What is The Workers’ Compensation Split Point, How is it Changing, and Why Should You Care?

To calculate workers compensation experience rating modifications, an insured’s incurred losses are split into a primary loss portion and an excess loss portion. The amount of the incurred loss equal or less than the “split point” is the primary loss and the portion in excess of the split point is the excess loss. Effective January 1, 2013 the split point is changing in many states.

It’s important to you and your insureds because the change will result in higher debit modifications for almost 25% of all insureds. Here are some examples calculated by one commentator:

1.) A 1.45 modification changes to a 1.83;

2.) A 1.36 modification changes to a 1.72;

3.) A .89 modification changes to a .96, and;

4.) A .96 modification changes to a 1.151.

What will happen when one of your insureds falls into this group? If you’re lucky, they’ll call you for an explanation. If you’re not so lucky, they’ll call one of your competitors. There are things you can do now to cushion the blow for your insureds. To do that, you’ve got to understand the change.

First a pop quiz:

Q. What’s the purpose of workers compensation experience modification?

a. Punish insureds that have claims

b. Unjustly enrich insurance companies

c. Predict what an individual insured’s future claims experience will be

d. Encourage insureds to create safe work environments

Answers:

No, much as we might like to, punishing insureds, particularly corporal punishment, is not permitted by the Law-of-the- Sea Treaty and a few other laws. Anyone who thinks insurance companies are being enriched by workers compensation insurance hasn’t seen the triple digit loss ratios that are being reported. And the current low-interest rate environment increases the pain. More to the point, the experience modification will not increase premiums in total. From the industry’s perspective, the amount collected from insureds whose modifications increase will be offset by the decrease in premiums from insureds whose modifications decrease.

Close, but no cigar. Experience rating doesn’t predict the claims experience for the individual insured. We’ve all seen businesses that have no claims for several years with a resulting large experience rating credit generate a huge loss in the next year. What it does do is produce equity between groups of insureds. Insureds with good past records will have lower claims, as a group, and insureds with poor past records will have higher claims, as a group, in the current year.

So “d” must be the right answer and it is. Cash incentives motivate businesses. The change in the split point will increase the rewards for good claims experience and increase the penalty for poor experience.

What’s the Reason for the Split Point?

The underlying rationale of experience rating calculations is that a frequency of claims is more meaningful than the severity of the claims. Consider two comparable firms in the same industry that each pay $50,000 in premium. Which is a better risk: Frequent Flyer, Inc., which had 5 claims resulting in $35,000 in incurred losses in the last three years or Slow And Steady, Inc., which had just one slip and fall claim that caused an $89,000 loss? Looking at just the loss ratio basis, Frequent Flyer appears to be a better risk. However, experience rating theory says Slow & Steady is the better risk, because in the long run, a firm with a greater frequency of losses will have worse claims experience than a firm with little frequency of loss.

Sure, Frequent Flyer may go many years without ever having a large loss and I might flip 10 heads in a row or win the lottery, but if 1,000 people flip a coin ten times each the total number of heads and the total number of tails will be approximately the same.

Similarly, 1000 insureds with claims frequency will, in total, have greater incurred losses than 1000 firms with infrequent claims, regardless of the number of claims incurred in any one year by any one insured. Experience rating calculations reflect this theory by giving more weight to smaller claims than larger ones. This is done by dividing the incurred loss for each claim into two parts: primary and excess. The full total of the primary portions of an insured’s claims is used in calculating the insured’s experience modification, but only part of the insured’s excess claim total is used. For smaller insureds, the portion of the insured’s own excess claims that enter the experience modification calculation can be less than 10 percent.

To see how it works, let’s add another hypothetical firm, Easy As ABC, Inc a firm similar to Frequent Flyer and Slow And Easy. However, Easy As ABC has had no claims at all during the three-year experience rating period and see what their modifications work out to.

