Workers’ Comp: An Introductory View into Loss Sensitive Plans

At a time in the California workers’ compensation marketplace where insureds are desperately seeking rate relief, many have begun to seriously evaluate alternatives to the traditional guaranteed cost plans they have been offered in past years. Loss sensitive rating plans have grown in popularity over the last few years because they are perceived to be more equitable than guaranteed cost plans. Loss sensitive plans give the insured the opportunity to have their insurance costs more directly related to their own losses during the policy period.

As the shift occurs and insureds move from traditional guaranteed cost plans to more complex loss sensitive plans, they will be looking for insurance brokers that have the ability to explain and analyze the different plans that are available. Understanding the alternative risk financing market gives brokers a unique opportunity to add value to their clients and differentiate themselves from price driven competitors.

The first step that brokers need to take is to understand the different types of loss sensitive plans and the important intricacies involved in evaluating each of them. This will allow the broker to evaluate his existing base of clients to see if any of them would be better served on a loss sensitive plan, which would mitigate the chance of another broker bringing a loss sensitive option to your client. Also, understanding the characteristics that make certain plans more advantageous to specific industry segments could make a strong strategy to target prospective clients. The following is an introduction to some of the more popular types of loss sensitive plans.

Retrospective Rating Plans

A retrospective rating plan can be defined as a rating plan “in which the final premium is based on the insured’s actual loss experience during the policy term, subject to a minimum and maximum premium, with the final premium determined by a formula which is guaranteed in the insurance contract.”

The insured pays a standard premium at the beginning of the policy year which consists of the basic premium and the loss projection. In 18 months from the inception of the policy, the insurance company values the losses and plugs them into the Retro Premium formula (See box).

If the standard premium is greater than the retro premium then the insured will receive a return premium in the amount of the difference. If the retro premium is greater than the standard premium then the insured will have to pay the insurer an additional premium. After the first calculation at 18 months, there will be subsequent calculations every 12 months until all losses are closed out.

Most of the time retro plans have a maximum premium limitation, which caps the amount of premium the insured must pay. This is necessary because many insureds would not be interested in a plan that did not place a limit on a possible loss. The maximum premium tends to be about 1.20 times the standard premium.

Large Deductible Plan

A large deductible plan is an insurance plan in which the insured is responsible for reimbursing the insurer for claims up to a certain dollar amount and the insurer is responsible for paying claims in excess of the deductible amount. The average retention level in previous years for California workers’ comp deductible plans has been about $250,000. In addition to paying for all losses under the deductible, the insured must pay a deductible premium which is the guaranteed cost premium multiplied by a deductible credit which depends on the retention level that the insured chooses. The larger the retention level, the larger the deductible credit given.

An important aspect that the broker needs to evaluate when analyzing a large deductible plan is the aggregate stop loss limit. The aggregate stop loss limit is the total amount that the insured could be obligated to pay for losses under the deductible. For example, if the aggregate stop loss limit is $1,000,000 and the combined losses for the insured is currently $900,000. If a claim occurred for $200,000, then the insured would only pay $100,000 because at this point the aggregate stop loss limit would be reached. The insurance company would pay the additional $100,000 and all losses for the rest of the policy period. If an insured had a deductible plan without an aggregate stop loss limit, multiple losses could have an adverse impact on earnings. The aggregate stop loss limit is usually set at around 1.5 to 2 times the loss projection.

In a large deductible plan the insurance company takes care of all the claims and then collects from the insured for loss payments that the insured is required to pay under the deductible. The insured will need to setup an escrow fund at the beginning of the policy period and the carrier will pay losses out of the escrow fund. The policy contract will discuss when and how often the escrow fund needs to be replenished by the insured.

The insurer, in a large deductible plan, has ultimate control over claims management and will charge the insured for the administrative cost in handling the claims. This charge could either be an LCF as mentioned in the retrospective plan or a specific dollar cost for each claims handled. The per claim method will have the same cost for all medical only claims and the same cost for all indemnity claims, which is higher than the medical only charge. If your client has enough historical information and the claims count is large enough to have statistical credibility it is a good idea to pursue per claim costs instead of a percentage based approach because the client will be paying a closer approximation of actual claims handling fees.

Another important component that the broker will need to understand is the Letter of Credit (LOC) that the carrier will ask for before binding coverage. This LOC is held in the event that the company is unable to pay claims under the retention level. Since the carrier is still responsible for paying these claims, the carrier can draw down on the LOC to provide claim payments. The reason that LOCs or cash collateral are mandatory for all large deductible plans is to make sure that the insurance company only takes on underwriting risk and not financial risk. Banks charge for issuing LOCs, so remember to include this cost in the total cost of the plan.

Captives

A captive is any insurance company that is owned by one or more organizations and that insures only the owners of the company. There are lots of different captive arrangements and self-insurance groups in the marketplace today. As far as evaluating captives go, brokers need to find out if their client will be sharing in the risk with other companies. If this is the case, the broker should evaluate the formal guidelines established within the captive on how prospective companies will be evaluated for induction into the captive. The monetary cost of the captive usually drives insureds into making a decision but brokers need to make sure the client evaluates not only the monetary costs but how the captive is run because it will be an important indicator on how successful the captive is over the long term.

In order to evaluate different types of loss sensitive plans it is important for the brokers to perform a loss projection for the upcoming policy year. Since the major driver of insurance costs is the losses, brokers can plug the ultimate loss numbers into the different loss sensitive formulas to estimate the total cost of each program.

Here is a quick five-step process to perform a loss projection:

• Take four or five years of loss history and multiply a loss development factor to each year to get an estimated ultimate loss amount for each year.

• Then adjust each year of ultimate losses and corresponding payroll with a trend factor. This is done to take into account inflation and make sure you bring everything to today’s dollars.

• Then you divide your trended payroll by your trended ultimate losses for each year to get a loss rate for each policy year.

• Take an average of your loss rate over the last four or five years.

• Multiply your average loss rate by your forecasted payroll for the projected policy period to get your loss projection.

When evaluating different loss sensitive plans, brokers need to understand how cash flow and tax deductibility are affected by the different types of workers’ comp plans.

How tax deductibility is impacted by different rating plans:

• Guaranteed Cost-Premium is paid during the policy period and the insured receives a tax deduction for all premium paid.

• Retro Plan-The standard premium is paid during the policy period and the insured receives a tax deduction for all premium paid.

• Large Deductible Plan-Deductible premium is paid during the policy period and the insured receives a tax deduction for all premium paid. The losses which are the substantial part of the total cost are not tax deductible until the losses are actually paid.

How cash flow is impacted by different rating plans:

• Guaranteed Cost-On this type of plan the insurance company reaps the benefits of improved cash flow because the carriers collect premiums before losses occur and insured losses may not be paid out for months or years after the premium is collected.

• Retro Plan-On most retro plans, the standard premium is comparable to the guaranteed cost premium. Like the guarantee cost plan the retro plan improves the cash flow of the insurance carriers.

• Large Deductible Plan-On this type of plan, the insured retains control of loss funds until they are actually used to pay losses. Under this type of rating plan the insured receives all the benefits of improved cash flow.

It looks like the trend will continue and more insureds will evaluate the alternative risk market before purchasing their coverage. Brokers that understand and have the ability to communicate the costs and benefits of each plan will be in high demand.

Robert Young is president of Magellan Insurance Services, a workers’ compensation intermediary in San Diego, California. Young started his insurance career at Golden Eagle and worked for Arrowhead General Ins. Agency and Marsh before helping form Magellan in 2003. Jeremiah Howard is a senior vice president of program development at Magellan.