minimum premium factor which is generally tied to the BPF. Therefore, a typical minimum factor is the result of the BPF time the Tax Multiplier. In this example, if the tax load was 5%, then the minimum factor would be .3675 (1.05 x .35).
Retro adjustments are not made until at least 6 months after the policy expires. At that point in time, the first adjustment will be made with annual adjustments thereafter until both parties agree to close the plan out. This serves to be both a benefit and a drawback of retrospective rating plans. Benefiting from favorable loss experience is delayed. On the other side of the coin, impact of poor loss experience is delayed allowing the insured additional time to prepare for the impact.
Prior to the 1990’s, retros were the primary way for clients to assume risk. With the arrival of large deductible plans in the 1990’s, they began to grow out of favor with just about everyone as large deductible plans offered cash flow advantages and the ability to tailor programs tightly to the needs of clients. In fact, I thought they were going extinct like the dinosaurs had. But the prediction proved to be immature.
In 2008, the financial crisis brought retros back into being vogue. The availability of credit was impacted. As letters of credit became more difficult to obtain with higher charges, retros began to make a comeback. Since retros charge an annual premium upfront, they are for the most part self-collateralized. Since the money is collected as premium, it remains in sole control of the insurance company and is not necessarily subject to bankruptcy courts as cash collateral would be.
Furthermore, it there is too much credit risk, carriers can adjust the standard premium and maximum retro premium to increase the amount which is internally collateralized. Let me demonstrate.
A carrier might offer a retro program with a standard premium of $1,000,000 and a 125% maximum retro premium. Upon review, they feel the client presents a greater than average credit risk. To compensate, they may increase the standard premium to $1,250,000 and use a 100% maximum retro premium. In doing so, they have fully collateralized the plan.
Another advantage of retro program is they traditionally come with all those services insureds have become accustomed to being provided by their carriers. This makes retros a bit more comprehensive or at least appear to be more comprehensive rather than a la carte. This makes retros a bit heavier on the expense load than comparable risk retention plans.
One final advantage a retro plan has over other retention programs is they just look less risky. For those clients who are more risk adverse, staring at a potential 25% retro adjustment post policy year looks less intimidating than a $250,000 deductible with a $1,000,000 annual aggregate.
My last comment on retrospective rating plans is the information I laid out in the preceding paragraphs pertains to “incurred loss” retros. There are retros which are called paid-loss retros. Paid-loss retros perform and act almost exactly like large deductible plans with then only difference being different terminology and are large deductibles disguised as a retro. But as the said at the end of the first Conan the Barbarian movie, “that is another story!”