Lesson 2 Introduction to Rates

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1 Lesson 2 Introduction to Rates 1. Objective The objective of this lesson is to give a description of how workers compensation rates are determined. Ratemaking is certainly not easy, but the goal of this lesson is to make the basic ideas used in pricing workers compensation coverage more familiar and understandable. 2. Introduction to Rates The ratemaking process - the pricing of workers compensation coverage - is a technical function, traditionally the domain of specialized technicians called actuaries. Actuaries are focused on concepts rather than strict mathematical formulas. Rates are mathematically based, producing an objective pricing system. 3. Introduction to Rates The employer s annual payroll (in $100 units) is multiplied by a price, or manual rate, to determine the annual premium contribution required to fund the benefit system. What does the rate cover? The product provided by workers compensation is security - in the form of weekly benefits paid directly to the injured worker, and in the form of payment to doctors, hospitals, and others for medical and rehabilitative services. The payments represent the product costs to the insurance carrier. 4. Introduction to Rates Rates for workers compensation coverage must: Provide sufficient funds to pay for benefits Provide sufficient funds to operate the system that will deliver these benefits The funds needed to deliver these benefits are obtained through the Expense Allowance.

2 Business Overhead = Expense Allowance The expenses include: Acquisition General Premium Taxes Claims Adjustment Contingency and Profit 5. Introduction to Rates Workers Compensation is a prefunded system. The premiums from policies written during a given year are intended to meet all future claim payments made under these policies. This prefunded system is contrary to the usual payment for product norm. Insurance is a business, and no business enterprise will knowingly assume a risk without an incentive to do so. Accordingly, it is necessary that the price for coverage provide such an incentive. Premiums are paid up front, while benefit payments are made over a period of years. This gives the carrier an interest-earning opportunity. This investmentearning potential provides the true incentive for writing this insurance, and provides the reward for assuming the risk. 6. Introduction to Rates What is meant by the phrase Premium Level? The book price, or manual rate, is the cost of workers compensation insurance per $100 of payroll. A single price for a state does not exist. There is a specific price or rate for each of the approximately 600 employment classifications, with each classification representing a specific activity. (For more information regarding classifications, please see the Introduction to Classification lesson.)

3 7. Introduction to Rates Insurance, as a product, is a promise to pay. The cost of the product is the sum of the liabilities incurred when the promise was made. Insurance is unusual as a product - we set the price before we know the cost! 8. Introduction to Rates The Ratemaker s Dilemma To price with a prefunded system, one must project benefit and expense costs in advance. Ratemakers face a difficult problem. They must decide in the year 2002 how many dollars will be needed for claims covered by policies written in Introduction to Rates A mistake in the calculation of the starting point will nullify the sophisticated calculations later (and impede reaching the final destination). Determining our starting point begins with Data Validation. All NCCI rates and loss costs are based on: actual premium loss cost payroll loss experience All reported to us by insurance carriers.

4 10. Data It is fundamental that, in order to make a premium estimate, data from the most recent past must be used. It is the best indicator of what is expected during the period the rates are in effect. NCCI, as the licensed statistical agent for workers compensation in most states, collects data periodically from its member insurance companies. 11. Data Types of New Data: Statewide Financial Data to determine what state average price level change is needed Statistical Plan or Policy-by-Policy Data 12. Data to determine how the average price change should be distributed The state s financial data is sent to NCCI in response to periodic data requests. The Workers Compensation Statistical Plan (WCSP) contains detailed policy information. First, the financial data is used to determine whether the overall level of premium in the state is too high or too low. Then, the highly detailed statistical plan data is used to apportion the average price change among the various work classifications. 13. Distribution of Overall Rate Level Notes on the Credibility of Data: If the volume of business is small, the recent experience may have little credibility the data is too limited from which to draw conclusions. The greater the volume of data available means the greater the reliability for predicting future occurrences and setting prices.

5 14. Data NCCI expends a considerable amount of effort validating the data making certain that the data it uses is accurate. NCCI is licensed in more than three dozen jurisdictions NCCI has approximately 1000 member companies These companies write over 1,300,000 policies annually Consider that each member submits many reports for each state it does business in. That is a lot of reports and data for NCCI to review! 15. Data When validating the data, two types of Actuarial Edits are discovered: Reconciliation Edits Consistency Edits For Reconciliation: NCCI compares data with annual statements and insurance expense exhibits. Errors are reconciled by checking with the insurance company to verify the reported results. For Consistency, we collect: accident year information policy year information insurance expense exhibit data calendar year information

6 16. Financial Data The financial data we collect covers several time spans, including: policy year calendar year calendar-accident year Policy year data is the aggregate experience of a specific group of policies. EXAMPLE: Policy Year Financial Data Policy Coverage Begins Coverage Ends A (first) 01/01/ /01/2003 B 03/07/ /07/2003 C 05/01/ /01/2003 D 08/12/ /12/2003 E (last) 12/31/ /31/2003 Time Span for Policy Year 2002 Experience (Diagram that shows the policies from page 16 covering 24 months.) 18. Financial Data Calendar year data groups financial transactions by sorting the date on which they took place. Calendar Year 2002 Time Span for Calendar Year 2002 Experience: 1/1/ /31/2002 First Transaction Last Transaction Occurs Occurs

