Fisher.OtherLSPlans

Reading: Fisher, G. et al, "Individual Risk Study Note," CAS Study Note, Version 3, October 2019. Chapter 2. Sections 5 – 10

Synopsis: In this article we look at a range of other loss sensitive rating plans that exist in addition to experience and retrospective rating plans.

Study Tips

This section is mostly a lot of low point value memorization. Don't overlook it though as these should be easy points on the exam. Make sure you can recreate the cash flows for a large dollar deductible policy.

Estimated study time: 1 day (not including subsequent review time)

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• Large Dollar Deductible Plans - understand and be able to compare and contrast.
• Alternate Rating Plans - describe, compare and contrast.
• Miscellaneous loss sensitive rating plan facts - lower likelihood of being tested but broad spectrum of information to memorize.

Questions are held out from most recent exam. (Use these to have a fresh exam to practice on later. For links to these questions see Exam Summaries.)

reference	part (a)	part (b)	part (c)	part (d)
E (2017.Fall #1)	ASOP 12 - rating variables	Modeling variables - choice of variables	GLMs - interpret results	Alternate Rating - suggest & advantages
E (2017.Fall #15)	Retrospective Rating - cashflow	Alternate Rating - suggest	Alternate Rating - disadvantages
E (2016.Fall #15)	Workers' Comp. - calculate deductible	Large Deductible Plan - contrast with WC.
E (2015.Fall #13)	Retrospective Rating - cashflows	SIR Plan - compare & contrast
E (2015.Fall #19)	Large Deductible Plan - credit risk	Large Deductible Plan - profit
E (2014.Fall #16)	Large Deductible Plan - design	Lee Diagrams - draw	Retrospective Rating - Table M
E (2012.Fall #19)	Retrospective Rating - cashflows	Retrospective Rating - development factors

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In Plain English!

Large Deductible Plans

Large Dollar Deductible (LDD) rating plans are typically for casualty lines of business which have a per-occurrence deductible of over $100,000. The insurer pays all claims upfront and then bills the insured for deductible reimbursements up to the per-occurrence deductible amount.

Under this type of rating plan, losses subject to the deductible may or may not include ALAE but are subject to a per-occurrence limit. The deductible reimbursement could be capped at an aggregate deductible limit and there is no minimum deductible reimbursement.

Premium is generally fixed for a large dollar deductible plan. However, the insured's cost (premium + loss reimbursements under the deductible) are not fixed. So large dollar deductible plans are loss sensitive as the total cost varies based on the actual loss experience.

The premium doesn't cover losses below the deductible (on a per-occurrence and aggregate basis). The insurer handles all of those claims but bills the insured the full amount. Net premium is the premium less any outstanding deductible payments. Net premium must cover the expected per-occurrence and expected aggregate losses, expenses and an underwriting profit provision.

Key Differences with a Retrospective Rating Plan:

• Provisions for premium tax and some premium based assessments (net of deductible premium) are lower since deductible reimbursements are not premium.
• Commission provision can be lower if it is a percentage of net premium.
• The insured's expected cost is generally lower under a large dollar deductible plan.

As the deductible (or attachment point) grows, the expected excess loss shrinks, so the insured is charged less premium. This means the expense and UW profit provisions can make up a large part of the large dollar deductible premium. The risk load for the excess losses can be material in terms of parameter risk and process variance.

See Fisher.CaseStudy for an example of how to calculate the net premium under a large dollar deductible.

Alice: "Hey, remember how you illustrated the cash flow for the policyholder and insurer in an incurred retrospective rating plan in the previous reading? Let's do the same exercise here for a large dollar deductible rating plan."

Construct the cash flows for a large dollar deductible rating plan

Self-Insured Retentions (SIRs)

Workers' Compensation and Auto Liability insurance in the United States are legally required coverages so regulatory approval is required to self-insure.

