How Are Premiums Calculated?
Understanding how workers’ compensation insurance premiums are determined is very important. Many calculations and comparisons are needed in order to customize each employer’s insurance premium. These calculations and comparisons ensure employers, in low hazard industries, pay smaller premiums than do high-hazard industry employers. Employers with fewer claims and good safety records pay less in premiums than do employers with many claims and undesirable safety records.
The National Council on Compensation Insurance (NCCI) keeps statistics necessary to differentiate high and low hazard industries and high and low hazard employers within the same industry. The NCCI combines statistics of hundreds of insurance carriers in several states, including Missouri. Each insurance carrier, writing workers’ compensation policies in Missouri, keeps a claims record for each of its clients. At the end of the policy year for each client, the carrier sends the claims records to the NCCI. This pool of statistics is then used to help calculate experience modifiers, rates, and classifications.
High hazard and low hazard industries are distinguished by the classification code they are assigned and the manual rate they pay for workers’ compensation insurance. The classification code and corresponding manual rate are the first factors used to calculate an employer’s insurance premium. If an employer is assigned to a high hazard code such as roofing, trucking or logging, the employer will pay a higher manual rate that employers assigned to a restaurant, clerical or light manufacturing code. Manual rates vary widely from one (1) classification to another and are expressed as a dollar figure per $100 of payroll. It is easier to look at rates, however, as a percentage of payroll rather than per $100 of payroll. For example, $13.71 per $100 of payroll is simply 13.71% of payroll.
Each occupational classification code may either represent entirely different industries or a segment within different industries. For example, Code 2501 Clothing Manufacturing represents an entire industry, but Code 8810 Clerical Office Employees represents a segment of employees within many different industries. There are three (3) classifications considered standard exception codes--Code 8810 Clerical Office Employees, Code 8742 Outside Salespersons, Collectors, or Messengers, and Code 7380 Drivers, Chauffeurs and their Helpers. Standard exception codes can be separated from the employers’ main classification code because employees engaged in these jobs are normally not involved in other operations.
After a specific classification and rate is assigned to an employer’s operations, their manual premium is determined by multiplying the employer’s payroll by the appropriate rate. Throughout this discussion a hypothetical employer, “ABC Trucking”, will be used to show how the entire rating system works. ABC Trucking has a $453,000 payroll and is classified as Code 7229, Trucking-Long Haul. Their manual premium would be 453,000 X 13.71% or $62,106. All employers’ worker compensation premiums are based primarily on their manual premium, adjustments are made to the manual premium that will be discussed later.
The company insurance agent or insurance carrier determines the company’s classification code from the definitions available to them from NCCI for the scope of work performed. These definitions are contained in the “Scopes of Basic Manual Classifications” manual which insurance agents use to classify their employer clients. Since many classifications are very similar, codes are sometimes difficult to determine. In these instances, an insurance agent or carrier may ask the NCCI to physically inspect a specific employer’s operations and make the final classification decision.
What Determines Manual Rates?
Two (2) factors affecting the insurance premium are the manual rate and company payroll. The third factor affecting the premium is the employer’s experience modifier. The experience modifier is one of the most important components of a company’s worker compensation premium. It is used as a multiplying factor of an individual company’s manual premium and is often the most effective tool for controlling premium cost.
An average experience modifier is expressed as 1.00 and simply means that a company has average losses and will pay 100% of their manual premium discussed earlier. A higher than average experience modifier would be any number greater than 1.00. A company with a 1.43 experience modifier will pay 143% of its manual premium. This 43% surcharge reflects the higher than average claims which the company has experienced. The experience modifier is not always 1.00 or greater, but can also be lower than 1.00. If a company has an experience modifier of .73, they will pay only 73% of their manual premium. This effectively gives the company a 27% discount, and reflects the company’s lower than average losses, claims and injuries.
The following chart compares different experience modifiers for ABC Trucking with varying results.
|Manual Premium||Experience Modifier||Discount/Surcharge||Modified Premium|
As this chart shows, the experience modifier has a significant impact as to what a company actually pays for insurance. The difference between the low experience modifier and the high experience modifier, in this example is more than $43,000! Experience modifier ranges are common and can vary significantly. Controlling the experience modifier is essential to reducing and controlling insurance premiums.
Each year, the experience modifier is re-calculated using the combined claims history from a three (3) year rolling period. By using a three- (3) year rolling period the experience modifier will remain more consistent and eliminate most wide variations from year to year. Each year the rolling period drops off the oldest policy year and adds the most recent policy year. If a company has unusually high claims during one (1) policy year their experience modifier will be affected for three (3) years. However, the effect of the high-claims year will be stabilized by the experience of the other two (2) years on the period. This stabilizing effect works the same when a company has an unusually low claims year. To effectively lower the company experience modifier, the company must consistently control claims over the entire three (3) year period of the experience modifier.
