Magazine article Risk Management

Learning the Pitfalls of Casualty Rating Plans

Magazine article Risk Management

Learning the Pitfalls of Casualty Rating Plans

Article excerpt

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. …

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