Embracing Higher Deductibles Can Be Smart Risk Management
The more a company controls insurable losses, the higher deductibles it can afford. This lowers premiums, enabling more loss control in a virtuous cycle.
Human psychology can cause us to act against our own interests. For example, we want to insure against the things that are frequently happening to us even if they’re not financially significant. That doesn’t make sense as a business strategy.
Insurance should be risk transfer, not a trading of dollars. When something happens so often that it’s a given, we can’t profitably insure that. It’s just the cost of doing business. Insurers will have our loss record. When we – and they – know a certain number of small losses will recur on a regular basis, that certain recurring loss will be factored into the premium.
A Simple Way to Look at it – the Coin Toss
Let’s say we’re flipping a coin and I give you $1 for heads and you give me $1 for tails. We’re just trading dollars. But if I give you $2 for heads and you only have to give me $1 for tails, that’s a great deal for you. You should take that deal all day long, and pay for any losses yourself, because dollar amounts are small and you’re going to be ahead soon enough.
Now if we go from $1 to 100 and from $2 to 200, the stakes are higher, but still a great deal for you. Keep doing it. You can do it all yourself – why bring in a partner and split the winnings?
But what if it’s now $10,000 for heads and $20,000 for tails. It’s still a great deal, but now the stakes are so high, maybe you don’t have the cash flow to afford a loss. Maybe you need a deep-pockets partner to fund you. You will ultimately still win big in the long or medium term, but you need risk funding for the short term. You’ve reached your risk tolerance level.
When the stakes get high and you do need a partner to whom you can transfer the risk, it will cost you something. But given the risk of large loss in the short term that you can’t afford, it’s worth it.
Insurance is risk transfer that works in a similar way. A company doesn’t need an insurer for the small, frequent losses – it would still be paying for the losses as they’re built into the premium – and would also be paying for the insurer’s overhead and profit. The company does need the insurer when the the potential loss is more than it can bear. Insuring risk is expensive, but at a certain point it’s a necessary and worthwhile expense.
How much loss a company can absorb without undue stress is its risk tolerance. In determining risk tolerance, the company must be careful to consider aggregation. If it can absorb $100,000 per occurrence, that’s fine. How many occurrences at $100,000 each can it absorb in a year, though?
Deductibles are, of course, a key aspect of the risk tolerance equation. They can be capped on an annual aggregate basis – for example, $100,000 per occurrence, not to exceed $500,000 in a one- year policy period. For a large company, deductibles (also called the “retention,” or the amount of responsibility for losses that the insured retains) might be, say, $500,000 per occurrence with no aggregate cap. It depends on the insured’s risk tolerance.
There are many other factors in determining risk tolerance. For example::
- Personality of the CEO/CFO
- Level of cash on the balance sheet
- Need for income statement stability
- Need to answer to the board
- Available credit lines for the worst- case scenario
Risk appetite is subtly different from risk tolerance. It’s more of an attitude than anything else. While risk tolerance is about avoiding losses, risk appetite refers to a positive desire to take risk for the purpose of achieving reward — for example, a fast-growing company wants to spend less on premiums in order to fund continuing growth.
As a concept it may be applied more often to uninsurable business risk – such as an entry to new markets or the manufacturing of a new product — than to “pure” or insurable risk (i.e., risk from perils, lawsuits, etc.).
But to some degree risk appetite does apply to pure risk because, again, premium saved can be used for new business ventures. So, the risk appetite mindset is more positive and adventurous in the acceptance of higher deductibles.
Negotiating Insurance Premiums
In addition to the high cost of insuring small losses, there is another reason not to do so.
Insurance underwriters look at one thing more than any other when considering what to charge for a company’s insurance program: loss history. Underwriters want to see your current year and five prior year “loss runs.” When is the company in a position to drive the deal its way? When the record is clean.
On the other hand, a record peppered with small claims (in addition to the rare large ones that do arise) will cause you to lose all leverage in a renewal negotiation. So, the company can save on the premium up front by managing it’s losses, and save again on the back end when renewing the program.
Combined with Loss Control
Good managed loss retention programs are achieved when a company has a measure of control over the occurrence of losses. Losses need to be reduced in two situations:
a) The company’s risk of loss is insured. In this case, containing losses is a tool for a company in negotiating an insurance renewal, and a very forceful one at that. An out of control loss record can result in an availability crisis where the company has trouble finding insurers willing to do business with it. And what does lack of supply do to pricing?
b) The company agrees to a retention under which it will bear losses. In this situation, every dollar in losses prevented is a dollar directly saved. Insurance premiums have an inverse relationship to the size of the retention. With large retentions, premiums are dramatically reduced. This reduction in premium needs to be used, at least partly, to fund a robust loss control/safety program. As losses go down, and premium goes down, more money becomes available for loss control, and so on – a virtuous loop!
“Loss Sensitive” Insurance Programs
A company above a certain size threshold with a significant loss control program in place has the option to move up to a formal “loss sensitive” insurance plan. It is similar to self-insurance, with the company paying its own claims, but unlike with self-insurance it still pays the insurer for claims administration. Why do this? Insurance is expensive but necessary in general. The larger you are, the more of your losses you can comfortably retain on your own, thereby saving much of the 30% of the premium which above and beyond the 70% that would fund the losses. The larger you are, the more effective loss control program you can install at your company also.
The difference between simple large deductibles and loss sensitive programs is the latter are more sizeable, more formal and more of a long-term commitment. Loss sensitive plans can group multiple lines of insurance together in the plan, including general liability, auto and workers compensation all together, for example. The plans require the insured to post collateral to pre-fund losses.
The structure of a loss sensitive insurance program is negotiable. The variables are
- the amounts the company retains under various measures: per claim, per occurrence, per location, aggregate per year, etc.
- the claim and loss control services provided and whether they are by the insurer or by third parties under contract to the company.
- the limits of the excess insurance (i.e. reinsurance) which attach above the retention.
- the premium for the excess insurance and the cost of the services.
Loss sensitive programs are the best way to keep control over the cost of risk. If a company’s loss control is effective and its retention great enough, it’s not subject to the whims and cycles of the primary insurance market, and has no party to hold accountable except itself. The company is lifting itself a bit above the fray.
The bottom line is that a company should experiment with gradually increasing deductibles. Over time, it might decide to move up to the larger, more formal programs. Well managed retention is a way for the company to assume and control risk. And of course, with risk can come reward.
(c ) Licata Risk & Insurance Advisors, Inc., 2020
Feb 15, 2020