Experience Rating in LMCIT s Liability and Workers Compensation Premiums

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1 INFORMATION MEMO Experience Rating in LMCIT s Liability and Workers Compensation Premiums Understand League of Minnesota Cities Insurance Trust s (LMCIT s) experience rating formula, which compares the city s actual loss history with the amount of losses that would be expected for a city of that size, if the city were a perfectly average LMCIT member. Learn how the comparison is used to adjust the city s future premiums above or below the average. RELEVANT LINKS: I. Experience rating The underlying premise of experience rating is to look at the city s past loss experience in order to project the city s future losses. A city that s had better-than-average loss experience in the past is a good bet to have betterthan-average loss experience in the future. Conversely, if the city has had more losses than the average city in the past, there s a good chance the city will continue to have higher-than-average losses in the future. Minnesota Workers Compensation Insurers Association. The workers compensation, municipal liability, and auto liability experience rating formulas differ somewhat in their details, but their basic structures are similar. LMCIT s workers compensation experience rating formula is closely modeled after the Minnesota Workers Compensation Insurers Association (MWCIA) experience modification formula used by private workers compensation insurers. In simplest terms, the experience rating formula compares the city s actual loss history with the amount of losses that would be expected for a city of that size, if the city were a perfectly average LMCIT member. This comparison is then used to adjust the city s future premiums above or below the average. II. Qualifying for experience rating Experience rating is only used for cities above a certain size. In very small cities, there just isn t enough volume and claims activity to be credible that is, to be useable as a way to predict the city s future losses. For liability, experience rating is used for any city with expected losses above $15,000 during the three-year experience rating period. For workers compensation, experience rating applies to any city whose annual premium is over $3,000. For those cities with annual workers compensation premiums under $3,000 or cities with expected liability losses under $15,000 (for the three-year experience rating period), LMCIT uses a simple credit/debit system. This material is provided as general information and is not a substitute for legal advice. Consult your attorney for advice concerning specific situations. 145 University Ave. West 10/31/2014 Saint Paul, MN (651) or (800) All Rights Reserved

2 Under the workers compensation simple credit/debit system, if the city has had no losses during the three-year rating period, the city receives a 10% premium credit. If the city has two or more losses, the city receives a 10% premium debit. Under the liability simple credit/debit system, if the city has had no losses during the three-year rating period, the city receives a 10% premium credit. If the city has two or more losses, the city receives a 10% premium debit. If the city has two or more of any combination of land use, police liability or employment losses, the city receives a 20% debit. III. Experience rating in LMCIT s no-fault sewer backup and liquor liability coverages You will find a detailed explanation for how experience rating is used in LMCIT s liability and workers compensation premiums in the following sections. However, how experience rating works for LMCIT s optional nofault sewer backup and liquor liability coverages is a little different. A. No-fault sewer backup coverage The rating system for the optional no-fault sewer backup coverage includes an experience-rating component. Members that have incurred no losses under this coverage within a three year rating period receive a 10% credit. Members that have incurred losses within the rating period at a perconnection frequency that is higher than the program average receive a 10% debit. B. Liquor liability coverage A 10% rate debit applies to any city which has had a liquor liability claim in the past five years. IV. Experience rating elements A. Manual rates and premiums In learning more about LMCIT s experience rating process, it s first helpful to begin with how LMCIT calculates cities premiums. Manual rates are the starting point for the premium calculations. The manual premium for a city is calculated by applying the manual rates to the city s exposure bases. Experience Rating in LMCIT s Liability and Workers Compensation Premiums Page 2

3 LMCIT s New Liability Rating System. The exposure bases equal: The city s payrolls in the various classes for workers compensation premiums. The number of vehicles by auto class for auto liability premiums. Annual expenditures, number of police officers, number of employees, number of sewer connections, and total number of households for municipal liability premiums. The manual rates are designed to produce a specific total amount of premium when applied to the total exposure base for all cities. That target total premium is the amount that, when combined with LMCIT s investment income, will cover the projected losses plus expenses plus an appropriate safety margin (i.e. a cushion in case losses turn out to be more than projected). If every member city s risks were perfectly average, the manual rates by themselves would be a fair way to allocate costs among member cities. But cities differ in the risks they present because of their differing situations, how they run their city operations, and so on. Experience rating is a way to take those differences into account in allocating costs among LMCIT members. On the average, about as many cities should receive credits (i.e., an experience rating below 1.0) as receive debits (a rating above 1.0) under the experience rating system. In fact, one of the checks on whether the experience rating system is working correctly is whether the experience ratings for all cities actually average out close to 1.0. B. Expected losses The first step in the experience rating formula is to calculate the city s expected losses. This is done by applying an expected loss rate to the city s exposure base. The workers compensation experience modification formula uses a separate expected loss rate for each payroll class so many dollars of loss per $100 of payroll. The liability experience rating system uses an expected loss rate for each of the manual rating bases above. In both cases, these expected loss factors are derived directly from the actual past experience of LMCIT s total membership. C. Experience rating period The experience rating formula looks at losses for the past three years, excluding the most recent year. The loss figures used in the experience rating formula are gross of deductibles For example, the city s experience rating for 2013 was based on the city s loss experience for 2009, 2010, and Experience Rating in LMCIT s Liability and Workers Compensation Premiums Page 3

