Advisory organizations, loss costs and loss cost multipliers

What advisory organizations do

The NAIC Product Filing Review Handbook describes advisory organizations as developing loss costs, policy forms, risk classifications and rating rules that their member insurers may use. The NAIC Property and Casualty Model Rating Law (Prior Approval Version) defines an advisory organization, in part, as an entity with two or more member insurers, or controlled by two or more insurers, that assists insurers in ratemaking-related activities.

The handbook names the Insurance Services Office (ISO), the National Council on Compensation Insurance (NCCI), the American Association of Insurance Services (AAIS) and the Surety and Fidelity Association of America (SFAA) as organizations authorized to make filings for or on behalf of insurers. In some states a state-specific rating organization performs this role for particular lines, most often workers' compensation. Their services generally include:

• collecting statistical data from member companies and analyzing it at a volume no single company could;
• filing prospective loss costs and rating rules, including classification plans, increased limit factors and experience rating plans;
• drafting and filing standard policy forms and endorsements.

Because advisory filings are used by many insurers, the handbook notes that states generally apply substantial review resources to them.

From final rates to prospective loss costs

Rating bureaus once published full rates that member companies used as filed. The handbook traces the shift: an NAIC working group formed at the 1988 Winter National Meeting concluded that advisory organizations should not prepare and distribute final rates, while recognizing the value of pooled loss data. In the late 1980s ISO and NCCI announced they would stop filing final rates and would file only the loss component, termed advisory prospective loss costs, leaving each insurer to determine its own expenses and profit.

The NAIC model rating laws, and the state laws based on them, define what advisory organizations may and may not do. Generally they may not publish fully developed rates that include expense and profit loadings.

What a loss cost includes

A prospective loss cost is the portion of the rate that covers expected losses. The handbook describes it as the recommended charge before expenses (typically other than loss adjustment expenses) and profit. The Missouri Department of Insurance describes NCCI loss costs as the pure cost of claims by class code, such as medical care and lost wages, excluding expenses common to all businesses such as salaries, rent and utilities.

Exactly which loss adjustment expenses are inside the loss cost differs by organization and line. The advisory organization's reference filing states what is included; anything not included has to be provided for in the company's multiplier.

The loss cost multiplier

The loss cost multiplier (LCM) converts loss costs to rates:

Rate = prospective loss cost x loss cost multiplier

The NAIC Loss Cost Filing Document, Calculation of Company Loss Cost Multiplier, sets out the standard calculation. The company selects provisions for:

• total production expense;
• general expense;
• taxes, licenses and fees;
• underwriting profit and contingencies, with an explanation of how investment income is taken into account;
• other items, explained.

The expected loss ratio is 100% minus the total of those provisions, and the formula multiplier is the loss cost modification factor divided by the expected loss ratio:

ELR = 100% - total of expense, profit and contingency provisions

Formula LCM = loss cost modification factor / ELR

A worked example with illustrative numbers:

The form also asks for the company's selected LCM and an explanation of any difference between the selected and formula values, and the rate level change for the coverages the page applies to. If the company uses expense constants, it attaches an expense constant supplement instead of completing the expected loss ratio section.

The handbook notes that the expense selection is often supported by a multiple-year analysis of the company's historical expense levels, along with an explanation of why those levels are appropriate for the future policy period. Reviewers also look at whether the profit provision is reasonable once investment income is considered.

Adopting loss costs by reference

On the NAIC form, the insurer declares that it is a member, subscriber or service purchaser of the advisory organization and files the referenced loss costs as if it had independently submitted them. It then chooses one of two options:

1. The LCM applies to future revisions of the advisory organization's loss costs for the line, so new loss costs take effect with the company's existing multiplier without a new LCM filing. This authorization stays in effect until disapproved, amended or withdrawn. The form notes that some states prohibit this option for some lines.
2. The LCM applies only to the specific reference filing, so later loss cost revisions require a new company filing.

Advisory rules and forms are adopted in a similar way. The handbook notes that, in most states, members may authorize the advisory organization to file on their behalf, and an insurer may respond to an advisory filing by implementing it at another time, not implementing it, or implementing it with modifications.

Deviations

A company can adopt loss costs without modification (a modification factor of 1.000) or with modifications. The handbook lists examples of deviations: adding, consolidating or eliminating classes or other rating factors, changing rating steps or the rating formula, or applying a percentage deviation to the advisory organization's overall level. Each deviation should be explained and supported, usually with company experience.

Some rating elements are always company-specific. The handbook gives two examples: minimum premiums, which the advisory organization does not set, and deductible factors, where the company starts from the advisory organization's loss elimination ratios and adjusts for expenses, since expenses are not eliminated in proportion to losses.

Workers' compensation

Workers' compensation is the line where loss costs and LCMs are most visible to policyholders. Missouri's explanation is typical: NCCI develops loss costs by class code, each insurer develops its own LCM from its operating expenses, taxes and profit provision, and the class rate is the loss cost times the LCM, applied per $100 of payroll. Other factors, including the employer's experience modification, are then applied. Because LCMs differ, two insurers starting from the same loss costs can charge materially different rates.

State oversight of LCMs varies. Some states collect the company's selected and current multipliers as standard filing data; New Mexico's 13.8.2.8 lists the selected LCM, any expense constant and the company's current LCM among the loss cost data required for loss cost filings. Check each state's rules for whether a change in multiplier requires approval before use.

What reviewers look for

• Support for each expense provision, and a clear explanation where the selected LCM differs from the formula LCM.
• A profit provision that reflects investment income.
• Data and rationale for every deviation from advisory loss costs, classes or rating rules.
• Company rating rules (minimum premiums, deductibles, schedule rating) that are consistent with the adopted advisory material.
• Correct identification of the advisory reference filing and the adoption option chosen.

For how these pieces fit into a complete submission, see what goes in a rate filing.