7 19. Financial Data Calendar-accident year refers to: calendar - refers to premiums being organized by transaction date accident - refers to benefit claim costs being organized by the date the accident took place Calendar-accident year data is used in the pricing of workers compensation insurance. 20. Financial Data Adjustments to Policy Year Data Premium: Effect of recent price changes Additional premium development (e.g. from late audits) Adjustments to Benefit Costs: Recent statutory benefit changes Additional benefit cost development 21. Financial Data Adjusting benefit claim costs to current law level: Benefit claim costs are adjusted to reflect cost of statutory benefit changes Adjusting benefit claim costs by a development factor, such as: 1. Incurred Benefit Costs = Amount Paid + Amount Still Owed 2. Incurred Benefit Costs = Amount Paid + Amount Outstanding 3. Incurred Benefit Costs = Amount Paid + Amount Reserved

8 22. The Test for Rate Adequacy Once all adjustments are made, the rates are tested for adequacy. The test for adequacy may be viewed as placing income and outgo on a scale to see if the two are in balance. The example shown on the next page uses data that has already been actuarially adjusted the premium expected to be collected is based upon the current rate level, and the benefits expected to be incurred are based upon the current benefit level. 23. The Test for Rate Adequacy Example 1 Current Rates too high Premium level decrease is indicated Example 2 Current Rates too low Premium level increase is indicated Example 3 Goal is achieved when funding system is in balance 24. Rate Adequacy Through NCCI ratemaking techniques, we can obtain a good indication of the ultimate value of the losses. Policies extend for a year - so rate levels overlap. To set prices that will adequately cover that length of time, we must determine: are we accelerating? are we decelerating? and how fast?

9 25. Rate Adequacy The result is called a Trend Factor. The factors measured are: payroll levels premiums benefits medical costs 26. The Trend Factor The Trend Factor Reflects: Premium Changes in Payroll Benefit Cost Changes in duration of claims Changes in the frequency of claims Inflation rate The trend factor is based upon a comparison of movements in benefit costs with movements in payroll. The trend factor accounts for anticipated movements in payrolls and benefit costs. 27. The Trend Factor Trend Analysis reveals benefit costs are growing faster than payrolls. The trend factor will show an increase. Trend Analysis reveals payrolls are growing faster than benefits. The trend factor will show a decrease.

10 28. Rate Adequacy Workers Compensation also factors in likely occurrences affecting losses and expenses for the year. In navigation, this compares to Dead Reckoning - the navigator notes the initial position and the direction to go to reach the final destination. However - how do you account for drift? (The changes that occur along the way.) In Workers Compensation we use actuarial science to adjust for the drift. We estimate the likely course of future events and account for them. If NCCI s actuarial calculations are correct - the insurer will have adequate premium to cover the risk. 29. Rate Adequacy In some states, NCCI prepares a full schedule of rates. These rates are then filed with regulatory authorities and are available to carriers. In other states, NCCI prepares data on cumulative loss costs. The individual insurance companies then make adjustments reflecting their own expenses. Each company must then file a schedule of rates with the regulatory authorities.

11 30. Rate Adequacy In administered pricing states those where full rates are developed by NCCI - assessing costs begins with overhead. Overhead includes the cost of: issuing the policy servicing the insured providing loss prevention activities auditing payrolls settling claims defending the insured in court Five categories of business overhead expenses are measured: acquisition costs and general expenses overhead and capital expenditures premium taxes claims adjustment expenses contingencies profit In a loss cost environment, NCCI does not address this issue. It is done by the individual insurer. 31. Rate Adequacy Establishing expense levels is difficult. Percentages of premium for expenses will differ. However, the system has been refined to account for this cost. 32. Rate Adequacy The amount available to pay losses is referred to as the balance point. These dollars pay for: medical costs vocational and physical rehabilitation income to the injured worker Actual losses divided by premium is the actual cost (or loss) ratio.

12 33. Rate Adequacy Determining projected cost ratio involves adjustments to actual losses. This is where the actuaries play their largest part. First They evaluate historical records on the basis of current reality. Second They audit workers compensation after the conclusion of the policy year. Third They determine any loss development. The premium collected must be sufficient to pay all the losses, even though many workers compensation claims are paid over a period of years. 34. Rate Adequacy Question: Why not use the losses already paid to determine rates? Answer: The losses already paid don t correct for the drift. Paid losses are a reliable guide only in a completely stable environment which doesn t exist in the real world. Paid losses must be weighed with: benefit changes court decisions industrial accident board actions other influences on payment patterns 35. Rate Adequacy To further adjust rates, we evaluate changes in statutory benefit structures. We also use claim distributions to tell us: what proportion of each kind of injury has been encountered what the claims cost under the old structure what the claims are likely to cost under the new structure

13 36. Rate Adequacy The projected cost ratio is compared to the balance point. If the cost ratio is lower than the balance point - rates or loss costs are decreased. If the cost ratio is greater than balance point - rates or loss costs are increased. 37. Distribution of Overall Rate Level The overall rate change is simply the average change needed to generate the proper premium for the entire state. We then need to calculate the rates or loss costs for each classification. Another two-step process is required. First, we calculate the needed change by Industry Group. The adjustment computed for each industry group is still an average. It represents the average change that all classifications in that group receive. 38. Distribution of Overall Rate Level The second step is to distribute the average industry group changes to the individual classifications. The manual rate reflects the exposure common to the business described. The classification s rate represents the average behavior of all members of that class. 39. Distribution of Overall Rate Level Each NCCI rate or loss cost filing is our best estimate of the needed rate or loss cost level, whether it be an increase or a decrease, using informed actuarial judgment. When the filing is ready, it is submitted to the insurance department according to statutory requirements. Then the course is set for next year s Workers Compensation Ratemaking Voyage!

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