Under a Self-Insured Retention Plan (SIR), the insured is responsible for adjusting and paying claims but can outsource to a third-party claims adjuster (TPA = Third Party Administrator). The insurer reimburses the insured for loss amounts in excess of the self-insured retention, i.e. the insurer has no credit risk.

Since the insurer doesn't deal with claims upfront there is no ALAE for self-insured claims. ALAE is shared on a pro-rata basis with the insured for claims which exceed the retention. There is also minimal ULAE due to the insurer only handling the payout for excess claims. This means premiums are lower for excess over self-insured retention coverage. In turn, lower premiums means lower premium based assessments and taxes.

A self-insured retention policy with a $1 million limit over a $250,000 per-occurrence retention covers the layer between $250,000 and $1.25 million. Contrast this with a large deductible plan with a $250,000 deductible and $1 million limit covers the layer between $250,000 and $750,000. The deductible is said to erode the limit and this typically doesn't happen with a self-insured retention policy.

Dividend Plans

In a dividend plan if losses are lower than expected then the plan returns money to the insured via a dividend. The dividend counts as an expense, it is not a premium credit. This means there are no savings on premium based assessments and taxes.

If losses are higher than expected then no additional money is collected. That is, dividend plans are not balanced.

Dividend plans are usually evaluated at 6-months after policy expiration and then annually. If losses develop upward then dividends decrease. Dividends paid earlier may need to be partially recouped from the customer which creates credit risk for the insurer.

Dividend payouts are not normally guaranteed in a contract and require approval from the insurer's board of directors.

Clash Coverage

When an insured event impacts multiple lines of business at once the insured could find itself paying out under each line for the same event. For example, suppose company has a large deductible policy for Workers' Compensation ($250k deductible) and an Auto Liability policy with $100k deductible. A serious at-fault auto accident injures their employee and a third-party. Without clash coverage, the insured would have to pay each deductible for the same accident. Clash coverage can be purchased to define a single deductible (of say, $300k for our example) that applies across all lines at once. This reduces the amount the insured is exposed to under a single event impacting multiple lines.

Clash coverage is difficult to price. It can require simulations with assumptions about frequency, severity and correlations between lines of business.

Basket Aggregate Coverage

When an insured has more than one loss-sensitive plan a basket aggregate (or account aggregate) policy puts a total aggregate limit on all ratable losses across the plans. Normally the underlying plans have no maximum ratable loss amount or aggregate deductible limit.

Basket aggregate coverage can be achieved by writing a General Liability policy for losses in excess of a maximum aggregate retention up to a policy limit.

Multi-year Plans

A multi-year plan stabilizes costs by lengthening the experience period so "good" and "bad" years should offset each other. Typically a three-year experience period is used.

Contract wording for a multi-year plan should allow for rate adjustments when exposures change significantly during the policy period.

There is credit risk for the insurer as they must evaluate the financial condition of the insured over a longer period. Loss trends for a longer period must be built into the per-occurrence and aggregate excess exposure.

Multi-year plans are popular during soft markets when insureds try to lock in favourable rates.

Captives

Captives are insurance companies formed to serve the needs of their parent companies. Insurers write policies to provide coverage and then cede losses (normally primary and limited to an aggregate amount) to the captive.

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Credit Risk

Retrospective rating, large dollar deductible, and loss sensitive dividend plans have credit risk because they depend on the insured being willing and able to pay for additional premium, loss reimbursements or return dividend amounts in the future. Credit risk increases with the size of the deductible (if applicable), the limits involved (if applicable), and length of the tail for the line of business.

Question: How could an insurer protect themselves against credit risk?

Solution:

Collateral	By holding collateral (security) from the insured against expected recoverable amounts. The collateral requested is likely inversely proportional to the financial strength of the insured - financially stronger insureds may be required to post less capital.
Holdbacks	Both parties agree when the policy is written to defer all or a portion of the retrospective premium adjustments and/or dividend payments until the policy reaches a specific maturity. Doesn't usually apply to paid retrospective plans.
Loss Development Factors	Apply loss development factors to the losses used in incurred retrospective rating plans or the dividend formula. The factors are normally chosen when the retrospective rating plan is written. This isn't an option for large dollar deductible plans.

