White paper: Casualty When to consider a loss-sensitive casualty program structure By Doug O Brien, National Casualty Practice April 2015
Most middle-market companies have guaranteed-cost programs for primary casualty insurance. In these programs, also called first-dollar programs, you pay a fixed premium in exchange for full coverage of a loss, including damages, defense costs, claims handling, and other costs. Companies have historically preferred the convenience and budget stability of these programs. Plus, the entire premium is a potential tax deduction, there are no collateral requirements, and the insurance company is somewhat motivated to help you control losses. However, times have changed. Today, during this tightening market, insurance companies capacity for these programs is decreasing and premiums are increasing especially for workers compensation due to a number of factors which is creating volatility in pricing from one year to the next. As a result, many companies are considering a loss-sensitive program instead. With this structure, you pay a lower premium in exchange for partial coverage of a loss in excess of a deductible borne by the insured, and you can further reduce your retained costs by improving safety and claims-handling procedures. For many companies, loss-sensitive programs are proving more cost-effective than guaranteed-cost programs. Organizations choose to retain risks for several reasons, and moving to a loss-sensitive program is not an easy decision. As you evaluate your options, it s important to consider the differences between guaranteed-cost and loss-sensitive program structures. Drawbacks of guaranteed-cost programs In the Wells Fargo Insurance book of business, guaranteed-cost programs account for 65% to 70% of the primary casualty structures for middle-market companies with average revenues up to $250 million. Although there are many benefits and they are suitable for many organizations, these programs also have several drawbacks: Price swings. During hard or tightening market cycles, guaranteed-cost programs can experience significant swings in premiums, carrier appetite, and degree of coverage. Reduced benefit for good loss experience. Many lines of business are rated by class, so you may not get credit for your historically favorable loss experience. And, if you do, it may be delayed. In workers compensation insurance, for example, experience modifications take a number of years to capture the impact of good loss experience and many carriers are eliminating optional schedule credit modifications. Less control over your costs. In a guaranteed-cost program, you have less control over claims handling, and you have less incentive to maintain safety standards since your insurer will cover any loss on a first-dollar basis. Less cash flow for you and more profit for the insurer. Since you pay your premium up front, any investment income on that money goes to the insurer not to you. Furthermore, for each dollar of guaranteed-cost premium, approximately 60% is intended to pay losses, while the remaining 40% goes to fixed costs, such as taxes, claims handling, loss control, administration, and broker commission. If your losses do not exceed 60% of the premium, then the insurer makes a profit. (In a loss-sensitive program, on the other hand, the more you can impact the expected losses and the fixed costs through proactive loss control and claims management, the more you can reduce your total cost of risk over the long term.) The advantages of loss-sensitive programs Compared to guaranteed-cost programs, loss-sensitive programs require you to bear some portion of the loss usually on a vertical, per-occurrence basis. Some losssensitive programs have a built-in maximum premium or provide the option to purchase an aggregate stop loss, which will cap your retained losses (please see the exhibit on page 5 for a comparison). This structure can provide several advantages: Lower premium. In exchange for bearing some portion of the loss, you receive a 20% to 70% credit on the guaranteed-cost premium. Your premium depends on the line of coverage, the amount and type of loss you retain, your company s historical and future loss profile, your initiatives for loss control and claims handling, general market conditions, and other factors. Although there are programs with small deductibles ranging from $1,000 to $25,000, you will derive the most premium savings by taking on higher retention levels at $50,000 or more. Wells Fargo Insurance white paper: When to consider a loss-sensitive casualty program structure April 2015 2
Savings through loss control and claims handling. In addition to taking a higher retention, you can further reduce your costs by preventing losses, since any reduction in losses below the chosen retention level accrues directly to you not the insurance company. When you pay the majority of your own losses, you have a clear and immediate incentive to prevent losses in the first place and, if they occur, manage them more proactively through aggressive claims handling, return-to-work programs, managed care, and other initiatives. Any reduction in loss has a direct impact on your bottom line. Improved cash flow and investment income. Losssensitive programs can be structured on a pay-asyou-go basis, which enables you to improve cash flow and receive investment income on the loss reserves instead of giving them to an insurer. Price stability and lower cost of risk. While losssensitive programs will not eliminate pricing volatility entirely, they can help reduce the swings in pricing that often come with guaranteed-cost programs. In addition, over several years of good loss experience, effective loss control, and proactive claims management, you can often reduce your average total cost of risk versus a guaranteed-cost