Explanation of Retrospective Rating Plans.
A retrospective rating plan can be defined as a rating plan in which the final premium is based on the insured’s actual loss experience during the policy term, subject to a minimum and maximum premium, with the final premium determined by a formula which is guaranteed in the insurance contract.
The insured pays a standard premium at the beginning of the policy year which consists of the basic premium and the loss projection. In 18 months from the inception of the policy, the insurance company values the losses and plugs them into the Retro Premium formula.
If the standard premium is greater than the retro premium then the insured will receive a return premium in the amount of the difference. If the retro premium is greater than the standard premium then the insured will have to pay the insurer an additional premium. After the first calculation at 18 months, there will be subsequent calculations every 12 months until all losses are closed out.
Most of the time retro plans have a maximum premium limitation, which caps the amount of premium the insured must pay. This is necessary because many insureds would not be interested in a plan that did not place a limit on a possible loss. The maximum premium tends to be about 1.20 times the standard premium.
In the current market, the majority of retrospective plans are written for risks in the $100K+ premium range.
Retro Premium Formula
At the simplest level, an insured’s retrospective premium is determined by the formula: R = (B + cL)t, where:
R = Retrospective Premium, subject to minimum and maximum amounts
B = Basic Premium
c = Loss Conversion Factor, generally reflecting loss adjustment expense
L = Actual incurred loss during the effective policy period
t = Tax Multiplier
R is not known until after the policy has expired and the actual losses are fully developed.