(December 2023)
The loss costs for a classification in a specific state are developed using the accumulated loss statistics for all reporting insurance companies in that state. Those pooled statistics develop an average loss cost that is then multiplied by a specific insurance company’s loss cost multiplier to develop that insurance company’s rate for that classification. However, there is no consideration given as to whether the specific risk is below average or above average with that classification.
To encourage improved safety records, NCCI developed experience rating. This mandatory rating method encourages active and effective loss control methods by reducing premiums for those employers producing above average experience and raising premiums for those employers producing below average experience.
Experience rate factors are actually credits or debits that reflect the specific risk's loss experience. They are applied to the premium developed by using manual rates. The National Council on Compensation Insurance, Inc. (NCCI), or another rating organization that has jurisdiction, calculates these factors. Experience rating is mandatory for all risks that meet certain eligibility requirements. For example, a risk must be in business under the same ownership for at least two years. Minimum premium eligibility thresholds also apply and vary by state.
Each risk pays its "fair share" of the average annual rate for the class or classes involved based on its own loss experience. The experience may be better or worse than average, which reflects the factor determined and applied. One of the most important consequences of experience rating is that it encourages the named insured to implement loss control, safety, and hazard reduction initiatives that control or reduce losses.
The experience rating factor is calculated using the latest three years of loss experience prior to the current policy period. It excludes the most recent full year. It is recalculated annually by adding the experience for the latest eligible year and dropping the oldest year. The problem with this approach is that it applies historical loss experience to the current policy period to predict future losses and results in a time lag in being applied. Effective loss control or safety initiatives implemented today will not impact the premium until at least two years following implementation.
The experience rating formula is standard for every eligible risk that qualifies. It consists of two fixed elements or factors.
Larger risks have greater
exposures, higher payrolls, and higher premiums. These factors make the loss
experience of that risk more statistically credible for the formula's purposes
than a smaller risk in the same class. For the formula to apply equally to all
risks, a credibility factor is developed and applied that makes the loss
experience of smaller risks more valid and statistically accurate.
Loss frequency has a greater impact on overall loss exposure than loss severity. Because of this distinction, losses are divided into two separate parts. One is known as the primary amount. This represents the first $15,000 of each loss. The other is the excess amount. It represents the excess amount of loss over $15,000.
The primary amount has a higher degree of credibility than the excess amount. For this reason, the formula gives more weight to loss frequency than severity. However, severity is still considered in its relative proportion to all losses.
Note: Prior to 2013, the split was at $5,000. The split became $10,000 in 2013, $13,500 in 2014, and $15,000 in 2015. The timing of this change may vary by state.
Referring back to "average losses for the class," every risk eligible for experience rating includes a calculation for expected losses. This is based on the losses normally expected for each $100 of payroll for that class and is known as the Expected Loss Rate (ELR). The ELR uses the risk’s actual payroll to determine an expected loss amount. The ELR amount is compared to the risk’s actual loss experience after it is divided into primary and excess amounts and weighted according to the formula.
Once the actual weighted primary and excess losses are calculated and compared to the expected losses, the individual risk modification factor is calculated. The actual losses for a specific risk are divided by the expected losses. If the actual losses are lower than the expected experience, it is a credit modification factor (lower than 1.00). If they are higher, it is a debit modification factor (higher than 1.00).
Individual risk rate modification factors are good for one year and usually apply on the risk’s normal anniversary rating date. This is the date when the workers compensation insurance coverage was first purchased. The rate modification factor is calculated and re-figured annually to add updated loss experience and to apply it for the next policy term.
The modification factor applies to the insured business and each business or entity under the named insured's common ownership.
The anniversary rating date is an important element in applying the experience rating modification factor and other statistics for a risk’s workers compensation insurance. It is established based on the effective date of the first policy issued. It includes both the month and the day of the month. It does not change from one year to another, even if the policy is written for a short-term, is cancelled and rewritten, or is modified in some other way to change the policy dates. In other words, a simple rewrite of a policy or issuing a short-term policy does not change the anniversary rating date. For it to change, the risk must file a change request on the appropriate form with either NCCI or the rating organization with jurisdiction.
The anniversary rating date is the date used to compile individual risk statistics and to calculate the experience rating modification factor. As stated in the experience rating section, it is valid for a one-year period and is based on the anniversary rating date. When a policy anniversary date changes due to a cancellation and rewrite in order to have a common expiration date with other policies, one factor applies for one part of the policy term and a different one for the other if the anniversary rating date is not changed. This complicates the rating factor calculation as well as the audit process.
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Example: Joe’s Manufacturing Company’s first workers compensation policy was issued with a January 1 effective date. Joe changed his fiscal accounting date and wanted his insurance to track with it. He had his 01/01/2023 policy cancelled and rewritten to a 07/01/2023 effective date. The experience rating modification factor was calculated at 1.20 for the 2023 year and 1.10 for the 2024 year and was based on a 01/01/2023 anniversary rating date. As a result, Joe’s workers compensation premium was based on payrolls from 07/01/2023 to 01/01/2024, multiplied by the rates that applied and then multiplied by the 1.20 experience modification plus the payrolls from 01/01/2023 to 07/01/2024, multiplied by the rates that applied and then multiplied by the 1.10 modification factor. The premium audit also had to be adjusted accordingly. This split continues until NCCI is notified of the change and modifies the anniversary date. |
An important factor that affects the experience rating modification is a change in either the insured's name or a material change in ownership that exceeds 50%. When one of these changes occurs, the insurance company, the state, and the rating organization with jurisdiction must be notified, and the change filed using the appropriate forms and procedures. Some changes in ownership result in changes to the experience rating modification factor and the anniversary rating date.
When the experience rating modification factor from the workers compensation rating formula modifies the manual class rate, the premium charged is far more credible and more accurately reflects the risk’s actual exposures and losses. It gives the risk an incentive to reduce losses and implement safety procedures. Even though it is based on previous experience and applies "after the fact," it is the fairest way for a risk to pay an equitable premium relative to its exposures and loss experience, except for retrospective rating plans.