My favorite analogy is the game of musical chairs. In this game it is always your goal to make certain you have a chair when the music stops. The same holds true when it comes to insuring your business. When a claim happens, (music stops), you want to be certain you have a chair, (insurance coverage or pool of capital other than your own). With poorly designed insurance coverage, the chances of you having a chair when the music stops diminishes greatly, putting your company at substantial risk of financial loss.
Soft markets are supposed to be a boon for purchasers of insurance products, however this market is substantively different, and not in a positive way for clients. Insurance carriers have figured out that the insurance buying pubic has a blind spot, and that blind spot is understanding how much of their business risk they retain, versus how much they actually transfer to an insurance carrier for a negotiated premium.
An example of a claim you might not retain is Products & Completed Operations exposure. An example of this may be years after a project is completed it’ determined that the wrong bolts were used to fasten railing to the stairs. Instead of galvanized bolts, which were called for in the drawings, untreated bolts were used, which eventually rusted. The corrosion weaken the bolts to the point where the railing that was fasten with the bolts eventually snapped off injuring a child. The cost to defend that suit, and ultimately the judgment should you lose could be financially devastating if you had to pay that out of pocket. Since the severity of the risk may be too much for you to retain, you make certain that exposure is transferred to an insurance carrier, so if the music stops, your company has the chair.
What you purchase when you buy insurance is a contract. Depending on how broad, or how narrow that contract is written will ultimately determine if what ever unfortunate event that has just occurred will be paid with your money, or the insurance carriers. People fact that fact and just focus on how much the "insurance contract " costs. Worse than the general public’s blind spot, is the large amount of insurance brokers or advisors that focus all the attention on the premium the clients pay, without balancing the amount of risk the client actually retains. In short they fail to properly address or overlook the holes in coverage, downplaying the ramifications of a claim denial, instead focusing on the short term often illusory gain in the cheaper cost of the insurance. Some insurance brokers do it so they can simply book the deal, others don’t even realize the holes or gaps in coverage themselves, leaving the insurance buyer at great peril.
Cost of Risk Equation
Here is my formula for greatly increasing your chances of always having a chair when the music ceases :
Cost of Insurance + Unpaid Claims (including legal and adjustment fees) = Cost of Risk. The Cost of Risk formula is one of the most important fundamental tools risk managers around the world use to decide how to allocate risk. Whether you are the risk manager for Exxon Mobile , or evaluating a small town bakery on Main St the science is the same. Do you retain the risk, transfer the risk, or abstain from the risk all together. These three allocation methods are essential for understanding and arriving at a level of risk your company can and will accept. We call this your “risk appetite”.
Too often when consulting with various businesses throughout the NY Metropolitan area the single most important factor they use to evaluate, and purchase insurance is the price or premium for the coverage. They only have half the information, and more often than not they arrive at an un-informed or wrong answer. Fortunately, or unfortunately contingent on where you stand, the true answer only manifests itself if your company has an event (music stops), and your insurance purchasing decisions are put to the test. Many companies can go years before their errors present themselves in the form of on balance sheet realized losses that can severely hampering their competitive position in the market place or worse, force them to leave the marketplace all together. At that point their education has become very expensive.
It may seem a fundamental axiom, however it’s irrefutable, you can’t manage what you don’t know, which is why it’s essential to have a feel or grasp of what you and your insurance advisor perceives are the greatest threats to your business. We typically create a risk profile with the clients to get a feel for what they do, how they do it, and overlay what we see are the potential dangers that threaten the business or Quantifying the Exposure. Any strong insurance advisor or broker can and should take the lead on building this risk profile which should be the blueprint for your insurance transactions.
After you have made your “Keep Me Up At Night List” of potential threats and dangers, decide which of those risks you want to retain, and which you would prefer to transfer to an insurance carrier, and at what cost. An example of a risk you might retain is any property damage claim under $10,000. You wont’ put a claim in for that anyway, so why retain it yourself, and get a cost savings on the insurance. A small claim like that might be an inconvenience, but it’s not lethal
Hopefully I have illustrated my point that you must understand what your potential exposures are, ( Keep Me Up At Night List), and then decide what which ones you are transferring and which you are retaining. It’s the risk that you are retaining that drives the Cost of Risk.
Consider this example:
ABC Development Company just saved $50,000 on their general liability premium because they went out to bid soliciting quotes from 3 outside brokers, plus their incumbent broker. After reviewing the 4 proposals they chose the cheapest quote, not picking up on the fact this quote had only a 3 year products & completed operations extension, where the incumbent had 6 years, or alternatively they did pick up the difference but decided that the premium savings was too enticing not to pocket, so they “took their chances, optioning for the short term benefit of a premium reduction.
Five years later the bolts snapped off, sending a child down two stories resulting in serious injuries.
Here is the Cost of Risk scenario broken out in two ways:
OPTION A : ABC Company chose the longer Products & Completed Ops coverage transferring the risk to the carrier.
OPTION B: ABC Company chose to retain the Products & Completed Ops exposure by only going out 3 years, anything after 3 years they would cover themselves.
Hindsight being 20/20 you would think the choice would be obvious, sadly too often it’s not. I have actually sat in front of companies that have been thru this very scenario, and will still try and debate me as to why they should continue to retain certain pieces of risk, even though the financial consequences to them were significant.
They say you can only help those that help themselves. Even if you are well capitalized and a loss like this won’t hurt you, from a business standpoint, you would have to go out over 20 years to break even on the above example. The label sucker bet seems to jump out at me when I see things like this which is exactly what the house(insurance carriers) are counting on!
Quick Tips To Assist In Evaluating Your Insurance Quotes
• 1) Have a checklist (Keep me Up At Night List) prepared. If you don’t have one, solicit help from a broker or third party consultant. I have provided my own evaluation list I custom tailored for my G.C. & Developers. It’s a bit technical, but it’s comprehensive and a great starting point.
• 2)How does each carrier address these exposures, or don’t they? What is your company retaining here, at what potential future cost? What are the consequences of loss, and can your company absorb it?
• 3)What is the discount you are getting from the competing carriers to retain exposure? On a worse case basis, how many years out are you before you break even on the discount you received versus a potential claim payout?
• 4)Erase the premium charged, and swap the proposals between two of your preferred brokers and have them criticize the other proposal. Also ask them for things they like about the proposal, (check their bias question).
• 5)Weigh the arguments on both sides, and list them.
• 6)If the answer is still not obvious, float the question and supporting documents to both your attorney, and perhaps your accountant for their view. Take with a grain of salt both opinions as they are not experts in insurance. You value their business acumen, but their true knowledge in this arena is limited. Too often companies rely on legal council that is short on all the facts and expertise. Don’t ask your insurance advisor for legal advice, and vice versa.
• 7)If you still have an issue, hire a risk consultant to evaluate the proposals for you so you may make an informed decision.
The knowledge you will get from the process, if structured properly will be invaluable. It will be the template for your organization going forward for years to come. It will make not only the insurance procurement process simpler and less painful, but you will arrive at a very informed answer. To evaluate any insurance purchase without using the Cost of Risk method is simply rolling the dice with your companies financial and competitive future.
