Kathy Antonello, FCAS, FSA, MAAA
Chief Actuary, NCCI
For years, NCCI has cautioned against the improper use of experience rating modifications (E-mods) to compare the relative safety of employers. Last fall, we explored a simplified example of how a debit E-mod for an employer that pays lower-than-average wages can be misinterpreted.1 In this article we’ll explore how net experience rating creates subsidies in the workers compensation system, exacerbates the existing issue of utilizing E-mods to compare employer safety, and reduces the safety and loss control incentives that might otherwise occur.
What Is Net Experience Rating?
The primary function of the Experience Rating Plan is to improve the estimate of an employer’s expected losses in the upcoming policy period by incorporating the predictive ability of the employer’s prior loss experience. The Plan generates a debit or credit known as an experience rating modification (E-Mod), which will cause an employer’s premium to go up or down.
By purchasing a deductible and sharing in a portion of each loss, an employer not only reduces its premium, but also has an incentive to increase safety for its employees. In some states, employers have an additional incentive to purchase a deductible. This is achieved through “net experience rating,” shorthand for using actual losses net of the deductible but expected losses gross of the deductible in the calculation of the E-mod. The additional premium reduction, beyond the deductible credit itself, is not actuarially indicated and creates unintended consequences that can impact system stakeholders.
Let’s start by looking at a hypothetical example of two employers purchasing workers compensation coverage in a net experience rating state. At its most basic level, an E-mod is a ratio of actual-to-expected losses. When an employer chooses to buy a deductible in a net experience rating state, actual losses that enter the E-mod calculation are reduced by the deductible, but the expected losses are not correspondingly reduced. In our example, the employer that chooses to purchase a deductible policy will have a lower E-mod, a lower premium, and a competitive advantage.
Consider a scenario where Employers A and B are identical in every aspect. As seen in the table below, the payroll, loss experience, and expected losses prior to the E-mod are the same for both employers. Each employer has:
- $10 million of payroll in a single class code
- An expected loss rate (ELR) of 1.86
- The same actual loss experience over the most recent three years—both had eight claims that each cost $25,000, or $200,000 in total
These two employers are indistinguishable, but the policies they purchased are not—and that changes everything! Employer A purchased a policy without a deductible, while Employer B chose a policy with a $2,500 deductible applied to each claim, reducing the total losses utilized in the E-mod calculation by $20,000. Therefore, the losses for Employer A remain at $200,000, while the losses for Employer B are reduced to $180,000, resulting in E-mods of 1.08 and 0.97, respectively.
The fact that Employer B chose a deductible does not change the fact that its actual loss experience is $200,000 and identical to that for Employer A. Taking the ratio of net-of-deductible actual losses to expected losses leads to an E-mod of 0.97 for Employer B. As a result, procurement offices may inappropriately view Employer A as “riskier” than Employer B simply because Employer A has a debit E-mod. In addition, since Employer B purchased a policy with a deductible, a premium reduction percentage is also applied—which further lowers the cost of its policy. The last line in the table shows that after the deductible credit, the modified premium for Employer B is approximately $71,000 less than that for Employer A. Factoring in Employer B’s additional deductible expenditure of $20,000 brings its costs to $51,000 less than Employer A.
How Does Net Experience Rating Impact the System?
When some employers receive a lower E-mod due to net experience rating, the experience rating plan does not perform as intended:
- The additional premium credit awarded employers that choose a deductible creates a premium deficiency in the workers compensation system which must be offset. As a result, employers not selecting deductibles subsidize those that do.
- Net experience rating offers the employer two opportunities to receive premium savings—once as an upfront premium credit, and then again via an artificially low E-mod. The fundamental premise that this additional incentive will result in better safety for workers is incorrect. In fact, NCCI research2 has shown that in net experience rating states, employers that choose a deductible not only have a downward bias in their E-mods, but also have higher frequencies (compared to those that did not choose a deductible).
- An inequity caused by net experience rating occurs between large and small employers. Losses for large employers are more stable so their actual losses receive more weight in the experience rating calculation. Because some of the actual losses are inappropriately removed with net experience rating, the improper reduction in E-mod will be greater for large employers, giving them a bigger benefit than small employers.
- The use of E-mods by procurement offices to evaluate contractor bids creates a great incentive to choose a deductible to “buy down the E-mod,” which gives the illusion of better experience in net experience rating states. As a result, some employers are viewed as “riskier” than others, simply because they declined to purchase a deductible. In addition, the predictive value of E-mods is undermined when employers can remove losses from the calculation.
- The experience rating plan recognizes that the frequency of claims is a better predictor of an employer’s future loss potential than severity. If the E-mod does not reflect an employer’s true frequency because claims below the deductible are removed, then the incentives for loss prevention and safety are reduced. The benefits to the employer that result from buying down the E-mod are relatively larger than the losses below the deductible that the employer pays for themselves.
NCCI’s Experience Rating Plan was designed to utilize gross-of-deductible losses in the E-mod calculation. Net-of-deductible experience rating is not actuarially indicated and creates unintended consequences that can impact system stakeholders. When actual losses for experience rating are reported gross of deductibles, the system works as it was designed, subsidies diminish, and loss prevention and safety incentives are enhanced.
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