Managing Risk: A Guide For Your Business Client, Part 3 Of 4

Everyone retains risk. Most car owners have a collision deductible of at least $100. Owners of $200 watches rarely insure them. Large organizations have correspondingly higher retention of risk. It isn't a question of whether risk is retained, but how much risk is retained and under what conditions.

Many phrases are used in risk management, and meanings vary with the context and speaker. For our purposes, definitions are as follows:

• Loss assumption. Planned acceptance of loss by deductibles or deliberate non-insurance.
• Risk retention. Virtually the same, but slightly broader. Could include the definition above plus loss-sensitive insurance plans where some risk, but not all, is retained. Note that you can't have risk without a chance of loss, but you can have loss without risk. This occurs when the loss is certain, as with small Workers Compensation losses of large organizations. However, many persons use 'loss assumption' and 'risk retention' interchangeably.
• Self-insurance. Another term often used to mean risk retention. In some cases, it implies a more systematic method of accounting for losses, making charges to related entities as though they were insured, and establishing reserves for future losses. Many risk managers studiously avoid this term because it's not insurance.

A more basic definition is for 'risk' itself. In a word, risk is uncertainty. Losses that occur with predictable regularity do not represent risks, but a reasonably predictable cost of operation.

The first reason for risk retention is that there's a charge for risk transfer (insurance is the principal means of risk transfer). To operate his business, an insurer must charge about twice what he pays in losses. Thus, in the long run, insurance will cost twice as much as retention. Insurance doesn't really pay losses for you; it merely spreads them in an easy payment plan. Note that we're speaking in aggregates. Some large insurance contracts can be designed for loss ratios of 60%, 70%, or even more.

Risk retention has the following benefits:

1. It eliminates the cost of risk transfer, including:

• Insurer overhead
• Producer's commission
• Rate-making bureaus
• State and federal taxes (in some cases, separate taxes apply to self-insurers)

2. It eliminates the trouble, time, and cost of negotiating and supporting property claims. Of course, estimating and recording the losses are needed, as is attention to subrogation potentials.
3. It eliminates much accounting detail for reports of values, payroll reports, audits, and so forth.
4. It focuses attention on the need for controlling losses, enhancing loss-prevention efforts.
5. In the field of liability and Workers Compensation, it allows more flexibility in claims administration. Important decisions regarding your claims are not pre-empted by the insurance adjuster.
6. It allows selection of the most effective claims, loss prevention, and computer loss-reporting services rather than taking all from a single source.

The principal disadvantage of a properly planned risk-retention program is that there may be a greater variation of costs from year to year. However, recent chaotic market conditions have demonstrated that even insured programs are subject to unplanned, substantial fluctuations.

Another disadvantage is the possible loss of desirable ancillary benefits such as statutory filings with state authorities and boiler inspections.

The possibility that assumed losses may exceed premium savings should not be considered a disadvantage. If these losses were insured, the insurer would soon request higher premiums, which could affect premiums in all layers of insurance. By retaining adverse loss experience at lower levels, you may protect against cost increases at higher levels, which cannot be self-assumed.

The first rule is that all predictable losses should be retained. Where losses up to a certain level occur so frequently that you'll be charged for them in your insurance premium either in the current year or shortly thereafter, they can be considered predictable and probably should not be insured.

It may, however, be desirable to retain loss at a higher level-often to the maximum acceptable amount. Although no firm formulas can be offered for determining this figure, the best rule is probably this: The risk retention level should be selected by the chief financial officer after considering how unbudgeted losses will affect the organization's current and future financial condition.

This is a fine rule-of great value to everyone but chief financial officers. To help them with this decision, here are some rules of thumb:

Probably the principal single measure of an entity's loss-absorbing capacity is its revenues. Annual flow of dollars best depicts the firm's 'financial bulk. 'After all, when a sudden expense occurs, what really happens is that expenditures are shifted, projects deferred, or finances juggled to accommodate the change. Most budgets have a certain degree of flexibility, which is one measure of the 'tolerable loss level.'

For perspective on the fraction of revenues that might be subject to adjustment, look first at some familiar examples. Many individuals with incomes of $20,000 annually accept $200 collision deductibles on their autos and own many $200 items that are not individually insured. This $200 sum represents 1% of their income, which they have found by experience to be tolerable. There's no reason that the same measure wouldn't apply to organizations. Remember, too, that this is 1% per loss, not per year.

A more pertinent example would be to consider the approach of professional reinsurers, which is to base their maximum acceptable loss on the effect a loss of that size would have on the companywide loss ratio rather than separate line ratios. Figures set by individual companies vary widely, but they usually fall into a range between one-hundredth and one-tenth of 1% (0.01% to 0.1%) of annual earned premium (revenues).

This speculative background, as well as our own experience with many organizations, indicates that 0.1% of revenues represents a reasonable and conservative per-loss figure for most entities.

Some finance officers establish a goal for the risk-retention program to vary within limits-say, to a maximum of 150% of budgeted costs. The risk manager is free to select the level of retention within which there's a high degree of probability that the total of insurance premiums plus retained losses will stay within that limit.

Perhaps the most common method of selecting a deductible is to have quotations presented on the premiums applicable to different deductible levels. The decision is then made on an intuitive balancing of dollars saved vs. losses assumed. Although this may have some limited advantages in certain situations, it's generally irrational and misleading because:

1. A fixed premium credit does not measure all the advantages of risk retention.
2. The premium reduction is always small compared with the possible assumed loss (at least, at higher levels) because of the infrequent occurrence of the loss. It thus appears to be unacceptable. Because the insured has no way to calculate the actuarial frequency, a premium reduction that's small in absolute magnitude but beneficial in the long run might be rejected.