4 The losses of any one member will vary from year to year. Using three years of loss experience levels the variations in loss history and helps stabilize the experience rating. Otherwise, a single bad year could cause a big swing in the city s premiums from one year to the next. The most recent year is not used because the data from that year is still pretty green. In other words, there may be losses that haven t been reported yet or the cost of claims that have been reported are still uncertain. By waiting a year, most losses will have been reported and many claims will have been closed. LMCIT can then be more confident in its cost estimates of those claims that are still open. D. Large loss limitations If the experience rating formula were calculated solely on actual loss costs, a city could see big swings from year to year in their experience rating and premiums, depending on whether or not they had the misfortune to be hit by one loss that turns out to be a big loss. For example, whether or not someone slips on ice in the city hall parking lot will depend on how well the lot was shoveled, sanded, and salted. It may also depend on whether the person lands on their hand and suffers minor injuries, or lands on their head and becomes permanently disabled. To address this, the experience rating plan limits the effect of large losses in two ways. First, loss amounts above a certain level aren t counted at all in experience rating. In the liability formula, individual police liability, employment, and land use losses are capped at $250,000, while other liability claims are capped at $150,000. For workers compensation, the cap is adjusted each year for inflation; for 2013, the cap is $202,500. Second, besides being capped, large losses are also partially discounted. Land use, police liability and employment claims will tend to affect the city s experience rating more than would any other type of liability loss, as these types of claims are capped and discounted at higher values. For example, in the liability experience rating system, the first $50,000 of a police liability, employment, or land use loss goes into the formula at 100%, and amounts between $50,000 and $250,000 are discounted. For all other municipal and auto liability claims, the first $15,000 goes into the formula at 100%, and amounts between $15,000 and $150,000 are discounted. The percentage discount varies with the size of the city. In the smallest cities covered by experience rating, 8.7% of the loss in that layer goes into the formula; for LMCIT s largest members, it s 61.2%. Experience Rating in LMCIT s Liability and Workers Compensation Premiums Page 4

5 In the work comp experience rating formula, the large loss discounting begins at $13,500 for This will increase to $16,250 in 2015, and will be adjusted for inflation annually thereafter. In the smallest experience-rated cities, 5% of loss amounts between $10,000 and $202,500 go into the formula; it ranges up to about 49% for LMCIT s largest member cities. Because of these limitations, having several small losses will affect the city s experience rating much more than having a single large loss of the same dollar amount. Another way to say this is that the formula reacts more to loss frequency than to loss severity. Because of the importance of loss frequency in experience rating, cities sometimes ask if they ll be penalized in experience rating if they report an incident that might or might not become a claim. The answer is no. Merely reporting an injury or incident or opening a claim file won t affect experience rating. Experience rating is only affected if actual loss or defense costs are incurred. E. Medical-only claims in workers compensation In the workers compensation experience rating formula, medical-only claims are discounted to 30%. For example, if a claim involved $1,000 of indemnity costs and $1,000 of medical costs, $2,000 total would go into the experience modification formula. But if the claim involved $1,000 of medical costs and no indemnity, only $300 would go into the formula. Since medical-only losses are now discounted heavily, small and mediumsized indemnity claims now have a proportionally greater effect on the experience modification. Besides trying to reduce the number of total injuries, it s now even more important to try to control the number of losttime injuries and to try to get injured workers back to work as soon as possible. F. Credibility and ballast factors The larger a city, the more likely its past experience will be a good predictor of the city s future losses (an actuary would say a larger city s loss data is more credible ). Both the liability and the workers compensation experience rating formulas incorporate provisions to take these differences in credibility into account. Experience Rating in LMCIT s Liability and Workers Compensation Premiums Page 5

