Understand how retrospective rating works, the formulas that help calculate the premiums, and the advantages and disadvantages to retrospective rating.
Definition and Examples of Retrospective Rating
Retrospective rating is a way of pricing an insurance policy premium based on the losses that occurred during the period of coverage. The policyholder pays a provisional premium that is based on estimated, or projected losses. At the end of the policy, the insurance company adjusts the premium to reflect the actual loss that occurred during the policy period. Retrospective rating is commonly used in workers’ compensation insurance. It is occasionally used in general liability, commercial auto liability, and commercial auto physical damage insurance. Here’s an example: ABC Inc., a large manufacturer, has just purchased a workers compensation policy for the period January 1, 2021, through January 1, 2022.
How Retrospective Rating Works
When a policy is subject to retrospective rating, the premium is calculated using a mathematical formula containing the elements described below. ABC Inc., from our example, would use the following elements in their formula:
Standard premium: The amount the coverage would cost if it weren’t retrospectively rated (i.e., if it were written on a guaranteed cost basis). It includes the experience modifier but does not include a premium discount.Minimum premium: Calculated by multiplying the minimum premium factor by the standard premium. It is the least the employer will pay for the policy.Maximum premium: Calculated by multiplying the maximum premium factor by the standard premium. It is the most the employer will pay for the policy.Basic premium: Calculated by multiplying the basic premium factor by the standard premium. The basic premium covers the expenses the insurer incurs to issue and maintain the policy.Expected losses: Included in the retro formula at the policy inception date. When adjustments are made after the policy has expired, actual losses are used.Loss conversion factor: Multiplied by losses to calculate converted losses. Converted losses include both claim payments and the insurer’s claims adjustment expenses.Tax multiplier: A factor applied to the premium as a charge for premium taxes and various assessments.
To calculate the retro premium, the insurer adds the basic premium to the converted losses. It then multiplies that sum by the tax multiplier. Some retro plans may include factors not outlined above. For instance, some include a loss limit, which caps losses that exceed a certain threshold (such as $100,000). If a plan includes a loss limit, a loss limit factor will be added to the formula.
ABC Inc.’s Calculations
For ABC Inc.’s one-year insurance period, their expected losses are $50,000, and their projected payroll is $45 million. The rate is $1.00, and ABC’s experience modifier is .90. ABC’s insurer has calculated the retro premium using the following factors: ABC’s estimated retro premium is determined by adding its basic premium ($58,725) to its converted losses ($56,000) and multiplying the sum by the tax multiplier (1.07). The result is $122,756. This number is less than the minimum premium ($243,000), so ABC’s retro premium is $243,000.
Loss Sensitive vs. Guaranteed Cost
Most worker’s compensation insurance is written on a guaranteed cost basis. When you buy a guaranteed cost policy, your premium is not affected by the number or size of claims you sustain during the term of the policy. If your policy is subject to experience rating, your cost of insurance will be impacted by losses that occurred in the past, not current losses. Like dividend plans and workers’ compensation deductibles, retrospective rating (retro) plans are loss sensitive. This means that the amount you pay to insure your worker’s compensation risks during a particular policy period is partly determined by your loss experience during that period.
Advantages and Disadvantages
A retrospective rating plan offers some potential advantages. First, businesses that have good loss experience may pay significantly less for workers’ compensation insurance under a retro plan than they would under a guaranteed cost program. Secondly, a retro plan gives policyholders an incentive to implement strong loss control loss and return-to-work programs. Thirdly, the premium an employer pays for a policy reflects the employer’s actual loss experience for the period covered by that policy. The primary disadvantage of retrospective rating is the risk of a large additional premium if an employer’s actual losses are significantly greater than expected.
Eligibility Requirements
All states have established retro plan eligibility requirements. For instance, many specify a minimum premium threshold of $25,000 for a one-year plan and $75,000 for a three-year plan. About three-quarters of the states in the U.S. (and Washington D.C.) have adopted a retro plan created by the NCCI. The remaining states utilize independent plans. Many states allow insurers to utilize their own proprietary retro plans with the approval of the state workers’ compensation authority.
Premium Adjustments
A key feature of a retro plan is periodic adjustments. Many plans require the first adjustment six months after the policy has expired. A second adjustment is made 12 months later (18 months after expiration) and a third one 12 months after that (30 months after expiration). The insurer recalculates the premium at each interval using a current assessment of losses. If the premium is less than the amount previously paid, the insurer returns the excess to the policyholder (subject to the minimum premium). If the premium is greater than the insured’s initial payment, the insurer bills the insured for the amount due (subject to the maximum premium).