Alice: "In times of uncertainty investors often look to the Swiss Franc (CHF) to protect their assets."

Setting Retention Levels

Retention levels should:

1. Keep more predictable losses with the insured. That is, the per-occurrence retention should be set so the insured retains the higher frequency claims while the insurer should cover the more volatile loss exposure above that level (low frequency, high severity claims).
2. Be within the insured's risk tolerance. If they're risk adverse or require greater stability then they shouldn't have a high retention.
3. Be lower if the insured is a high credit risk or a financially weaker company.
4. Increase with loss trends else retention becomes less effective.
   • Important for per-occurrence definitions as these are typically fixed dollar amounts. Inflation means more claims will exceed the limit without adjustment. Aggregate limits are normally set as a multiple of expected primary losses or a multiple of guaranteed-cost premium, so are less subject to inflation.

Capital and Profit Provisions

In general the risk transferred from the insured to an insurer under a loss-sensitive plan is lower than that transferred under a guaranteed-cost plan (dividend plans are an exception). This is because the insured retains the risk for their primary losses up to an aggregate limit.

Since the insured retains more risk in a loss-sensitive plan, the insurer requires less capital to support the plan. However, the reduction in required losses is less than the expected loss retained by the insured because the insurer assumes the tail risk, i.e. riskier per-occurrence and aggregate excess losses. In particular, this means although the dollar amount of the profit provision is reduced for a loss-sensitive plan, it increases as a percentage of the expected loss.

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Dissolution of Loss-Sensitive Rating Plans for Long-tailed Lines

Retrospective rating adjustments and large deductible reimbursements continue until both parties agree to close the plan. There may be a contractual limit to the annual number of premium adjustments.

Question: What are some reasons to close a loss-sensitive rating plan?

Solution:

• Free up a balance sheet from plan liabilities - for instance, the insured could be putting itself up for sale.
• Eliminate the need to post collateral.
• Either the insurer or insured could be going through bankruptcy proceedings.
• Eliminate administrative costs due to billing additional premium or loss reimbursement amounts (benefits the insurer).

Question: How can we end a loss-sensitive rating plan?

Solution:

Method	Type of Plan(s)	Description
Closeout	Retrospective Rating	Apply final loss development factors to the losses to calculate the final premium. Some of the closeout terms are determined when the policy is first written.
Buyout	Large Dollar Deductible	In a buyout, for a fee, the insurer agrees to assume the liabilities related to the deductible layer of loss. Loss-based assessments associated with the losses may be included because some of the deductible layer losses may pierce the excess layer, causing the insurer to get hit twice. Loss-based assessments offset this.
Loss Portfolio Transfer (LPT)	Large Dollar Deductible, Self-Insured Retention	An LPT is a separate policy which transfers the insured's remaining loss obligations.

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Comparison of Retrospective and Deductible Policies

A retrospective policy with a per-claim limit, D, and a maximum ratable loss, M, covers the same amount of claims as a large dollar deductible policy with deductible D and aggregate deductible M.

The retrospective policy pays all losses and the insured pays additional premiums (or receives refunds if better than expected performance) at later evaluation points. The large dollar deductible plan pays all losses but the insurer gets reimbursed by the insured for losses below the per-occurrence deductible and aggregate limit.

The final premium charged for a retrospective policy is usually comparable to a guaranteed-cost policy. There is uncertainty about the final premium amount because it requires all claims to be settled. However, there is a predetermined schedule of premium adjustments.

A large dollar deductible policy typically has a much lower premium than a guaranteed-cost policy and is fixed ahead of time. The insured does not know the timing or amount of each deductible reimbursement payment it will have to make to the insurer.

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