RISKVUE ARCHIVE | RISK BITES

Buy Now, Pay Later

By Timothy Law, Esq. and John L. Ellison, Esq.

Even before the September 11 terrorism attacks, insurance was expensive. Since then, insurance premiums have skyrocketed. Companies that have traditionally purchased low-deductible, guaranteed-cost insurance are now finding the cost to be virtually prohibitive and are giving serious thought to so-called retrospective premium policies. Here are some of the things to be wary of under a retrospectively-rated insurance program.

Long a fixture in workers’ compensation and some types of liability insurance, retrospectively-rated insurance policies are gaining increased prominence as insurance companies insist that policyholders shoulder more of their own risk. With such policies, premiums are directly linked to the amount of loss that a policyholder suffers during the policy period.

Risk managers often view a retrospectively-rated policy as a way to reap the rewards of improved loss control efforts. This is because such policies are initially rated and priced based on expected average losses. Good loss control can result in losses being less than the expected average, thereby resulting in a “premium refund” from the insurance carrier.

Despite the appeal of retrospectively-rated policies in a “hard” insurance market, there can be a real downside to the insurance buyer. The insurer writing a retrospectively-rated policy has entirely different financial incentives than it does when writing a fixed-cost policy. Some of the ways insurers can overcharge insureds for retrospectively-rated insurance programs are described below.

Reserving Claims at Excessively High Levels

Especially with “incurred loss” retrospective programs, the insurance company has an incentive to set claim reserve at an artificially high level. Under such programs, premiums are directly linked to the total estimated cost (paid-to-date plus future reserves) of the claim, rather than to the amount actually paid (as is the case under a “paid loss” program). Consequently, the insured may end up paying more premium than necessary for a given loss. Additionally, if the reserves are too high, the insured’s loss experience will be inflated and may result in higher premiums in the future as well.

Settling Claims at Excessively High Levels

Insurers have an incentive to settle a claim at an amount that exceeds the worth of the claim. Under retrospective policies, a “loss limit” usually limits the amount a policyholder must pay for a single loss, while a “maximum premium” limits the total premium the policyholder must pay for all claims that occur during a particular policy year. As long as the cost of a claim or claims remains below these specified limits, a higher settlement amount means more premium revenue for the insurance company.

Delaying the Claim In Incurred Loss Policies and Settling Too Quickly In a Paid Loss Policy

Under “incurred loss” policies, the insurance company receives premium (and begins to earn interest on that money) based the reserves. The insurance company thus has an incentive to delay payment of the claim. For example, this incentive sometimes results in an insurer’s failure to pursue a quick, lump-sum settlement with a workers’ compensation claimant. The insurance company makes more if it sets a reserve in the amount it expects to pay in the future (without discounting those payments to present value), collects that amount from the policyholder now, and then pays the claimant over a period of several years.

Under a “paid loss” policy, on the other hand, the insurance company receives premium when the loss is actually paid. Consequently, the insurer has an incentive to settle quickly so it can obtain and invest the premium as soon as possible. If the insurer settles too quickly, it may pay more than the claim is worth, thereby costing the policyholder more than necessary.

Not Zealously Investigating and Defending Claims

Under some retrospectively-rated programs, the insurer is responsible for payment of claim investigation and defense costs. When it’s own money at risk, the insurer may fail to spend adequate resources to investigate and defend claims brought against the policyholder. For example, an insurance company might not send an investigator to obtain background information about the claimant that potentially result in savings to the insured.

Allocating Losses To A Single Policy Period

Some types of losses can occur in more than one policy period. Asbestos, repetitive-trauma and environmental claims are examples of such claims.

Insurers sometimes try to allocate the entire cost of such claims to the year(s) in which the policyholder purchased a retrospective premium policy. By so doing, the insurer both avoids having to pay under a guaranteed cost policy and at the same time increases its revenue from the retrospectively-rated policy. Fortunately for insureds, many if not all courts disapprove of such an allocation.

Categorizing Losses to Avoid Loss Limits

Insurance companies sometimes try to spread a loss among various coverages or policies, thereby attempting to avoid a loss limit applicable to any one coverage. If the insurer is successful in this attempt, the policyholder may end up paying more than it reasonably expected to pay for any one occurrence or loss.

Failing to Aggregate Occurrences

Under retrospectively-rated policies, insurers have a financial incentive to argue that a particular incident is not a single occurrence or loss, but instead is numerous separate claims. If the incident is viewed as separate claims, the per-claim loss limit may not be reached. For example, assume an employee has five re-occurrences of the same repetitive-trauma injury and that the policy has a loss limit of $100,000. If each re-occurrence costs $25,000 in indemnity and medical expense, the total cost would be $125,000, although the insured would only have to pay $100,000 (the loss limit). However, if each occurrence was treated as a separate claim, the $100,000 per-claim loss limit would not be reached and the insured would have to pay $125,000 (assuming the policy’s maximum premium limit was not reached).

Side Agreements

State Insurance Departments are supposed to protect policyholders from premium rates that are too high and to maintain the solvency of insurance companies by prohibiting rates that are too low.

Sometimes insurers try to reach a side agreement with a policyholder that contradicts, supplements or amends the premium structure of the retrospective policy as originally approved by the Insurance Department. The policyholder should reject such an overture and contact the Insurance Department immediately.

Math Errors

In retrospective premium programs involving a high volume of claims, miscalculation or miscoding of losses can have a dramatic effect on total cost. Also, potential overstatement of an insured’s loss experience can negatively effect premiums for years into the future by making the policyholder’s business appear riskier than it actually is.

Conclusion

Many courts have ruled that an insurance company has the burden to show that it is entitled to retrospective premiums and that it has met its obligation to act reasonably and in good faith where the money of its policyholder is concerned. Although policing insurance company conduct under retrospective premium policies takes some effort, the incentives for an insurance company to act wrongfully are many and a strong measure of vigilance is therefore required. 

ABOUT THE AUTHORS

Timothy P. Law is a shareholder in the Philadelphia office of Anderson Kill & Olick, P.C. and represents policyholders in disputes with their insurance companies. He can be reached at 215-568-4762 or tlaw@andersonkill.com.

John N. Ellison is the Managing Shareholder of the same office. He can be reached at 215-568-4710 or jellison@andersonkill.com.

The original, longer version of this article appeared in the Spring 2001 issue of the Journal of Workers Compensation, published by Anderson, Kill and Olick, P.C.

riskVue | The webzine for risk management professionals
March 2003