Back in September, we promised to provide a strategic look at experience rating, the calculation unique to workers' compensation insurance that aligns every insured's premium with that company's historic losses. For a basic primer on experience rating, we recommend going to the source: The National Council on Compensation Insurance website provides a well-written document (PDF) that will walk you through the fundamentals of experience rating.
When we train employers on experience rating, we focus on employer strategies: what can you do to minimize the future cost of insurance? How can you translate a basic understanding of experience rating into a reduction in future premiums? Keep in mind that in experience rating, size matters. Large insureds with large premiums are expected to have more losses than smaller insureds. Indeed, because their margin of error is smaller, companies with premiums in the $10,000 to $50,000 range can easily find themselves in a lot of trouble with just a few injuries.
The Rating Period
In workers' compensation, your past history follows you along like a faithful dog. In fact, losses that occurred 5 years ago still impact what you are paying today for insurance. The rating period for your 2005 policy (the policy which begins any time during the 2005 calendar year) includes all the losses from 2001, 2002 and 2003. On the other hand, losses prior to 2001 are gone forever: they cannot impact your experience rating, even if the reserves are increased substantially.
Primary Losses Are the Most Expensive
Every time you report a claim to your insurance company, a reserve is set for the claim. The reserve projects the total indemnity payments (lost wages), medical bills and expenses for this particular claim. The first $5,000 of each claim is considered "primary." Any amount of reserve above $5,000 is considered "excess" loss. Any reserves above a state-specific ceiling (ranging from $100,000 in most states to as high as $175,000 in Massachusetts) is "unratable"; that is, it does not count at all in the calculation of your experience rating.
So what does this mean? Experience rating places more emphasis on the frequency of injuries than on the severity. An employer with one large loss ($100,000) will pay less for future insurance than an employer with 10 smaller lost time claims of $5,000 each - a total of $50,000 in losses -- because the full $50,000 is "primary loss" in the premium calculation for the second employer, while there is only $5,000 in primary losses for the first employer. Experience rating cushions the blow of the large loss, but hammers employers with frequent losses.
Small Employer, Big Trouble
Here's where a lot of smaller employers get caught: if you have a frequency problem (a lot of relatively small injuries involving at least some lost time) and just one big loss, the primary losses add up in a hurry. You quickly exceed the "expected" level of primary losses. As a result, your experience rating pushes up into the "debit" zone. You start paying a lot more for insurance.
If you find yourself in this position, with an experience modification well above 1.0, you need to learn more about the intricacies of the rating process itself. There are opportunities for minimizing the impact of your losses. All of which will be the subject of additional blogs over the next month.
NOTE: States vary in their application of experience rating procedures. Check with your local authority if you have specific questions.