Does Your Self-Insured Program Need a Tune-Up?
Many insurance professionals believe the next hard market may be lurking right around the corner. Is your self-insurance program ready?
Many insurance professionals believe the next hard market may be lurking right around the corner. Historically in hard markets, self-insurance has been used as a risk financing mechanism to offset higher insurance prices and the lack of capacity. But just as a diligent driver would be sure to have a mechanic perform a full tune-up before embarking on a long car trip, a risk manager also needs to periodically conduct a systematic check of insurance exposures in order to maximize the performance of a self-insured program and determine if there are any issues hidden below the surface. The following key questions can guide your assessment.
Is Self-Insurance a Viable Option?
Self-insurance and large-deductible programs are usually mentioned at the top of the list of ways to control insurance costs in a hard market. A risk manager needs to first determine which lines of business are best suited for this option. Some issues to think about are:
Availability and capacity of commercial markets
- Cost of expected retained losses vs. commercial insurance
- Variability and predictability of retained losses vs. the stability of commercial insurance
- Tolerance of risk
When considering lines for self-insurance a risk manager should utilize an independent feasibility study to estimate expected costs, variability of costs and costs at various retentions in comparison to the fixed costs of commercial coverage. Theoretically, a self-insurance program will save on the commercial insurer's expenses, profit and contingencies that are included in the premium rates. Of course, with any self-insured or large-deductible program there is additional risk, so premium savings must be weighed accordingly with this risk. This risk can be quantified and uncertainty reduced through a detailed analysis.
Typical corporation self-insurance lines include workers compensation, auto liability and general liability. Historically, these coverages have been successfully self-insured, which is due to predictability, effectiveness of loss control and premium reduction at higher retained limits. Less traditional exposures such as product liability and warranty sometimes get overlooked even though self-insurance may be a clear winner.
A feasibility study can also help confirm which self-insurance structure is appropriate with the risk manager's goals, i.e., a pure self-insurance program with an excess limit; a large-deductible program; or even a captive insurance company with reinsurance. Regulations and rules also influence which program is most favorable. In addition to the feasibility study, a risk manager should discuss the benefits of each structure with a qualified, trusted broker.
What Is a Reasonable Retention Level?
A feasibility study enables a risk manager to explore initial costs of a self-insured program, but what about a self-insurance program that already has a retention in place? When is it appropriate to raise or lower the retention? A risk manager may consider reviewing the retention level to ensure maximum insurance savings through a retention analysis. This analysis should determine the "working layer" of losses on an empirical basis and is best completed by a source independent of the insurance carrier when reviewing renewal premium quotes. Proper retention varies depending on company size, lines of business, risk appetite and variability of historical losses.
A company with more equity and cash flow may be able handle the risk associated with a larger retention. Higher limits bring higher variability for retained losses within a year. Overall, insurance lines with low frequency and high severity, such as professional liability or products, have more risk than lines with high frequency and low severity, such as auto physical damage. Ultimately, an appropriate risk level must be decided by risk management. Maintaining adequate and verifiable self-insured program reserves for the chosen retention(s) will also support the long term success of the self-insurance strategy.
If one division within a program has losses that significantly vary from other divisions, a risk manager might consider adjusting the retention specifically for this division, which will help contain the commercial premium to a reasonable level. An assessment of the historical frequency of large losses and projection for the future may influence the decision of the self-insured retention. It is important to balance self-insured losses of the program with costs of commercial insurance above the retention.
Is the Allocation Process Meeting Goals?
Companies with multiple divisions or entities often allocate future expected insurance costs and historical unpaid claim liabilities. A risk manager should first determine the goals of the allocation process. Is the ultimate goal:
- To be easily administered and understood by the members?
- To not significantly fluctuate from year to year?
- To be equitable to all members?
- To promote safety?
A sound allocation will promote safety from management down to division managers and individual employees, as well as maximize the above goals capitalizing on cost reduction.
The most common allocation scheme is based on exposure, losses or a combination of the two. Allocation purely on exposure is easily administered. It is important to consider risk class among and within the entities and test for true homogeneity. For example, an allocation of a company's workers compensation program based on payroll needs to be adjusted for differences between factory and office workers. An allocation based on losses promotes loss incentives but presents more of a challenge, so a risk manager may include a cap on the losses that go into the equation so as not to penalize a division too much for a random, large loss. The cap is often decided by estimating the "working layer" of losses. A decision also needs to be made as to how many years of loss experience are appropriate for the allocation. For example, an allocation based on the last five years of losses would be more responsive, but one based on the last 10 years would be more stable.
