Managing Service Contract Risk – Loss Ratio Gotchas
Manufacturers and retailers often outsource their service contract claim risk to third party insurance carriers. The manufacturer or retailer pays a premium to the insurance carrier, who in turn pays for claims. As part of these agreements the insurance carrier reports back to the insured a loss ratio, or claim costs as a percentage of premium. If the loss ratio becomes too high, then the insured may be forced into paying higher rates; if it’s too low, then the insured is likely paying excessive fees and/or receiving detrimental rebates.
With so much at stake it’s critical that the loss ratio be on target. But how can one know if the loss ratio is even accurate? To be sure, we recommend that three key questions be asked of an insurance carrier:
- Which contracts are included in the loss ratio calculation: complete, active, or both?
- How is the premium earned?
- Is the reported loss ratio incurred or ultimate?
The first question – which contracts are counted in the loss ratio — is especially important for mature programs. Complete contracts could have different premiums, older technology, and/or shorter term weightings than the active. As a result, the loss ratio for complete contracts often differs greatly from the active. Sometimes losses or gains in the early years may be written off or forgiven; or in some situations, the carrier may try to recoup early losses with higher go-forward premiums. Regardless, the manufacturer should know exactly which contracts are counted in the loss ratio, as well as the extent of any overpayment or underpayment during the early years.
The second question pertains to the denominator in the loss ratio calculation. Insurance carriers often report loss ratio based on a schedule of how they expect claims to emerge. These schedules, often shown as curves, should be provided to the manufacturer for careful review. Even a small shift in earning assumptions can lead to huge swings in the loss ratio calculations.
Our third question is perhaps the least understood of the three. We find that insurance carriers typically report an incurred loss ratio, which is loosely defined as observed claims divided by earned premium. But more often than not, the incurred loss ratio is a poor and misleading metric; a better choice is the “ultimate” loss ratio, which is (observed claims + predicted future claims) / (total premium). The numerator in this calculation can be thought of as predicted end of life cost.
To illustrate the difference, consider a two-year extended service plan measured from the unit purchase date. During the first year, no premium is earned as the limited warranty is in effect; during the second year, the plan earns 8.3% of premium per month.
| Contract ID | Gross Premium | Months Elapsed | Percent Earned | Earned Premium | Incurred Claims | Predicted End of Life Cost |
| 1 | $200 | 21 | 75% | $150 | $90 | $120 |
| 2 | $200 | 18 | 50% | $100 | $60 | $120 |
| 3 | $220 | 10 | 0% | $0 | $0 | $120 |
| 4 | $240 | 6 | 0% | $0 | $0 | $120 |
| $860 | $250 | $150 | $480 |
The table shows a sample portfolio of four contracts of varying ages. Notice that the first two contracts have reached the extended service period, whereas the last two have not. The third and fourth contracts, which were sold more recently, have greater premiums due to rate increases. Comparing the two methods for computing loss ratio, we have:
- Incurred loss ratio = (Incurred Claims) / (Earned Premium) = $150 / $250 = 60%
- Ultimate loss ratio = (Pred. EOL Cost) / (Premium) = $480 / $860 = 55.8%
The main problem with the incurred method is that some contracts are weighted more than others. In this example the incurred loss ratio overstates claim costs as a percentage of premium because the recent changes in premium are ignored. That is, the $240 is not even considered in the calculations. Imagine if the premium for contract id 4 were $500 or $1,000 instead of $240? For a portfolio with changing technology, plan choices, or premium changes, biases from the so called “incurred” method are exacerbated.
Clearly, differences in loss ratio calculations can have a major impact on the perceived value of a service contract program. Therefore we recommend that manufacturers audit underwriter loss ratio figures at least twice per year. If you would like to speak with After, Inc. about conducting an audit, then please give us a call at 800.374.4728.