The basic formula for experience modification is:

Actual Primary Losses + Adjusted Actual Excess Losses + Ballast Expected Losses + Ballast

(Ballast is a number found in the manual that is added to the top and the bottom of the equation to lessen the swings in the experience modification—the resulting credit and debit modifications are closer to 1.0 than they would otherwise be.) Based on its payrolls and classifications, the experience rating manual shows that each firm is expected to have a total of $50,000 in losses during the experience period. (For the purposes of this example, we’re assuming that the three firms are identical except for their loss experience.) The manual also shows that the expected losses for each firm will be split 20% primary and 80% excess. That means that expected excess losses are $40,000 (80% of $50,000). Finally, the manual shows that for risks with their payrolls and classifications, only 10% of the firm’s actual excess losses is to be used in the modification calculation, the remaining 90% will be derived from the expected losses.2

Easy As ABC

(No claims at all during the policy period)

Denominator calculations:

Actual Primary losses . . . . . . . . . . . . . Zero

Adjusted Actual Excess losses: $36,000 (90% of $40,000 expected excess losses). ABC had zero actual excess losses so there are no actual excess losses to add.

Ballast . . . . . . . . . . . . . . . . . . . . . . . . $30,000

Numerator calculations:

Expected Losses. . . . . . . . . . . . . . . . $50,000

Ballast . . . . . . . . . . . . . . . . . . . . . . . . $30,000

That makes our formula:

Zero + $36,000 + $30,000 ______________________ = .83 (17% credit) $50,000 + 30,000

I’ll just show the formula for the next two hypotheticals.  Frequent Flyer (5 claims totaling $35,000—one for $10,000 and four for $6250 each. Actual primary is $25,000—only the first $5,000 of each claim is primary. Actual excess is $10,000)

Modification Calculation:

$25,000 + .1 x $10,000 + .9 x $40,000 + $30,000 92,000 ______________________________________ = _____ = 1.15 (15% debit) $50,000 + 30,000 80,000

Slow And Steady

(1 claim for $89,000 Actual primary is $5,000. Actual excess is $84,000) Modification Calculation:

$5,000 + .1 x $84,000 + .9 x $40,000+ $30,000 79,400 ____________________________________ = _____ = .99 (1% credit) $50,000 + 30,000 80,000

Notice that Slow And Steady, despite the fact that its losses totaled two-and-a-half times as much as Frequent Flyer’s, has a 1 % credit rating while Frequent Flyer has a 15% debit rating and watch what happens to their ratings when we switch to the $10,000 split point. How is the Split Point Changing and What Will it Mean?

The last change in the split point (from $1,000 to $5,000) occurred 20 years go. At that time the average claim at first report was valued at less than $4,000. In 2012 that figure had grown to more than $9,000.3 The National Council on Compensation Insurance (NCCI) has filed a change in the split point effective 1/1/13. The filing calls for the split point to increase to $10,000 in 2013, $13,500 in 2014 and to $15,000 adjusted for inflation in 2015 (I’ve seen estimates that in 2015 the adjusted split point will be about $17,000 once it’s adjusted for inflation.) Thereafter, it will by increased by inflation each year. That means that insureds with a frequency of claims will see continuing increases in their experience modifications in the future. The higher split points will result in both debits and credits becoming larger for most insureds. The primary portion of a loss will be an ever larger influence on an insured’s experience modification.

NCCI estimates that when the $10,000 split point is effective, about 76% of all insureds will see a decrease in their experience modification factor, about 21% will see an increase in their experience modification factor and about 3% will be unchanged.4 Here’s what the change would mean in year 1 in the three hypotheticals used above if they were subject to the $10,000 split point. With a $5,000 split point, expected losses were divided 20% to primary and 80% to excess. The $10,000 split point changes that to 30% primary and 70% excess. Easy As ABC (No losses in the modification period) ABC’s adjusted actual excess used in the numerator of experience rating calculation is reduced because only 80% instead of 90% comes from expected excess losses, resulting in an experience modification of .77 (23% credit) instead of .83 (17% credit). (We have a winner!)

