Fisher.RiskSharing

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

Synopsis: To follow...

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...your insights... To follow...

Estimated study time: x mins, or y hrs, or n₁-n₂ days, or 1 week,... (not including subsequent review time)

BattleTable

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

• fact A...
• fact B...

reference	part (a)	part (b)	part (c)	part (d)
E (2018.Spring #1)
E (2018.Spring #1)
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E (2018.Spring #1)
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In Plain English!

Risk Retention and Risk Transfer

A guaranteed cost policy is where the insured's premium is fixed upfront and the insured doesn't share in their own risk except maybe via a small deductible. Private Passenger Automobile bodily injury coverage is a good example of this.

Risk sharing is where the insured's risk tolerance and financial capacity allows them to retain the smaller, more predictable losses but transfer the more volatile and uncertain larger losses to the insurer (the excess losses).

The primary risk retained by the insured is often limited in aggregate to some total. For instance, only the first $1 million of primary losses may be retained. The risk of losses over the aggregate amount is transferred to the insurer.

Rating plans in which the insured shares/retains a (material) portion of the risk are known as loss-sensitive rating plans.

Question: What are four advantages of loss-sensitive rating for the insured?

Solution:

1. Incentive for loss control - affects both direct and indirect costs such as lost productivity.
2. Immediate reflection of good loss experience. Experience rating has lag and is credibility weighted.
3. Cash flow benefits
4. Reductions in premium based taxes and assessments (premiums are lower due to more retention, so taxes and assessments are lower).

Question: What are some disadvantages to the insured when using loss-sensitive rating?

Solution:

1. Uncertain costs compared to fixed premium from guaranteed cost plans.
2. No immediate tax deduction of full guaranteed cost premium.
3. Poor loss experience is reflected immediately.
4. Future financial statements impacts due to cash flows.
5. Higher, ongoing administrative costs.
6. Collateral/security costs for credit risk.
7. Overall higher complexity compared to a guaranteed cost plan.

Question: What are three advantages of loss-sensitive rating for the insurer?

Solution:

1. Insured has loss control incentives which are stronger than those through experience rating.
2. Can write some risks that otherwise the insurer would decline to write on a guaranteed cost basis.
3. Less capital is required to be held for loss-sensitive policies.

Question: What are five disadvantages of loss-sensitive rating for the insurer?

Solution:

1. Higher administrative costs.
2. Credit risk.
3. Less cash flow because the insured is covering the primary losses.
4. Insured may attempt to second guess the claims handling and claims expenses.
5. Insureds may question the profit provision magnitude since they're taking on risk.

What is Retrospective Rating?

Retrospective rating is using the experience from a policy period to adjust the premium for the same policy period. Adjustments to the policy premium are made after reviewing the actual loss experience in the period. The policyholder pays or receives the difference between the prior premium amount and the newly calculated premium after each adjustment. Retrospective rating plans may be on an "incurred" or a "paid" basis.

• Incurred Loss Basis: The first evaluation is six months after the policy expires and then every 12 months afterwards.
• Paid Loss Basis: The first evaluation is after the first month of the policy and then every month onwards.

It is normal to switch from a paid basis to an incurred basis after a period of time (such as five years) which was agreed at policy inception.

Generally a primary layer of loss is used to retrospectively adjust the policy premium. Primary losses may be capped at a maximum ratable loss amount to protect the insured from volatility. The cap may be either a maximum loss amount or a maximum premium. There may also be a minimum loss amount or minimum premium.

Retrospective Rating Formula

The retrospective premium, R, is calculated as [math]R=(B+cL)\cdot T[/math], where

B	basic premium amount
c	loss conversion factor (LCF)
L	loss amount used in the calculation (the ratable loss)
T	Tax multiplier

B accounts for fixed charges that won't vary with losses. Some examples are:

• Underwriting expenses and commissions not included in the tax multiplier.
• Expected per-occurrence excess losses assuming losses are subject to a per-occurrence limit. Generally, this includes a provision for associated loss adjustment expenses. The NCCI and ISO retrospective rating plans have a separate component in the formula for the charge per-occurrence excess losses.
• Expected aggregate excess losses or insurance charge if there is a maximum ratable loss amount. This generally includes an provision for loss adjustment expenses.
• A credit if losses which influence the premium are subject to a minimum ratable loss amount, or if the retrospective premium is subject to a minimum premium. This is often called the insurance savings or just savings.
• Underwriting profit provision.

The combination of the insurance charge and insurance savings is called the net insurance charge. The basic premium, B, will only change as the result of a premium audit.

c accounts for expenses which vary with the actual loss experience, such as loss adjustment expenses and loss based assessments. It is fixed at policy inception. It is possible to switch expenses between B and c but if you charge fixed expenses in c and the losses are lower than expected then you won't get those expenses back...

To switch expenses between the basic premium and the loss conversion factor, use the following formula: [math]e-(c-1)E[/math] to calculate the expense portion of the basic premium. Here

e	is the expense ratio for the guaranteed cost premium. It includes loss adjustment expenses and reflects the premium discount (expenses are a lower percentage of premium for large accounts).
c	is the selected loss conversion factor.
E	is the expected loss ratio for the guaranteed cost premium policy.

Note that as c increases the expense portion of the basic premium decreases.