Once upon a time, there was a little girl named Goldilocks and her friends, the three bears. The bears lived in a cabin in the woods. Fearing windstorm and hail damage, but wanting to save money in fifteen minutes or less, Papa Bear asked Goldilocks, "What size deductible should I carry on my homeowners' policy?"
Goldilocks replied, "$100 is too low, $1000 is too high but … hmm, $500 is just right!"
Though you will never encounter her at the annual RIMS Conference, Goldilocks was perhaps the quintessential risk manager. She sought to minimize her risk — seeking porridge that was neither too hot, nor too cold but … just right.
Moving from fairy tales and into Real World 101, risk managers can relate. Perhaps few decisions by risk managers are fraught with as much uncertainty as setting the right level on deductibles or self-insured retentions (SIRs). Set them too high, and the company may be financially strapped trying to fund for losses. Set them too low and you risk merely "swapping dollars" with an insurer, wasting money on unneeded layers of financial protection. The key is to be the risk equivalent of Goldilocks and find a monetary retention level that is just right.
No one size fits all and no pat answers abound, but here are some questions to ponder as the risk manager tries to set the right retention levels:
What is the downside risk of guessing wrong? It's one thing to self-insure plant, equipment, or property items which can be more easily replaced, items whose value can be calculated to the near penny. It's altogether different to self-insure for, say, product liability or pollution liability when the financial tab may be millions. Here, unlike in some property risks for example, guessing wrong and setting low retention levels may court bankruptcy.
What is the insurer's comfort level? Hey – it's not all about you. Just because you want a high retention does not necessarily mean that you will get it. The higher the retention desired, the more exacting the underwriting criteria and process. Why? Insurance companies are concerned (if not downright paranoid) about the prospect of a policyholder not having the financial wherewithal to shoulder its retention, and a court coming along after the fact and making it drop down to provide primary, first-dollar coverage. To insurance company management, this scenario is as welcome as Michael Vick at an SPCA Convention. Thus, any insurance company that you approach about a retention, especially a high retention, will want to see your balance sheet and verify that you have the financial strength and liquidity to fund the desired retention level.
What are your company's financial resources? Your company should have the financial strength, health, and balance sheet to absorb the financial hits that may come from the retention level the risk manager selects. Further, the risk manager must make sure that there is sufficient liquidity in the financial assets to allow funding of the retention levels. It helps a risk manager little if the company is in great financial shape, but most of the assets are tied up in real or personal property. Not only asset size but asset liquidity is key to determining the comfort level with a menu of retentions.
What is your loss history? Another crucial factor to weigh is your loss patterns and history in a particular line of coverage. Your appetite for retention may inversely correlate to your loss frequency and severity in any given line of coverage. The more losses and more severe losses you have, your appetite for retention should be moderated. The fewer losses and small degree of loss severity might drive an appetite for higher retention levels.
What is upper management's appetite for, and tolerance of, risk? How much does your upper management value a good night's sleep? (No, we are not talking here about Ambien or Tempur-Pedic mattresses.) Instead, we are talking about upper management's tolerance for financial uncertainty. Some CEOs are comfortable with pushing the envelope, trading off premium savings for higher retentions. Other CEOs and executives are wary of exposing their firms to sizable financial hits that they may or may not be able to weather. The point here is not that one philosophy is by definition good and the other is bad, only that the corner office's perspective should impact the risk manager's marching orders for high retentions or low retentions.
Retentions are a matter of degree, not either/or. At the one extreme is first-dollar coverage with no deductible or retention whatsoever. At the other extreme is pure self-insurance, where a risk manager opts to totally forgo buying insurance. In this discussion, retention blends a happy medium between the two extremes, a way of combining insurance with self-insurance.
Broker's Role in Giving Input
Don't overlook your insurance broker as a resource in helping you set the right levels. Chances are the broker has worked with other clients on this issue and this is not a novel exercise. The broker cannot make the decision for you, but might provide input as to the degree of financial retention that your company should consider shouldering, whether it is on your flood coverage, directors and officers (D&O), or fleet automobile exposures. Ask your broker to do some analytical work and make a recommendation for what you're retention should be. In some cases, the risk manager may even want to engage a consulting actuary to help recommend retention levels. (Caveat: since broker commissions tend to be tied to premium levels, some argue that brokers are biased in favor of insurance over-retention.)
Also, "high" or "low" in the context of retention levels may vary depending on a company's size and financial wherewithal. For some firms, a $50,000-per-occurrence retention might be a sizable amount. For a Fortune 500 enterprise, by comparison, that level would be a pittance and its retention might easily start in the millions. Size matters, but in retaining financial risk, it is also a relative concept that may hinge upon the size and financial strength of the company under consideration.
Setting retention levels, and the tradeoffs involved, are not unique to those with the words "risk management" in their job titles. We all likely wrestle with retention decisions in our own lives and with our own insurance coverages. Do we notch up to a $500 deductible on the SUV or go even higher to bring down the cost of our policy? The $1000 deductible on our homeowners' policy captures meaningful premium savings. If I have a loss, though, do I have the dollars available to shoulder that deductible? In "cafeteria" style employee benefit plans, some workers may be able to set higher or lower deductibles, depending on how much they are willing to pay in health-care premiums and their own assessment of their likelihood of needing to tap into health coverage due to illness or injury. Hmmm, should we buy the extended warranty on the new Kenmore fridge or "retain" the cost of repairs if it conks out one day after the standard warranty expires?
Setting retention levels is not an endeavor unique to risk managers, but one that looms in our everyday lives. The stakes are higher, though, with many more zeroes at risk in the realm of the risk manager. Failure to get it right could spell bankruptcy for the company or unemployment for the (former) risk manager.
Use these tips and questions — as Goldilocks would say — to get it just right!
Kevin Quinley is a claim executive in the Washington D.C. area. You can reach him at kquinley@cox.net or at his web site, www.kevinquinley.com.
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