New Solutions Vol. 5, No. 1

Volume 5, Number 1

ModMaster Subscriber Coins
New Mod Analysis Terminology

We Can't Quit Talking About Specific Loss Sensitivity

...or About the Minimum and Controllable Mods

ModMaster FAQ Highlight:
What is the Controllable Mod?

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ModMaster Subscriber Coins New Mod Analysis Terminology

One of the most valuable analyses that you can perform on the mod is a specific loss sensitivity analysis. For each loss, this analysis lists

the loss amount
the contribution this loss made to the mod
the value of the mod if this loss had not occurred, and
the one-, two-, and three-year cost of the loss in terms of increased premium.

ModMaster makes this analysis available at the click of the mouse through the Specific Loss Sensitivity Report. But ModMaster subscriber Thomas Scrivner, a partner with GBP Risk Solutions in Arizona, has taken this report a step further to make some interesting observations concerning the impact of a loss on the premium paid under certain circumstances. Tom has coined the term "magnification factor" to describe the changing year to year impact that a loss can have as a company's premium fluctuates.

ModMaster subscriber
Tom Scrivner

We are pleased to feature Tom's article in this issue of NewSolutions.

ModMaster is designed to make it easier for you to identify and communicate experience rating issues such as the one described in this article.

If you have your own story about how ModMaster helped you "save the day", let us know at NewSolutions@specificsoftware.com. Perhaps we'll feature your experience in an upcoming NewSolutions.

The Magnification Factor
by Thomas Scrivner
Partner, GBP Risk Solutions

Have you ever wondered why the impact on premium from a $1,000 claim affects the mod factor differently from one year to the next? For many brokers and their clients, this observation reinforces the impression that the mod factor is derived from a mysterious and unpredictable formula.

This apparent mystery is explained by something I call the "magnification factor." As you probably know, the mod factor is a multiplier developed from three past policy periods and assigned to the upcoming period. Each loss in the mod calculation contributes to the mod and the premium paid during each of the three years it is included in the calculation.

We Can't Quit Talking About
Specific Loss Sensitivity...

The use of the Specific Loss Sensitivity Report in both this issue and a previous issue of NewSolutions underscores its usefulness to our subscribers. To use this report, you must enter the manual premium on the Company Setup screen.

The manual premium is an estimate of the unmodified premium for the policy period for which the mod is effective. As indicated in this article, you may base this on the average of actual premiums during the experience period, or you may adjust it to reflect payroll or rate changes.

...or About the Minimum and Controllable Mods

If you'd like to understand more about the minimum mod and the controllable mod, take a look at this previous issue of NewSolutions.

Terms Used in This Article

“Experience Period” is the three past policy periods used in the mod calculation. Four periods or combined policies spanning three or four years are also somtimes used.

“Subject Manual Premium” is the actual manual premium for the policy to which the mod in question is going to be applied. The "Average Manual Premium" is the estimated premium based on the experience period average.

“Additional Premium Factor” (APF) is the ratio of additional dollars in premium a client pays for every claim dollar that is included the mod formula. This ratio will be exactly the same for all primary losses for the same account in the experience period. This ratio will diminish in severity for claims that exceed $5,000 each within the same account and experience period.

“Magnification Factor” (MF) is the ratio between the subject manual premium as it relates to the average manual premium of the experience period.

When a loss occurs, it is typical to estimate the ultimate "cost" of the loss based on historical trends in the manual premium. But what if the premium for future policy periods changes significantly due to payroll or rate fluctuations? In that case, the true impact in cost to your client will be magnified proportionally. Your client can end up paying much more - or less - for a specific loss than what you initially estimated. Be prepared to monitor and explain this change.

To explain and predict this phenomenon, you first need to understand two basic components of the mod formula:

1. The minimum mod is what the value of the mod would be if there were no losses. This is essentially the statistical relevancy of the account's premium size (and you thought you would never use what you learned in statistics class!). The larger the account's expected losses, the lower their minimum mod.

2. Every claim the insured has in the experience period is assigned a numerical value that becomes a part of the total modification factor. The cumulative effect that each of these losses has on the mod totals to the controllable mod. The minimum mod plus the controllable mod equals the total mod factor.

With ModMaster, it is very easy to determine both the minimum mod and what each loss is adding to that minimum. Consider the following example:

The chart at the right (from the ModMaster Mod Impact on Premium graph report) shows how the minimum mod, 0.71, plus the controllable mod, 0.34, total to the current mod of 1.05. The excerpt from the Specific Loss Sensitivity Report, below, shows that a specific loss of $6,079 impacted the mod by 0.0172.

In this example we assume an average manual premium of $240,000. The one-year cost of a claim is the manual premium times the impact on the mod for that particular claim. So we estimate our $6,079 claim cost to be $240,000 x .0172 = $4,128 per year. We multiply that by 3 to arrive at a three-year cost of $12,384. This is, of course, an estimate since the exact dollar impact cannot be calculated until all three policies affected by this claim have run their course and exact manual premiums can be determined.

The additional premium factor (APF) is calculated by dividing the three year cost of premiums by the original loss amount. So in this example APF = $12,384 / $6.079 = 2.04. This means that for every dollar going into the mod, the client will pay $2.04 in additional premium.

We cannot calculate the magnification factor (MF) until we know the actual subject premium. Let's say that the actual premium is $324,000. Then

MF = actual premium / historic average premium = $324,000 / $240,000 = 1.35

So our original three-year estimate of $12,384 is increased by our magnification factor so that the new cost is $12,384 * 1.35 = $16,719. So we are now anticipating $16,719 - $12,384 = $4,335 additional cost simply due to rate increases, payroll growth, or both.

The amount that the mod formula initially intended to affect an insured's premium can be dramatically affected by this magnification factor. This also works in reverse. If the subject premium is less than the average historical premium, then the cost impact will be smaller than expected.

Since the trend of workers comp rates in most states is headed higher, the "true cost" of an historical loss may be much more than originally expected. This means that your clients should pay extra attention to their claims, which may have an even larger impact than would ordinarily have been expected. Since most states have had falling rates for five years or more, the contrast may be startling. Add this consideration to your cost analysis and be prepared to explain it to your clients.