How much risk should an insured retain?
I can still remember my Corporate Finance class when I was in college 45 years ago. Professor Rini’s comments still ring loud and clear in my ears. “Do you want to eat well or sleep well?” That sums up the idea of retaining risk. But not quite. The truth is taking risk does not have to be as dangerous as the picture illustrates.
Back when I was behind an underwriting desk, one of the most asked questions I would field is how much risk should an insured take? There is an easy answer. As much as they can. The reason for this is insurance is an expensive tool to finance risk. Think about it. There is an expense, profit, and contingency load between 45% and 20% depending upon the line of commercial insurance. Compare that to the interest rate on loans and revolving credit ranging from 5% to 25% depending on the credit worthiness of the business.
Add to that most of the claim dollars are packed into the lower layers. The marginal loss cost for claims under $25,000 are 2 to 10 times higher than the loss costs over $25,000 depending on the line of business. Since loss costs represent over half of each premium dollar, that is very expensive insurance coverage. So, the answer is simplistic. It is also accurate.
But insurance is a critical component of any risk management program. Insurance is an effective method to transfer of finance risks from which a client cannot recover. So, the secret is to find the sweet spot to maximize both protection and value. To do so, you need to figure out just how much risk a client can take on. That will require digging into their financial condition.
Risks take on risk through primarily through deductibles, self-insured retentions and retrospective rating programs. In doing so, they remove the carrier further away from being in the claim paying business and more into the catastrophic protection business. But the risk does not go away and the client accepts the responsibility for financing the risk. That means the need to fund for the exposure. There are 4 sources for funding and financing the risk.
1. Working Capital
3. Availability of credit
4. Premium savings
Working Capital is the amount of liquid capital they have. The accounting definition is current assets minus current liabilities. Current asset are assets which can be converted into cash within 12 months and current liabilities due within the next 12 months. The excess is the working capital or put amount of current assets which in theory are not already allocated to paying a future bill. It is one source for financial capital to fund risk retention.
The second source are profits. Future profits can be allocated to pay for future losses within the retention. As a precautionary note, future profits are not guaranteed. Changes in the client’s business environment can dry up profits. Hence, requiring a secondary source to finance risk.
The third source of funding is taking on additional debt by securing credit for collateralizing the risk. However, one can make the argument the availability of credit is dependent upon financial strength of which both working capital and profits, so credit is more a derivative of the first two.
Finally, the amount of premium saved may provide funding to finance taking additional risk. In fact, one retention method, retrospective rating, is structured around premium savings to finance some of the risk.
The amount of funding is going to vary from one client to the next, depending on things like the amount of retention and the historical claim patterns. It goes without saying, the decision to retain the first $100,000 of risk will require more funding than retaining $50,000 and require less than retaining $250,000. That is a “no brainer.” But historical claim patterns vary from one client to the next and from one line of business to the next.
Exposures presenting significant frequency level will generally require a greater level of up-front financing to fund retention. Exposures present low frequency but higher severity can generally spread their financing over a longer term. Let me illustrate.
A crane manufacturer which wishes to retain risk for product liability has an exposure for a large loss once every few years. Furthermore, those claims develop slowly. They are less likely to have an immediate need to pay claims. Hence, financing can be spread over a longer period of time.
In contrast, a national chain of retail stores, who are seeking to retain risk for their premises and operation exposures. They can expect a certain level of immediate claim activity. Hence their funding will have to be more immediate. Therefore, they type of risk being retained and the historical loss history will impact the amount needed to safely finance the retention.
The ultimate decision should be based upon the calculation of more than one level. The first is the expected net costs for various increased retention levels. The ultimate expected net cost is represented by the formula shown below.
Expected Net Cost = Expected losses under the retention + Premium + other expenses
Under “ground up” programs, a variety of carrier services are provided by insurance carriers without any additional cost, such as safety and loss prevention service. Often under programs with higher retentions, services are provided on an “ala carte” basis with those services shown as a line-item expense. For example, if a client opts for a $100,000 General Liability deductible, the insurance carrier may opt to provide loss control services on an extra cost basis with an hourly surcharge. Therefore, the client needs to understand they may need to spend extra cash if they are counting on engaging those services.
Expected Net Cost can be thought of as the most likely outcome as it is based on the client’s past performance, with past performance being the best indicator of future performance. But it is not the only possible outcome as the client may experience greater or lesser claim activity in the future. Furthermore, the predictability may vary as well.
When reviewing and analyzing past claim activity as a predictor of future claim activity, one need to consider the range of outcomes in the past. For example, 2 risks may average $300,000 in annual losses. However, one risk’s past claim history may have closer packed historical claim history with outcomes between $250,000 and $350,000 in past years. While the other may have historical outcomes between $50,000 and $550,000. Both companies have the same expected net cost, but the second example has a greater range of costs because of wider swings in claim experience. Hence, there needs to be greater consideration given to other potential outcomes when there is greater volatility.
Volatility increases the consideration to be given to other negative outcomes. In the second example, the client would need to be more concerned with outcomes over $400,00 as they have proven a $550,000 year is achievable and much more likely than with the first example. Perhaps the second client should consider the need to fund for $550,000, whereas the first client can successfully fund retention with only $300,000 as they have lower volatility.
In theory, they would be able to retain risk in the amount of the sum of all 4 of the sources. However, theory not always in touch with reality. Some of those sources will be earmarked for other projects. For example, a contractor may be thinking of buy more equipment in the next 12 months so they would not be able to allocate all their working capital or future credit to retaining risk. Also, they may not want to allocate their future profits to pay for future claims. The actual amount available to finance retaining risk will be significantly less than the sum total, but it is a starting point to begin thinking about structuring coverage for greater cost effectiveness.
With adequate funding available, the focus of setting a good retention point shifts to a cost-benefit analysis. The primary rule I have applied over the years is to never risk a lot for a little. By that, I mean taking risk should present enough premium reduction. For example, a crane manufacturer should not retain the first $100,000 of loss to save $5,000 in premium. In contrast, it is a no-brainer to retain the first $100,000 to achieve a $100,000 premium savings. The balancing point is usually somewhere in between.
With that said, it becomes obvious retaining any substantial risk does not usually work for clients who already pay little in insurance premiums. Still, small businesses have the opportunity to improve the cost effectiveness of their insurance programs.
At what point does the potential loss begin to cross the threshold from annoying or discomfort to real financial pain to something which shuts them down or has a dramatic impact on their business? The tipping point will vary from one client to the next, but I guarantee you it is well above the $500 or $1,000 deductibles we sell. In some cases, insuring property may not make any sense at all because personal property values are not high enough to create enough true risk to make insuring it necessary, making other methods to finance that risk more efficient and attractive.
For the most part, clients can easily recover from losses greater than the traditional deductibles we sell. Just like my laptop computer example. For example, let us look at the laptop computer I am using to type this article. Any number of things could happen to it. It could be stolen. It could burn up in a fire. It could crash (which probably has a higher probability of happening). As an owner, I am completely okay to take the risk of the computer crashing. If that happened, the first thing I would do is swear! Then, I would go online and order another to take its place immediately. If I am willing to take on that risk, why should I be willing to pay premium to cover the risk of it being stolen or being destroyed in a fire?
Based on ISO property rating algorithms, small businesses can see upwards of a 20% rate reduction by increasing their property deductible from $500 to $5,000. While reductions on the casualty side for selecting small deductibles are available, they have less of a rate impact since they do not have the same capacity for reducing claims dollars.
So, here we are back to the question we started out with. Do you want to eat well or sleep well? My answer is why not both. I’d love to hear your comments.