Retrospective Rating Alternative
July 2005
A few days ago I received an e-mail from one
of IRMI's readers, which referred to a prior article that I wrote on loss forecasting.
The question on the table had to do with a loss picture which an insurer foisted
on the insured, after having actuarially trended and developed their combined
commercial liability and commercial automobile experience over a protracted
period of time. In actuality, the loss pic was quite reasonable.
by Peter
M. Polstein
The reader wanted to discuss alternatives other than guaranteed cost which
was the current program, and felt that neither self-insured retentions nor deductibles
provided a satisfactory alternative as premium credits were not supportive of
the increased risk taken on the part of his client. His client was not at all
interested in any retrospective rating programs, simply due to the potential
of long-term adjustments.
I called back, talked for a bit and I said, "Have you ever considered a divisor
program?"
His answer was, "Not really." Okay, divisors have been around the insurance
industry for years. I utilized them frequently at Alexander & Alexander, and
they are really a simple alternative to what is a myriad of loss sensitive programs,
where adjustments have the habit of driving both client and agent/broker nuts.
The Divisor Example
Assume the insured's guaranteed cost was $2 million per annum, which now
becomes unity premium, based in part on the underwriter's concern that the risk
had the potential for catastrophic loss. In fact, over a 3-year period, the
actual loss pic averaged $500,000. I said, ask the underwriter for a divisor
of 60 percent, which would provide the underwriter with the reciprocal of 40
percent or $800,000 which covers boards, bureaus, taxes, profit, administration
and loss costs, and represents minimum premium, irrespective of losses.
Underwriters will then ask for a deposit premium which represents a negotiated
value of trended and developed losses, or perhaps something in-between. Let’s
assume a loss pic of $500,000; the insured’s premium would be $500,000 or a
$1.5 million cash flow benefit. There is also the possibility that underwriters
may demand some collateral to make up the difference between the actual loss
pic whose actuarial confidence level may be somewhat less than the perceived
potential for loss. The only adjustment that is made will be paid losses divided
by the 60 percent factor.
If you assume that the ultimate losses stay at say $500,000, then the total
loss cost becomes $833,000 rounded off. If all of the assumptions held, the
insured’s total annual premium would be $1,633 million (minimum plus loss costs)
providing both a cash flow benefit and additional savings of $367,000. On the
other hand, if the experience went south, then underwriters would have no less
than the $2 million they would have derived from the guaranteed cost program.
Conclusion
You might ask, why would underwriters entertain this sort of program? Why
not? It provides protection for the underwriter, and while their written premium
will suffer to some degree, there is the likelihood of having a client as a
long-term partner.
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