Pitfalls of the Current Experience Rating Plan

Abstract

Introduction Workers' compensation insurance is the largest line of commercial casualty insurance in the United States and the oldest for which standard rating approaches have been developed. The principal statistical and ratemaking body, the National Council on Compensation Insurance (NCCI), uses similar experience rating techniques for individual states with variations by state, depending on unique classes or individual state requirements. The rather complex rate development process can be summarized as follows: (1) The premiums and losses for a state are collected totally; separately by manufacturing, contracting, and all other classes; and individual classification. (2) Rates are determined by class using credibility factors and adjusting total rate levels in accordance with permissible levels and state increase parameters. The insurance rates developed through this process may be modified under the regulatory process in each state. The results of the ratemaking process are known as class rates. The premium for an individual risk is the result of applying class rates to the applicable number of payroll units ($100 of payroll) subject to a premium discount based on the size of the overall premium. Experience rating is a supplemental procedure that utilizes the individual risk's past loss experience to forecast future losses. It is an effort to modify the ratemaking process by recognizing an individual risk's potential for incurring claims. An effective experience rating plan surcharges poor risks and credits good risks in proportion to relative exposure to loss. In other words, experience rating adjusts the class premium to provide all policy holders with relatively equal expected loss ratios. However, when basic assumptions involving firm ownership are violated, the appropriateness of the method comes into question. For example, significant rating differences may exist depending on whether Company A buys Company B or Company B buys Company A. The experience rating procedure utilizes three years of loss history (second through fourth prior) as an indicator of future losses. A policy rated on January 1, 1993, would therefore utilize the loss experience of 1989, 1990, and 1991 to develop an experience modification factor. (Losses for the immediate prior year are considered too green and generally are not available for use in the experience rating process.) The process used to calculate an experience modification factor is a form of rating. The incurred loss value for each claim is split between a value and an value. The rationale is to give more weight to the frequency than to the severity of claims. This is intuitively reasonable as the size of the loss is more subject to chance than the number of losses. Perryman (1937) developed the generally accepted formula for experience modification factors: M = |A.sub.p~ + B + W|A.sub.e~ + (1 - W)|E.sub.e~/E + B, (1) where |A.sub.p~ = actual primary losses, B = ballast (stabilizing) value. W = credibility weight assigned to actual excess losses, |A.sub.e~ = actual excess losses, |E.sub.e~ = expected excess losses, and E = total expected losses. The values B and W vary according to the size of the risk. At one extreme, a small risk will have no credibility assigned to historical excess losses (W = 0) and will have a ballast (stabilizing) value of $20,000 added to the numerator and denominator of the experience modification formula. The use of a low W-value and a high B-value gives lower credibility to actual loss experience and thus reduces the difference from the rate. A large, self-rated risk, however, could have full credibility for its loss experience (W = 1) with no ballast. In such a case, the individual risk's own loss experience is weighted 100 percent. Thus, the experience modification formula for a self-rated risk reduces to the formula M = A/E. …