• Medical payments
• Auto physical damage
• Uninsured motorists
• Floaters (fine arts, camera, equipment, etc.)
• Some residential and small buildings
• Money and securities
• Machinery breakdown
• Pressure vessels
• Hot-water boilers

3. No one particular deductible saving quotation is highly credible. It could be different with another underwriter or at another time with the same underwriter.

In the final analysis, selecting a risk retention is not quite a shot in the dark; let's call it a shot in the twilight. But risk managers who have a finely tuned program and who are sensitive to shifting market conditions can lower deductibles when markets are soft, and then raise them when conditions are more restricted.

It may be useful, in some situations, to break loss history down into three categories:

1. Regular: occurring at least once a year
2. Intermediate: expected to occur once every two to 10 years
3. Catastrophic: occurring hardly ever, maybe never-but possible

Category 1 should usually be retained. Category 2 could be retained or treated in some loss-responsive rating plan. Some sophisticated risk managers feel that they can profitably insure this category under soft market conditions, when they can outguess the underwriter. This may sometimes be true, but the practice should not be pursued long term. Category 3 (in which loss potentials exceed the tolerable limit) should nearly always be insured.

Where data are reasonably complete and reliable, probability distributions using mathematical techniques may be used. They give a more accurate measure of the chance of loss occurring at various levels; however, they should be used with careful attention to the data's limitations.

Trend factors should be applied wherever forecasts are made. For example, property losses should be adjusted for inflation. Compensation losses should be trended for changes in benefit levels. Liability losses have various trends (usually steeply upward) depending on many factors.

It's easy to misapply the precision inherent in mathematical techniques, particularly since organizations having computer-backed mathematical facilities are eager to make use of their capabilities. Some proposals use mathematical techniques to calculate acceptable deductible levels, but this is rarely possible because all such calculations must rest on a base of loss data and deductible credits.

Loss data are rarely dependable because:

• Many losses are never reported and the ones reported are not always properly classified.
• Amounts reported are often inaccurate, with many indirect aspects overlooked.
• Conditions that create hazards often change from year to year: People move and processes change.
• Loss-control measures change: Sprinklers are added and safety programs are improved.

Deductible credits are even less precise because no one knows what they should be. A quotation of one underwriter at one time is some indication, but may be different than what another underwriter would offer-and even different than what the same underwriter would offer at another time.

With such highly inaccurate figures for deductible savings and losses assumed, it seems that decisions should be based on more fundamental criteria, such as loss-prevention incentives, management control of claims, and long-term calculations of cost savings.

One valuable function of loss analysis is a statistical breakdown by loss size for presentation to underwriters. If data are sufficient to be statistically credible, they may aid greatly in supporting a more reasonable rate than could otherwise be obtained.

Risk Retention By Line

Fire. Deductibles are most common in Fire insurance and other Property lines. Boiler & Machinery insurance, however, is less commonly subject to deductibles because of the relatively small premium, and because a major part of the premium is allocated to engineering and inspection services.

Fidelity. Fidelity bonds also are less often written with a deductible because of the low premium. But deductibles are desirable here in large measure to eliminate the cost of adjusting small claims. Loss adjustment costs in fidelity can be extremely high because of the need for detailed accounting, which may go back many years.

Auto. Auto Physical Damage is one area in which almost all companies of any size should retain the risk, using insurance only where many vehicles are stored in a single location subject to a windstorm, explosion, fire, flood, or other catastrophe.

Liability. Public Liability has not often been subject to deductibles except for minor deductibles in Property Damage Liability. The rationale is that outside adjusters are necessary to deal with the claimant, and it used to be difficult to employ adjusters without an insurance policy. Now that there are many professional adjusting firms available on a fee basis for self-insureds, this is no longer a consideration, so retention of the liability risk is becoming increasingly common. In addition to generating premium savings and freeing reserves, it develops better control of loss adjustments.

Techniques of subrogation-recognizing the potential and following through systematically against the guilty party-should be carefully planned when liability claims are assumed. Retrospective rating plans also represent a form of partial risk retention often used in Liability lines.

Types of Deductibles

Straight. For every loss, the insured pays up to the deductible amount.

Franchise. The franchise, most often used in Marine insurance, is a deductible that applies only until the loss reaches or exceeds the deductible amount. Losses in excess of the amount are paid in full-that is, with no deductible.

Disappearing deductible. This is similar to a franchise, except that the insured assumes all losses up to a certain figure. When a loss exceeds this figure, the insured's risk retention diminishes as the loss increases, until at a certain level the insured has full coverage.

Annual aggregate. The insured assumes all losses during a year until the total of all the losses reaches the aggregate figure. From that point on, losses are paid in full or, more commonly, paid in excess of a small straight deductible to eliminate nuisance claims. This is almost always used in conjunction with a straight deductible.

Waiting period. Business interruption policies are sometimes written with a dollar deductible, but more often with a waiting period such as second midnight. This means that the amount of loss between the time of the loss and the second midnight after is not included in the loss computation.

FPA. This is a term used in Marine insurance, meaning 'free of particular average' (FPA). Particular average is partial loss, so insurance written FPA is free of partial losses-or in other words, a claim is paid only if the loss is total. A synonym is TLO (total loss only).

If risk is retained to a substantial level, it may seem desirable to establish a reserve fund to ensure availability of cash when the need arises. Public entities and other tax-exempt organizations often do this, sometimes combining this reserve with other contingency reserves.

Retention of risk is the natural method of treatment, with insurance used principally where losses exceed a tolerable loss level (TLL). The chief financial officer, after considering all internal financial and external conditions, should establish the TLL, after which insurance or other risk transfer should be specified for risks in excess of this amount and retention for lower risks.