Frequent Flyer

(5 claims totaling $$35,000—one for $10,000 and four for $6250 each. Actual primary will now be $35,000—the first $10,000 of each claim is now primary and there will be no actual excess.) The numerator will increase. Modification will be 1.21 (21% debit) instead of 1.15 (15% debit). (A loser!)

Slow And Steady

(1 claim for $89,000 Actual primary is now $10,000. Actual excess is now $79,000)

Modification will be unchanged, .99 (1% credit). Slow And Steady won’t see any change at first, but, if it keeps plugging away and avoids frequency, it will see a pleasing reduction in its experience rating modification when the one shock loss drops out of the calculation.5

How Can You Prepare Your Clients for this Change?

You won’t get any complaints from those whose credit modifications improve, but you can almost hear the outcry now from those whose debit modifications increase. The upcoming split point change offers you a great opportunity to demonstrate the value-added services you provide. Here are my suggestions:

1. Let your clients know the change is coming. Tell them that there will be winners and losers and that you want to help them be among the winners. (Remember, more than 75% of all insureds will get a reduction in their modification. Telling them about the change, may give you some reflected glory.)

2. Point out that your clients can make the new split points work for them if they reduce claim frequency. That’s good news, because frequency is much easier to control than severity. Assemble a list of loss control techniques and tailor them to your clients.

I’ve found safety meetings and training to be a great way to change a company’s compensation-claim culture. Demonstrating to employees that the employer cares about reducing accidents and keeping employees safe has helped many of our clients markedly reduce claim frequency. Ask your workers compensation insurance companies for other loss control suggestions. It’ll improve their opinion of your client and you. 3. Review current loss runs and experience modification calculations. That’s good advice even before the split point changes. There are firms that review modifications on a contingent- fee basis and many larger insureds should consider that option. However, you should review all your clients’ experience modifications first—many errors in experience modifications calculations are obvious.

Always compare the losses used in the modification calculation with the losses shown on the current loss run. I just looked at the data for one of our clients. A claim valued at $3,000 was shown in the most recent calculations, but the current loss run showed the claim had been closed for $86. The revised experience modification percentage was four points lower and the insured received a return premium credit. Nothing makes clients happier than reduced cost!

4. For clients with a frequency problem, recalculate what their modification would have be using the changed split point. You’ll need the new factors that are filed for the states in which the insured operates, but with that information, it shouldn’t be a difficult task. In many cases it will be dramatic and will motivate the insured to work on loss control.

The Affordable Care Act May Reduce Workers’ Compensation Claims

Co-morbidity is a huge factor in swelling workers compensation expenses. Co-morbidity means that an individual has two or more diseases or conditions at the same time. Common additional conditions or diseases that drive up the cost of workers compensation claims are hypertension, obesity, and diabetes but also include cancer, drug abuse, chronic pulmonary problems, pregnancy, etc,.

All these conditions make treatment of a workers compensation injury more expensive and prolong the period of recovery, especially if they are untreated. A NCCI study found that obese workers are likely to have 5 times the disability of a non-obese worker with comparable injuries and that co-morbidity doubles total claim costs.6 Peter Rousmaniere, a workers compensation industry expert, writes: “The Affordable Care Act changes the game. Every worker will have a (personal) health plan. Workers should be accountable for getting medical treatment for personal conditions that impede recovery from work injuries.”7

States that Have Approved the Change

All states served by the NCCI have approved the change. It’s been recommended by the rating organizations in most of the other states that have their own rating bureaus (CA, DE, MA, NJ, NY, PA, and TX). Of course, neither group includes the four monopolistic states (OH, ND, WA & WY). The split point change is still in the future for some sates (including New York and New Jersey), which is good, because experience modification calculations are based on past claim history. This will give insureds time to improve their claim histories. They’ll benefit now and even more when the new $10,000 split point kicks in.