Ready to Switch from Guaranteed-Cost to Loss-Sensitive? 5 Considerations for Your Insurance Program

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1 Ready to Switch from Guaranteed-Cost to Loss-Sensitive? 5 Considerations for Your Insurance Program January 2018 Lockton Companies Fixed pricing is convenient. Small businesses can benefit from an insurance program that provides this convenience while minimizing their risk. Guaranteed-cost programs often fit the bill. In a guaranteed-cost program, all liabilities and administration costs are transferred to the carrier; the insured pays an up-front premium to cover these costs. However, as your business grows, you may want to explore more financially beneficial options for financing and managing risk. With a loss-sensitive program, the cost of risk varies with loss experience. The insured is responsible for costs incurred up to a retention amount, and the carrier pays for all excess costs. Although the total cost depends substantially upon ultimate losses, there are additional determining factors to consider. LIZETH MCDONALD Risk Analyst mlmcdonald@lockton.com KELLY BILLINGS, FCAS, MAAA Vice President Manager of Casualty Analytics kbillings@lockton.com GUARANTEED-COST: Insured pays a set cost. Carrier pays all claims and admin costs. LOSS-SENSITIVE: Cost varies based on loss experience. Insured pays a premium and costs up to a retention amount. Carrier pays excess costs. L O C K T O N C O M P A N I E S

2 Deciding which insurance program is best for your growing company is sometimes overwhelming. Here are five factors to help you determine whether you are ready to make a switch: 1. Determine your risk tolerance with volatility modeling The first thing to consider when evaluating a program is how much risk your company is willing to take. In a guaranteed-cost program, the final cost of each policy year does not depend on the losses from that year, but instead on those from the previous two to three years combined with industry experience. An experience modification factor (emod) is calculated from this loss experience to modify industry rates, and once exposures are determined for the policy year, the premium is fixed. How much risk is your company willing to take? By contrast, the total cost of a given policy year in a loss-sensitive program is dependent on the losses. The total cost is an estimate until all losses are fully closed, which could take up to 20 or 30 years. Lockton looks at a range of outcomes to measure volatility based on total cost of risk, including retained losses, vendor costs and premiums. Looking at point estimates, as well as ranges around these estimates, can help you make an informed decision on acceptable risk tolerance from both expected cost and variability standpoints. If the insurance carrier isn t giving you enough credit for your favorable experience in its pricing, this option can help you capture that additional benefit. Program comparison Total program cost Projected Losses Lowest Loss amount Highest Retention: Guaranteed cost $250K $500K $750K 2

3 January 2018 Lockton Companies 2. Evaluate your readiness for claims handling Guaranteed-cost programs give you less control over the cost of claims handling because it is included in the premium. This can be a disadvantage if your company has good loss experience. If the carrier can settle losses for less than anticipated, the benefit goes directly to the carrier, and you forfeit any possible returns from favorable losses. This can also be problematic if the carrier handles claims in a way that s not in your company s overall best interest; for example, handling claims that can affect your company s reputation or increase negative publicity. On the other hand, a loss-sensitive program provides more options to manage claims outcomes. In many cases, you can choose your own claims handler and other risk control vendors and direct their policies and procedures. Taking a higher retention gives your company incentive to prevent losses. Any reduction in losses below the retention lowers the total cost of the program. By having direct control over losses, your company can actively reduce cost through aggressive claims management, effective safety practices and return-towork programs. 3. Be aware of unpaid claims liabilities and potential collateral requirements Because all risk is transferred to the carrier under a guaranteed-cost program, there is no need to worry about how losses pay out in the future. With a losssensitive program, how and when claims are paid needs to be considered. Loss-sensitive programs come in two forms: self-insured retention and deductible. In both instances, the company needs to set aside money on its financial statements to account for the unpaid claims. This can become a point of negotiation if the company ever changes ownership and problematic if claims come in higher than initially expected. 3

4 With a deductible program, the carrier requires collateral from your business. With deductibles, the carrier pays all losses and seeks reimbursement for retained losses from the insured. This creates a credit risk for the carrier and requires that the company post collateral to securitize the risk of not being reimbursed. The carrier may reduce the amount of collateral required if it s proven that the company is a good credit risk and the company continues to renew with that carrier. Collateral grows because new policy years are added before the prior ones are totally paid out, causing the amount of unpaid loss that the collateral secures to increase. This growth in collateral can be anticipated by forecasting five years of collateral requirements. The graph below demonstrates stacking new policy years at each renewal as the prior year s amount decreases as claims payouts. Since this collateral amount can stack to be a material amount, it is important to identify the best form of collateral to achieve your company s goals and evaluate whether a self-insured program is a viable option to avoid or reduce collateral requirements. Collateral scenario analysis Does the five-year collateral estimate breach your credit capacity? Collateral required Upcoming renewal Next renewal 3rd renewal 4th renewal 5th renewal Total collateral held Collateral held for upcoming renewal Collateral held for next renewal Collateral held for 3rd renewal Collateral held for 4th renewal Collateral held for 5th renewal 4

5 January 2018 Lockton Companies 4. Know the impact to your cash flow Another important variable to consider when evaluating options is how they will fit your company s cash-flow needs. A loss-sensitive program offers a cash-flow advantage because claims are paid out over time as opposed to prefunding losses through guaranteed-cost premiums. Under guaranteed-cost programs, all investment income on those funds stays with the carrier. Lockton supports program structure decisions by providing estimates of the cash-flow impact to your company s finances. We help you understand your choice of structures, minimize the net present value (NPV) of costs and focus on optimizing cash flow for your business. A loss-sensitive program offers a cash-flow advantage because claims are paid out over time as opposed to prefunding losses through guaranteedcost premiums. 5. Understand the tax implications Changing the structure of your program can also have tax implications. Premiums for guaranteed-cost and loss-sensitive programs are both tax-deductible in the year they are paid. Losses retained under the deductible are only tax-deductible when paid. However, case reserves and incurred but not reported (IBNR) reserves are not deductible, so this creates a book-versus-tax timing difference. This portion of the tax deduction will be delayed until the case and IBNR reserves pay out, which could take several years. 5

6 Another option: group captive programs Sometimes the size of a company s premiums is not large enough to generate an appropriate amount of premium savings for taking on a large deductible. For example, with a smaller program, the credit for taking a $100,000 deductible might be only $45,000, and the risk-to-reward trade-off is unattractive. In these instances, group captives can be an ideal third option. They offer a company the ability to save on commercial insurance costs by taking risks and benefiting from good loss experience, many times before this opportunity is available in the commercial marketplace with a large deductible. Under a group captive program, the initial premium is paid like a guaranteed-cost premium and is tax-deductible. Your company s historical claims determine the claims-funding portion of the premium. Group captives may be an ideal option for companies with relatively low loss frequency that spend approximately $300,000 $1,200,000 on guaranteed-cost insurance. Changing the structure of your insurance program can be a complicated decision. Lockton can help you evaluate your options and determine the best fit for your company. 6

7 January 2018 Lockton Companies NOTES 7

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