What Are Experience Ratings in Insurance

Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

Janet Berry-Johnson is a CPA with 10 years of experience in public accounting and writes about income taxes and small business accounting.

What Is an Experience Rating?

An experience rating is the amount of loss that an insured party experiences compared to the amount of loss that similar insured parties have. Experience rating is most commonly associated with workers’ compensation insurance. It is used to calculate the experience modification factor.

Key Takeaways

• Insurance experience ratings are losses an insured party has relative to similar insured parties.
• Experience ratings help determine the likelihood an insured will file a claim.
• Insurers charge higher premiums to risky policyholders, which also incentivizes the policyholder to improve risk management practices.
• Experience modifiers are adjustments of annual premiums based on previous loss experience.

Understanding Experience Ratings

Insurance companies closely monitor the claims and losses that come from the policies that they underwrite. This evaluation includes determining whether certain classes of policyholders are more prone to claims, and are thus more risky for the company to insure.

The experience rating helps an insurance company determine the likelihood that a particular policyholder will file a claim. In this sense, the past loss experience of a policyholder is used to determine future changes to the premium charged for the policy. In general, it is easier for an insurance company to determine the risk associated with an entire class of policyholders, but harder to determine how risky an individual policyholder is.

For example, an insurance company will look at whether a large-sized construction services company has produced more workers’ compensation claims than similar-sized companies. If the claims occur more often than expected, the insurance company may increase premiums in order to cover the increased expectation of payouts.

By charging higher premiums for more risky policyholders, an insurance company can incentivize its policyholders to improve its risk management practices. For example, a business that is considered high-risk for a workers’ compensation claim will have to pay more than a low-risk policyholder. However, the high-risk policyholder can improve its safety procedures and workplace conditions to lower its premium. Experience rating is typically based on the three years prior to the most recent expired policy period.

How an Experience Rating Is Used

An experience modifier is the adjustment of annual premium based on previous loss experience. For instance, three years of loss experience are typically used to determine the experience modifier for a workers' compensation policy. An experience modifier is calculated every year. A modifier may be less than, greater than, or equal to one.

A modifier of one means that your loss experience is average for your industry group. That is, your loss history is no better or worse than other businesses similar to yours. In such a case, your premium will likely remain unchanged. If your modifier is greater than one, your loss experience is worse than average for your industry group. A modifier that is greater than one will increase your premium for the upcoming policy period. Likewise, a modifier of less than one signifies a loss history that is better than average. A modifier of less than one will achieve a premium reduction.