In addition to common allocation schemes, a risk manager may consider a more sophisticated process to reach risk management goals. A system of credits and debits based on historical data can be applied to encourage more safety practices. Rather than a straight cap on losses in the allocation equation, a sliding scale of losses might be appropriate so there is more pooling with larger losses. Finally, a retrospective system might be appropriate if the goal is to return credit to divisions that have performed well, and assess those that have had adverse experience. Some risk managers prefer having the allocation calculated by an outside party to be able to "put the blame" on someone else; especially when members challenge their share.
Does the Program Have a Safety Issue?
Creating and maintaining a culture of safety is a variable issue risk managers face on a daily basis. When was the last time the details of the loss drivers were examined? Are most loss report summaries simply reporting on a small segment of losses but not providing the full picture? Preventive measures and new safety initiatives will affect both self-insured results as well as commercial premium.
A risk manager may consider conducting a safety study to help identify loss drivers that will enhance the ability to create solutions. Even though frequency may be improving, severity may be increasing. To identify the correlations between losses and associated demographic characteristics, risk managers should ask the following questions of potential loss drivers:
- Is it a particular type of injury such as a back or knee injury?
- What is the average severity of this injury?
- Does a particular division cause a disproportionate share of the large losses?
- Is safety up to speed within each division?
- Is there a time of day when loss frequency is unusually high?
- Are losses more of a frequency or severity issue?
Starting with a detailed loss run, a safety study will answer many of these questions. The risk manager can then implement an appropriate plan but may also want to consider completing a cost benefit analysis of safety initiatives. For example, would losses eliminated from an onsite nurse exceed the salary expense? How would a safety initiative impact the ultimate retained losses and projected losses? Risk managers need to ensure credit is received for the prevention activities implemented for all exposures. An in-depth safety study will demonstrate the effect of a safety program on losses.
Is the Program Being Given Proper Credit?
A risk manager should be looking out for the interests and needs of the program, which requires contact with many outside parties such as the company's broker, third party administrator (TPA) and actuary. Each party has different motives and concerns, making it important for the risk manager to ensure all interests align with company risk management goals to achieve full transparency. Communicating any program changes or changes to risk management philosophy to these parties is essential for success.
Discussions should be held with all service providers with direct influence on program costs. Is proper credit being given for the company's loss trends and loss development or are only industry standards being used? While the answer typically depends on the credibility of a company's loss history, a blend of industry and the company's own history may not be inappropriate. It is also important to understand any "cushion" or contingencies that might be included in the loss estimates. If the program incurs a large loss, what will the impact be? How conservative is the estimate of losses underlying the letter of credit? Is the collateral estimate fair? An outside, independent review will shed light on these questions.
Looking "through another's eyes" can help parties promote additional and alternative considerations and solutions for a self-insured program. After discussions, it may be decided that more frequent evaluations or monitoring of results are necessary. Doing so allows one to examine how results are changing and provides the opportunity for a mid-course correction. At the end of the day, a risk manager should feel comfortable that any outside party is performing at a satisfactory level and meeting the goals and needs of the program.
Ready for the Road Ahead
The insurance industry has historically cycled through both soft and hard markets. When prices are low the cost of insurance may not be at the top of the list, but it is the perfect time to prepare for when those prices will increase. Proper action taken today can provide significant cost savings in the future. Moreover, many of these cost-saving actions can be executed quickly and with very little cost so a more frequent review of these actions is not unreasonable.
A risk manager may want to consider creating a checklist of items in order to review the goals and business plan of the risk management program. What works best for one company may not be the best for another so customization is always recommended. For example, through a self-insurance checklist, a company may unbundle activities that were previously combined, which creates a higher level of intelligence about the particular operations of a business. Knowing its strengths and weaknesses can provide an advantage to internal and/or external resources, which in turn will contribute to the bottom line.
To ensure the insurance program is running at full efficiency and properly focused, outside sources such as brokers, TPAs or actuaries can provide expertise and empirical support. In the post-Sarbanes-Oxley world, a risk manager may value independence in order to make sure all parties' interests meet those of risk management and provide full transparency. By utilizing this expertise and independence, a risk manager can confidently lighten his or her load.
With the right assistance, a risk manager can "get under the hood" of the insurance program and be better equipped with the knowledge of what actions today will best manage the expected hard market journey ahead. After implementing your checklist, you will be more assured that your program is ready to withstand the ever-changing needs and future challenges.
Richard C. Frese, FCAS, MAAA, is a consulting actuary in the Chicago office of Milliman.