6 See also section IV.D, Large loss limitations. Both formulas add a ballast value to both the actual loss side and the expected loss side of the city s experience rating calculation. The ballast value has a stabilizing effect on the mod calculation. Both experience rating formulas use a percentage credibility factor that s applied to the city s actual losses above a split point threshold. The split point for workers compensation is $13,500 for 2014, which will increase to $15,000 in 2015, then adjusted annually thereafter for inflation. The split point for liability is either $15,000 or $50,000, depending on the type of loss. The ballast factor and credibility factor both come from a formula based on the city s size - or more accurately, the amount of the city s expected losses. The purpose and result for the workers compensation and liability experience rating formula are the same: The larger the city, the more the city s past loss data affects the city s experience rating and future premiums. V. Calculating the experience modification The final experience modification is determined by comparing the expected losses and expenses of the city to its actual losses and expenses. If the city s losses and expenses are better than average, they receive a credit. If the city s losses and expenses are worse than average, they receive a debit. A. Schedule rating In most cases, the final premium determined by the experience rating system should be a fair estimate of the premium necessary to cover a city s losses and LMCIT expenses for the next year. Sometimes though, there may have been significant changes in a city s operations or risk characteristics since the three-year rating period (e.g. the city may have added new functions or discontinued a former operation). If the liability risk characteristics change during the experience period, the city s liability premiums can be modified by a schedule credit or debit. This type of schedule rating is not used in the LMCIT workers compensation program. When schedule rating is used, a city s loss experience and schedule rating adjustments are taken together to estimate what the experience modification would have been if the city s risk characteristics had been the same in the current experience period. It s important to keep in mind the purpose of schedule credits and debits is to help arrive at a premium that reflects the best possible evaluation of the city s risks. Unlike the way some private underwriters use schedule credits, LMCIT does not use schedule credits simply as a convenient way to put a cheaper price on the table in order to meet or beat a competitor s quote. Experience Rating in LMCIT s Liability and Workers Compensation Premiums Page 6

7 LMCIT Underwriting 651, Contact your LMCIT underwriter if your liability risk characteristics have changed during the city s experience rating period. B. Relation to the dividend formula Unneeded surplus funds are available to be returned as a dividend to members of LMCIT; although, because it can never be known what losses may be in the future, LMCIT can never know for certain how much will be available for a dividend or whether there will be a dividend in any given year. The experience rating system uses the city s loss history to project what the city s future risks might be, and to adjust the city s premiums accordingly. But while such a projection is useful, it can never be 100% accurate. Actual losses will always turn out to be different from what is projected. Because of this, LMCIT s dividend formula includes an experience component as well. When the LMCIT Board determines there are unneeded funds that can be returned to members, the dividend formula allocates those funds based on the difference between the city s total earned premiums and total incurred losses for all years the city has been an LMCIT member. Thus, if the experience rating formula over-estimates the city s losses, the city will have paid more in premiums. It s important to note, though, that if the experience rating formula or other aspects of LMCIT s premium system make mistakes in setting a city s premiums either too high or too low, the dividend formula will tend to correct those mistakes in how the costs are allocated among members. C. Changes in experience ratings If your city is trying to understand what caused a higher experience rating, here are some things to look for: 1. Compare losses Compare the losses in the fifth year back with those in the second year back. Experience rating looks at a rolling three-year experience period. Each time the city s experience rating is re-calculated, there s a new year of claims rolling on and an old year rolling off. All else being equal, if the fifth year back (which rolls off the formula) was a good one, and the second year back (which rolls onto the formula) was not so good, your experience rating will increase. Experience Rating in LMCIT s Liability and Workers Compensation Premiums Page 7

8 2. Changes in cost of claims Look for changes in the cost of claims in the third and fourth years back. These two years losses affect both last year s and this year s calculation. Look for changes in reserves on open claims, or for claims that closed for more than what the reserves were. 3. Pattern of little claims Look for a pattern of a several little claims. Remember that large claims are pretty heavily discounted. That big claim with the six-digit reserve that catches your eye when you look at the loss run probably is not what causing most of the problem. It s those fourteen $6,000 claims. 4. Certain liability and workers compensation claims Look for employment, police liability, and land use claims on your liability loss run, and for indemnity claims on your workers compensation loss run. Remember that employment, police liability and land use claims are weighed heavier in the liability formula; and that medical costs are discounted in the workers compensation formula. LMCIT Underwriting 651, VI. Further assistance The LMCIT underwriting staff is available to assist you with questions about workers compensation coverage. Experience Rating in LMCIT s Liability and Workers Compensation Premiums Page 8