Experience rating is a mathematical tool used by insurance providers that considers your previous loss experience in calculating your current premium. It's based on the presumption that your historical loss experience predicts your future loss experience. In other words, your future losses are likely to be similar to those you incurred in the past.
Experience rating is commonly used in workers compensation insurance. It is also used, to a lesser extent, in other types of casualty insurance, such as general liability, commercial auto liability and professional liability. This article focuses on its use in workers compensation policies.
Purpose of Worker Comp Experience Ratings
Experience rating is based on the idea that employers should be charged a premium that accurately reflects their risks. Experience rating plans compare employers to other employers in the same industry group. This means that roofers are compared to other roofers, and bakeries are compared to other bakeries. The loss experience of each group is averaged. Each employer's loss experience is then compared to the group's loss experience. Based on this comparison, an experience modifier is calculated for each employer.
Employers whose loss experience is better than the group average are normally assigned an experience modifier that is less than 1.0. As explained below, the modifier is multiplied by the premium. Thus, a modifier that is less than 1.0 will generate credit. Employers whose experience is worse than the average are typically assigned a modifier that is greater than 1.0. A modifier that is larger than 1.0 will result in a debit.
Experience rating provides a financial incentive for employers to reduce losses, perhaps by implementing a safety program. It also encourages employers to return injured employees to work as soon as possible. For workers compensation insurers, experience rating ensures that enough premium is collected to cover the risks being insured.
Experience rating is performed by a workers compensation rating bureau. In NCCI states, this task is performed by the NCCI. In independent states and monopolistic states, experience rating is performed by a state rating bureau.
To understand experience rating, you must first comprehend how workers compensation premiums are calculated. Premiums are determined by multiplying a rate times each $100 of employee payroll. For instance, suppose your payroll is $500,000 and the rate is $1. Your premium will be (500,000/100) X 1.00 or $5000. This premium is called the manual premium. This phrase indicates that no experience modifier has yet been applied. When an experience modifier is applied to the manual premium, the result is called the standard premium.
Before a workers compensation premium can be developed, your business must be assigned one or more classifications. Suppose that your company performs clerical duties for other businesses. Most of your workers have been assigned to the classification Clerical Office Workers. Your company also employs outside salespeople to recruit new customers.
Each classification is assigned a four-digit identifying number called a class code. The NCCI class code for Clerical Office Workers is 8810. Your sales workers have been assigned a separate classification, namely 8742. Your employees' payroll will be allocated between the two classifications, and a separate rate will apply to each.
Experience Rate Calculation
Experience rating is typically based on a three-year period called the experience period. This period usually consists of the three years prior to your most recent expired policy period. For instance, suppose your current worker's compensation policy runs from December 31, 2015/2016. The experience modifier that will apply to your current policy will be calculated based on the time period from December 31, 2011, through December 31, 2014. The claims that occurred in the 2014 to 2015 policy year are not considered because some of them may still be open.
An experience modifier is calculated every year. It is usually—but not always—effective on the inception date of your policy. Your modifier may be less than, greater than, or equal to "1."
A modifier of "1" means that your loss experience is average for your industry group. That is, your loss history is no better or worse than other businesses similar to yours. Your annual premium will remain unchanged.
If your modifier is greater than 1, your loss experience is worse than average for your industry group. A modifier that is great than 1 represents a debit as it will increase your premium.
Likewise, a modifier of less than 1 signifies a loss history that is better than average. A modifier of less than 1 will achieve a premium reduction.
An experience modifier is applied to the manual worker's compensation premium to calculate your standard premium. For each classification, the insurer determines your manual premium by multiplying the rate times the payroll, which is divided by 100.
An Example of Using Experience Modifiers
For example, suppose that your business is categorized into two classifications. The annual payroll for the first classification is $300,000 and the rate is $1.25. For the second classification, the payroll is $100,000 and the rate is $3. Your manual premium will be 300,000/100 X 1.25 plus 100,000/100 X 3.00 ($3750 plus $3,000) or $6750. If your experience modifier is .90, your standard premium is $6750 X .90 or $6075. Many states add a surcharge or assessment that is used to support the state guarantee fund. When this surcharge applies, it is added to your standard premium. The result is your final premium.
Experience modifiers may be intrastate or interstate. If you have operations in two or more NCCI states, the NCCI will provide you an interstate modifier. If you operate in a single NCCI state, the NCCI will issue an intrastate modifier. An intrastate modifier will also be provided by an independent state in which you operate.
The experienced rating applies only to businesses that meet state eligibility requirements. The rules vary from state to state. In most states, a business is eligible for experience rating only if it has been in business for a specified time period—such as 3 years. New firms don't qualify. States also require a minimum amount of premium within a certain number of years. For example, suppose that businesses are eligible for experience rating in your state if they meet either of the following criteria:
- $10,000 in combined premium for the two most recent years of the experience period; or
- an average premium of $5,000 per year if the experience period exceeds 2 years
If your premiums were $4500, $5500 and $4800 during the experience period, you would qualify for experience rating based on the first criteria.
When the NCCI or a state bureau issues an experience modifier, the agency provides an experience rating worksheet. The worksheet shows how your modifier was calculated. It lists the relevant class codes and applicable payrolls, claims numbers and losses used in the calculations.
Note that if you have incurred a large loss, only a portion of that loss is typically included in the calculation of your modifier. If you have incurred several small losses, all of those losses might be included in the calculation. Thus, your modifier is generally more adversely affected if you have incurred numerous small losses rather than one large one.