structure. Of course, in any given year, the total cost of a loss-sensitive program may exceed a guaranteed-cost premium; nevertheless, companies that switch to loss-sensitive programs are usually satisfied with their decision. Types of loss-sensitive programs Middle-market companies have access to several different loss-sensitive programs, including: Dividend plans Deductibles (paid and incurred) Retrospectively rated programs Captive reinsurance Self-insurance (more common for general and product liability; less common for workers compensation and auto liability) When to consider a loss-sensitive program While there is no specific rule of thumb for determining the right kind of program for your company, it might be wise to consider a loss-sensitive structure if one or more of the following applies: Your guaranteed-cost premium is high relative to the expected losses. Your aggregate loss experience at various retention levels by coverage line is fairly predictable year over year and can be actuarially measured. Review of prior losses is usually a good gauge of the future. You understand the potential severity for aggregate and large losses. Your company has the financial capacity to assume the maximum amount of retained losses within a given policy year and over a period of years. There are no contractual requirements that prohibit your company from assuming a certain level of risk. Your company wants a financial incentive to control losses and manage claims. Your company can post collateral in the form of a letter of credit, cash, or other vehicle. A guaranteed-cost program is not available. In addition, consider how peer companies are structuring their casualty insurance programs, and work with your broker to analyze the suitability of a loss-sensitive program. Wells Fargo Insurance, for example, can help you in your decision by offering: Loss forecasts and variability studies Risk-retention analysis to help you determine the optimum per-occurrence retention levels, maximum premiums, and the impact that accruals for retained losses will have on your balance sheet Calculations of the compounded savings expected over a multi-year period in varying loss scenarios Evaluation of pre-loss efforts, such as safety initiatives and other loss-control programs Evaluation of post-loss efforts, such as claims handling, managed care programs, and return-to-work initiatives Wells Fargo Insurance white paper: When to consider a loss-sensitive casualty program structure April 2015 3
Analysis of additional administration needs Evaluation of different loss-sensitive program structures Assessment of insurance companies, claims handling companies, and loss control specialists Conclusion How can we help? For more information on this topic, please contact your Wells Fargo Insurance sales executive, or: Douglas O Brien 212-209-0253 office doug.obrien@wellsfargo.com As companies see higher insurance premiums and reduced capacity from carriers, loss-sensitive programs are becoming an important alternative to guaranteed-cost structures. While loss-sensitive programs can result in a higher cost than first-dollar programs in any given year, loss-sensitive programs tend to be more cost effective over time, especially for companies that remain proactive with respect to controlling losses and managing claims. Wells Fargo Insurance white paper: When to consider a loss-sensitive casualty program structure April 2015 4
Exhibit Guaranteed-cost program Individual claims or occurrences Losses paid by carrier Loss-sensitive program Individual claims or occurrences Losses retained by ABC Losses paid by carrier Limited or unlimited Primary limits Primary limits $250,000 $250K level $250,000 $250K retention level Losses collateralized Loss amount negotiated separately Losses within policy year Losses include defense costs and claims handling Losses within policy year Need to negotiate inclusion of defense costs in losses. Claims handling costs usually in addition Optional aggregate protection This material is provided for informational purposes only based on our understanding of applicable guidance in effect at the time of publication, and should not be construed as being legal advice or as establishing a privileged attorney-client relationship. Customers and other interested parties must consult and rely solely upon their own independent professional advisors regarding their particular situation and the concepts presented here. Although care has been taken in preparing and presenting this material accurately, Wells Fargo Insurance Services disclaims any express or implied warranty as to the accuracy of any material contained herein and any liability with respect to it, and any responsibility to update this material for subsequent developments. To comply with IRS regulations, we are required to notify you that any advice contained in this material that concerns federal tax issues was not intended or written to be used, and cannot be used to avoid tax-related penalties under the Internal Revenue Code, or to promote, market, or recommend to another party any matters addressed herein. Products and services are offered through Wells Fargo Insurance Services USA, Inc., a non-bank insurance agency affiliate of Wells Fargo & Company. Products and services are underwritten by unaffiliated insurance companies except crop and flood insurance, which may be underwritten by an affiliate, Rural Community Insurance Company. Some services require additional fees and may be offered directly through third-party providers. Banking and insurance decisions are made independently and do not influence each other. 2015 Wells Fargo Insurance Services USA, Inc. All rights reserved. WCS-1184719 (05/15) Wells Fargo Insurance white paper: When to consider a loss-sensitive casualty program structure April 2015 5