Definition - What does Experience Rating mean?
Experience rating, in the context of insurance, is a rating method that takes into account the amount of loss experienced by an insured party as compared to the amount of loss experienced by other insured parties with similar characteristics. Insurance companies use it to adjust premium rates typically for workers' compensation and liability policies to reflect more accurately the amount of risk a policyholder actually represents. The assumption is that past losses would continue similarly into the future.
Insuranceopedia explains Experience Rating
Insurance companies regularly monitor the claims filed and paid out for their policies to determine what category of policyholders are more or less prone to filing claims and thereby more or less risky to insure. They then use the experience rating to adjust future premiums to better reflect the level of risk in a policy.
In other words, an experience rating helps insurers determine whether a particular policyholder files more claims than a similar policyholder. For instance, an insurer would compare a construction company to other similar sized ones to determine whether the former produces more claims than average. If the policyholder is found to result in claims at a higher rate, then there would be an increase in future premiums to cover the expected rise of pay out losses.
In addition, insurers also use the same information to develop an experience modification factor, which refers to the adjustment level of the premium. By increasing premiums of higher-risk policyholders, they create an incentive to focus more on risk management. For example, the construction company could develop better safety procedures and improve workplace conditions to lower the risk of workers' compensation claims being filed.