The three (3) year rolling period includes a one- (1) year lag period immediately preceding the actual three- (3) year claims period. The one-year lag period is included because of the difficulty placing an immediate cost on claims resulting from serious injuries. A claim resulting from a serious injury may take several months or even years before it is settled. If ABC Trucking has an employee injured on June 30, 1997, and their policy ends the same day, it would be impossible for their insurance carrier to determine a cost for the claim and apply it to that claim year. Since the experience modifier is required for the new policy beginning the next day, a lag period is necessary. The one-year lag period allows the insurance carrier time to settle and close most claims, and more accurately estimate the cost of claims that continue for more than one year.
It is important to remember the lag period when analyzing an experience modifier and when setting goals to reduce it. If ABC Trucking has a year with an unusually high claim it will not be reflected in the next experience modifier. It will, however, be reflected in the experience modifier two (2) policy years away. If, for example, ABC Trucking has a claim on July 1, 1997, the first day of their 1997-98 policy, it will not affect their experience modifier for the policy due on July 1, 1998. The premium for the policy year beginning July 1, 1999, is the first time the employer actually is charged for the 1997 claims.
Management needs to understand the lag year in order to evaluate the effectiveness of their safety programs. Suppose ABC Trucking implemented a successful safety program beginning July 1, 1997, and had no claims for the next two (2) years. It would still be July 1, 1999, before ABC Trucking realized any monetary savings from a lower experience modifier. The full benefits of the safety program wouldn’t be realized in the experienced modifier until the policy due on July 1, 2001. Understanding the one year lag period and subsequent three (3) year rolling claims period can help management set realistic goals for new or existing safety programs.
To forecast whether an experience modifier will be higher or lower, analyze the oldest or first year on the current record and compare that year to the lag year. The experience modifier will likely decrease if the year dropping off the record had more claims and losses than the lag year. If, however, a year with fewer claims and losses than the lag year is dropping off the record, the experience modifier is likely to increase.
An excellent estimate of the next experience modifier can be calculated as much as a year in advance. This can be accomplished using three (3) tools:
An insurance agent should be able to obtain all of these. The booklet will explain how to calculate the experience modifier. This will only yield an estimate, but if the loss runs are accurate and all the claims are closed, this estimate should be very close to the next effective modifier. If there are open claims on the loss runs, the estimated experience modifier can be calculated using the insurance carrier’s reserves. Since it is unlikely the insurance carrier has underestimated the cost of a claim, calculations based on a reserve will likely yield an estimated modifier higher than the actual modifier.
It is only possible to lower the experience modifier by implementing a successful safety program and reducing claims over a period of at least two (2) years. However, it takes four (4) complete policy years for the experience modifier to decrease from reduced claims and better safety. There is little a company can do to have an immediate impact on the experience modifier. Patience and consistently controlling claims through safety and proper claims management will have a positive impact, but it does not happen immediately.
New companies are often confused about when they will be assigned their first experience modifier. Companies with first time policies pay their manual premium without the adjustment of the experience modifier. This is the same as having an experience modifier of 1.00 because there is no surcharge for a higher than average claims record and no discount for a lower than average claims record. The first experience modifier will be assigned depending on the size of the first year’s policy premium.
The following statement is taken directly from a NCCI publication:"A risk is eligible for intrastate experience rating when the payrolls or other exposures developed in the last year or last two (2) years of the experience period produced a premium of at least $7,000. If more than two (2) years, an average annual premium of at least $3,500 is required."
A company with a first time policy received their first experience modifier after two (2) years, but only if the first year’s premium is $7,000 or more. Their first experience modifier is applied to the premium on the third insurance policy. Claims during the first year are used to calculate the experience modifier and the second year is the lag year that was discussed earlier.
If a company’s first two (2) policy premiums are less that $7,000 each, but at least $7,000 combined, it will receive its first experience modifier after three (3) years. The first experience modifier is applied to the premium on the fourth insurance policy year. Claims during the first two (2) policy years are used to calculate the experience modifier and the third year is the lag year. If a company has an average annual premium less than $3,500 they will not receive an experience modifier. Premiums under $3,500 are considered too small of a statistical sample to accurately measure performance. Companies with premiums less than $3,500 must pay the manual premium that was discussed earlier.
Source: Missouri Department of Labor and Industrial Relationss
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