Human psychology can cause us to act against our own interests. For example, we want to insure against things that frequently happen to us, even if they’re not financially significant. But that doesn’t make sense as a business strategy.
When something happens so often that it’s a given, a company can’t profitably insure it. Why? Because when insurers know that a certain number of small losses will recur on a regular basis, those losses are factored into the premium.
Of course, the insurer gives some of the premium back in claims — on average, about 70% of what the company paid. The remaining 30% is the insurer’s overhead and profit.
Here’s a simple way to look at it. 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 give me only $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 the 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 it’s still a great deal for you. Keep doing it. And you can still do it all yourself; why bring in a partner and split the winnings?
But what if it’s $10,000 for heads and $20,000 for tails? It’s still a great deal, but now the stakes are so high that 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 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 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 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 potential factors in determining risk tolerance. For example:
Risk appetite is subtly different from risk tolerance. It’s more about attitude than anything else. While risk tolerance is about avoiding losses, risk appetite refers 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, any premium saved can be used for new business ventures. So, the risk appetite mindset is more positive and adventurous in its acceptance of higher deductibles.
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 the current year’s and five prior years’ “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 the company to lose all leverage in a renewal negotiation. So, the company can save on the premium up front by managing its losses, and save again on the back end when renewing its policy.
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 when 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 a 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. For example, a strong loss control/safety program under which the company self-funds losses related to employee injury will result in a lower premium.
Now, premiums have an inverse relationship to the size of the deductibles. When premiums go down, deductibles go up. But that’s OK.
The reduction in premium should be used, at least partly, to fund an even more robust loss control/employee safety program. As losses go down, and premium goes down, more money is available for loss control, and so on — a virtuous loop. The company may even decide to itself pay for all losses caused by employee injury.
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’s similar to self-insurance, with the company paying its own claims, but unlike with self-insurance, it still pays the insurer for claims administration.
In so doing, it saves much of the 30% of the premium it would otherwise be paying the insurer above and beyond the 70% that would fund the losses. (The company doesn’t save all of that 30%, because of the claims administration and because the company takes on the overhead for running the rest of the program.)
The difference between simple large deductibles and loss sensitive programs is that the latter are larger, more formal, and more of a long-term commitment. Loss sensitive plans can group multiple lines of insurance together, including general liability, auto, and workers compensation, 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:
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.
Frank Licata is president of Licata Risk Advisors, a Boston-area risk management consulting firm.
© Licata Risk & Insurance Advisors, Inc., 2020