Risk Managers' Forum
Choosing the right deductible/retention levels
Risk appetite and financial wherewithal are key factors
By Leonard J. Watson, Ed.D., CIC, CRM, CPCU, AIC
Deductible choice, like other risk management decisions, is ultimately the responsibility of the business owner or senior manager. It is part of the process of deciding which risks should be transferred and which should be retained. However, businesses look to the insurance professional to make deductible recommendations and to provide information that will help them quantify the impact of their retention decisions.
What are the business owners’ attitudes toward increasing overall risk from greater retained loss? How much potential loss can clients accept without endangering the financial strength of their businesses? How reliable are the available data for predicting future loss trends? How predictable is the loss frequency and severity? How much would it cost to transfer financial consequences of certain risks to insurers?
For years, many insurance professionals have counseled their commercial insurance clients about deductible options as a normal part of the development of insurance proposals. However, few of them think of their deductible counseling as a type of risk management consultation. Instead, they see their evaluation of deductible as just another part of developing an insurance proposal appropriate to the client’s needs. Is it both risk management consulting and proposal development? Some say yes.
Here is a common situation. Client A is an electrical contractor with 20 years of growing and profitable business experience who employs 45 people, owns 30 work trucks and an assortment of professional tools and equipment necessary to his profession. Consider only the physical damage exposure to the trucks. Client A employs experienced workers, proud of their work and careful with the vehicles they use. However, even with good care, the company averages one or two minor collisions each year with an average annual damage amount of $8,000 to owned vehicles.
Should Client A have collision coverage for the vehicles? If not, why not? If so, what deductible should he have? How does an insurance professional evaluate these questions and others like them?
Good insurance professionals typically assess both the client’s attitude toward assuming increased financial exposure from higher deductibles, and the client’s financial ability to respond to retained loss. But many good agents, brokers and producers have acquired the ability to provide such professional consultation only after years of industry experience. Is there some way to make evaluation of retention more explicitly a part of the insurance placement process? Might that improve the quality of advice received by more clients? Might it even speed the learning curve of today’s newer producers?
What could be done to help clients better understand the retention consequences of deductible choices? This article suggests some basic risk management concepts that could be useful in the deductible analysis process.
Appetite for risk: This is an organization’s desire or willingness to retain the financial consequences of risk. Owners and leaders of organizations demonstrate different attitudes toward the uncertainty of retaining risk. As insurance professionals work with clients over time, they usually gain a basic understanding of each client’s relative appetite for risk. This appetite can range on a scale from aggressive risk taker to conservative risk avoider. Most business leaders are somewhere between those two extremes.
Understanding where each client’s owners and leaders place themselves on a risk appetite scale can influence the insurance professional in making retention recommendations. For example, clients aggressively willing to assume risk might appreciate learning about the range of optional deductibles and corresponding premium discounts that may be available. On the other hand, leaders and owners who are generally uncomfortable with relatively high levels of risk might be disinclined to accept higher than average levels of retention, even if insurers offer sizeable discounts for accepting higher deductibles and the organization has the financial strength to fund significantly higher retention levels.
Financial ability to retain risk: Financial ability to retain risk is an independent factor that also should be considered by insurance professionals in making retention/deductible recommendations. Clients with many consecutive years in which the value of assets greatly exceeds the value of liabilities and with consistent and substantial profits over many years are in a stronger position to accept high levels of retention than are organizations with a relatively weaker financial condition. Insurance professionals who have a basic ability to read and interpret client balance sheets and income statements are well situated to assess the appropriateness of different levels of retention.
Discussions with a client’s accountant and financial advisors can often assist the insurance professional in determining the relative financial strength or weakness of the client’s business. An insurance professional would probably be unwilling to recommend increased retention amounts to a client with a relatively weak financial condition, even if that client’s management had an aggressive appetite for assuming the financial consequences of higher risk. Similarly, a financially strong client might be averse to increased risk from higher levels of retention because of a low appetite for risk. The insurance professional can often assess the match of the client’s risk appetite and financial strength.
Availability of reliable data: Analysis of an organization’s financial condition should include, among many items, an assessment of past and present losses and reserves for at least three years. Historical data should also be consistent over time. Changes in claim coding, claim information systems, third-party administrators, insurers, or claims management could have significant effects on the credibility of historical data and its usefulness as a predictor of future losses. Insurance professionals depend on having adequate and reliable data in assessing whether changes in deductibles are appropriate.
Volatility of loss frequency and severity: Some types of losses are more predictable than others. For example, a group of 10 grocery/food stores would realistically anticipate a number of customer and employee slip and fall injuries over the course of a year. Given adequate and reliable data, it should be possible to predict with reasonable accuracy future loss trends for those types of losses. On the other hand, product liability claims are less predictable in terms of frequency and severity, particularly for new and relatively untested products. So, if an insurance professional’s analysis of past client claim experience suggests that losses are relatively unpredictable for frequency, severity or both, high levels of retention are generally not advisable, provided adequate and acceptable insurance coverage can be purchased at reasonable prices.
Current price level and availability of insurance: The relative cost of insurance is a function of many factors influencing the availability of insurance from financially sound insurers. Some of those factors include the insurer’s loss experience, its ability to effectively and accurately assess new risks, its capacity to charge an adequate yet competitive rate, the particular trends of the market for the class of risk involved, and the investment income anticipated by the insurer in setting its rates. Fully understanding the underwriting and pricing process requires years of study and experience. However, it is reasonable to state that poor underwriting experience (high levels of loss frequency and severity compared to premium revenue), high expense ratios, and poor investment results can all be significant factors in determining rates over time.
The current state of the market also tends to influence rates. Insurance professionals are generally aware of the relative softness or hardness of a particular market and can use this information to help a client compare the relative current cost of insurance to the estimated costs of retaining higher levels of risk through higher deductibles.
These five retention-setting issues are examined in detail in the Certified Risk Manager program called Principles of Insurance. Attendees at programs seem to indicate that they have performed many of these five analyses over their years as insurance professionals. However, they also agree that they have not thought of these analyses as a risk management function. Clearly describing an analysis as a risk management function, with a defined process to help perform it regularly and consistently, might help professionals better serve their clients in evaluating different retention options. *
The author
Leonard J. Watson, Ed.D., CIC, CRM, CPCU, AIC, is president of Phoenix Resource Systems, Inc., a risk management consulting firm based in Statesboro, Georgia. He is a charter member of the national faculty of the National Alliance’s Certified Risk Manager (CRM) program. Len also teaches in the College of Business Administration at Georgia Southern University in Statesboro. For more information on the CRM program, call (800) 633-2165 or go to www.TheNationalAlliance.com.