Retrospective Rating Plans

Purpose and Operation of Retrospective

Rating Plans
Organizations that desire more risk retention while still keeping an insurance
program often consider a retrospective rating plan that provides an alternative
means for insurance pricing. Because a retrospective rating plan is an optional
pricing plan applied to insurance, the insurance professional needs to know
the types of losses covered by the plan and how the retrospective rating insurance premium is determined.
The purpose of a retrospective rating plan is to adjust the premium for
guaranteed-cost insurance to reflect the insured organizations current losses.
Rather than using industry-wide loss experience to determine premiums, a
retrospective rating plan uses the insured organizations own losses from the
current policy period to price the current policy period. To the extent that
the insurer assumes the insured organizations losses above specified monetary
limits, the retrospective rating plan is a risk transferplan.
Because the retrospective premium reflects losses incurred during the policy
period, the retrospective rating plan provides an incentive to the insured
organization to use risk control and thereby reduce losses. To the extent that
the insured controls losses, it is rewarded through lower premiums.

Retrospective ratingplan
A rating plan that adjusts
the insureds premium for
the current policy period
based on the insureds
loss experience during the
current period; paid losses
or incurred losses may be
used to determine loss
experience.

Lines of Business and Characteristics of Losses

Organizations commonly use retrospective rating plans for losses arising from
their liability loss exposures that are covered by workers compensation, auto
liability, and general liability insurance policies. Organizations can also use
retrospective rating plans for auto physical damage, crime, and glass loss exposures. A single retrospective rating plan can be used for more than one type of
loss exposure. For example, workers compensation, auto liability, and general
liability are commonly combined under a single retrospective ratingplan.
In general, organizations use retrospective rating plans to finance their
low- to medium-severity losses.1 These types of losses usually have a high
frequency and are therefore somewhat predictable in total. See the exhibit
Characteristics of Losses Usually Covered by a Retrospective Rating Plan.

5.3

5.4 Risk Financing

Characteristics of Losses Usually Covered by a Retrospective

RatingPlan
High

Low

Loss
Severity

Predictability of
Total Losses
Retrospective
Rating Plan

Low

High

Relative Loss Frequency

[DA01348]

Other characteristics of organizations that are typically not suited for retrospective rating plans include these:
Small premiumsize
Wide premium fluctuations
Financial problems
Insurers generally use retrospective rating plans developed by the National
Council on Compensation Insurance (NCCI) for workers compensation and
by the Insurance Services Office (ISO), Inc., for coverages other than workers compensation. Both organizations have developed eligibility rules, pricing
procedures, and retrospective rating premium endorsements that are filed with
and authorized for use by the state insurance departments. When a retrospective rating plan is used, the insurer attaches the appropriate retrospective
rating premium endorsement to the policy. If multiple insurance policies are
subject to the same insurance plan, a retrospective rating premium endorsement is attached toeach.

Premium Determination
As with any insurance plan, the insured organization under a retrospective
rating plan pays a premium to the insurer. The insurer uses the premium to
reimburse claimants for losses and to pay other expenses, such as premium
taxes, residual market loadings, loss adjustment costs, and legal defense fees.
The premium also includes an amount to cover the insurers overhead and
profit.

Retrospective Rating Plans 5.5

Comparing Guaranteed-Cost and Retrospective Rating

Insurance Plan Premiums
Under a guaranteed-cost insurance plan, the premium for the policy period
does not vary with the insureds losses that occur during the policy period.
Therefore, guaranteed-cost insurance is a risk transfer technique.
In contrast, under a retrospective rating plan, the insured organization pays a
deposit premium at the beginning of the policy period, and the insurer (using
a rating formula agreed on before the policy period) adjusts the premium after
the end of the policy period to include a portion of the insured organizations
covered losses that occurred during the policy period. Because the premium
is adjusted upward or downward based directly on a portion of covered losses,
the insured organization is, in effect, retaining a portion of its own losses.

Retrospective Rating Versus Experience Rating

Retrospective rating plan rating is frequently confused with experience rating,
because both consider the insured organizations loss experience.
In contrast, retrospective rating plans adjust the premium for the current
policy period to recognize the insureds loss experience during the current
policy period. The insured organizations past loss experience is not completely ignored in the retrospective rating plan because past loss experience
is reflected in the standard premium. However, past lost experience is less
important relative to current losses.

Experience rating
A rating plan that adjusts
the premium for the current
policy period to recognize
the loss experience of the
insured organization during
past policy periods.

Maximum and Minimum Premiums

The adjusted premium under a retrospective rating plan is subject to a maximum amount and a minimum amount agreed to in the policy. The maximum
premium is the most an insured organization is required to pay under a retrospective rating plan, regardless of the amount of incurred losses. By agreeing
to limit the amount by which the premium can be adjusted upward based on
covered losses, the insurer accepts the risk that total losses during the policy
period could exceed a maximum amount. The adjusted premium is also often
subject to a minimum amount, called a minimum premium.

Maximum premium
The most an insured
organization is required to
pay under a retrospective
rating plan, regardless of the
amount of incurred losses.
Minimum premium

For example, the maximum and minimum premiums for a retrospective rating
plan might be $1,000,000 and $200,000, respectively. If during the policy
period the insured organization experiences a total of $1,400,000 in losses
subject to the policys loss limit, the premium is limited to the maximum premium of $1,000,000. If the insured organization experiences no losses during
the policy period, the minimum premium of $200,000 still applies.

The least an insured

organization is required to
pay under a retrospective
rating plan, regardless of the
amount of incurred losses.

Provided the insured organization has a sufficiently large premium, the retrospective rating plan can be designed to cap losses and thereby minimize the
insured organizations retention by using a loss limit. A loss limit is the level
at which each individual accident or occurrence is limited for the purpose of
calculating a retrospective rating insurance premium. The use of a loss limit is

Loss limit
The level at which a loss
occurrence is limited for
the purpose of calculating
a retrospectively rated
premium.