Focusing on Lowering the Total Cost of Risk, Not Just Finding Cheaper Insurance

Editor's Note: In this Thought Leadership article, Jeremy Colombik, managing partner at Management Services International, and Adam Perea, executive vice president of captive programs and services at Elite Risk, explore how insureds can lower their total cost of risk.

When an insured finds itself in a hard insurance market, the business is faced with increasing premiums and often larger retentions affecting the business's total cost of risk. Owners will turn to the insurance broker to market the insurance program, looking for cheaper insurance in the form of reduced premiums or lower retentions.

It is easy to get caught in the cycle of constantly shopping for lower premiums to keep insurance costs as low as possible. Captive insurance managers are working to change the way some people buy insurance by focusing on lowering the business's total cost of risk rather than hunting for lower premiums.

As an insured begins to evaluate the total cost of risk for its program, the insureds must evaluate several factors outside of the premium spend. When an insured chooses to take control of the insurance program, the business should have options to take as little, or as much, risk as it is comfortable with within its budget.

Taking control of risk gives the insured the ability to custom manuscript policies, allowing it to cover what is needed and to not be charged for unneeded add-ons or sublimits. When manuscripting policies, this gives the insured the opportunity to insert professional service providers.

Contributing factors to an increased total cost of risk calculation are the allocated loss adjustment expenses and the incurred loss payout. There may be times a business deems a claim to be baseless and the business wants to fight it, only for the insurer to settle the claim and approve a payout. Based on a business's retention, this can impact its total cost of risk by increasing the amount above premiums paid that the insured contributes to the settlement. By inserting their desired legal team and other third-party administrators, businesses may have the ability to fight claims or achieve reduced settlements.

Forming a captive insurance company can assist an insured in taking control of its risk management program by taking on a portion of the commercial program either through a deductible reimbursement policy, quota share arrangement, or a reinsurance agreement. Getting 5 years of premium history and 5 years of loss runs can be beneficial in helping the captive manager do a loss stratification report showing how much the business would have paid in the business's retention layer.

An important part of this exercise is to understand how much the business would have paid at different retention layers. We can look at deductible schedule credits and see how much premium is attributed to each layer of losses and begin to hone in on the optimal retention layer for a client's program. Two factors to look into while performing this exercise: (1) the amount of scheduled credit premium the business gets for taking on the amount of risk and (2) the amount of losses that are in that layer. An insured may not choose to take on a certain retention layer if the schedule credit premium is not large enough; conversely, a client may also not choose to take on a certain retention layer if losses exceed the schedule credit premiums.

Performing a deductible optimization is one tool businesses can utilize to help select the right retention layer for a client's program. While past results don't dictate future success, we can use that as a baseline to see how the business's insurance program has performed over the past 5 years. We can use this data and pair it with a captive insurance company and run a 5-year hypothetical proforma to see how the business could benefit from taking on more risk over the next 5 years.

Partnering with the right insurer is crucial to a business's success. Many insurers will require collateral in the form of a letter of credit, or cash, to enable a business to take on a larger retention or reinsurance position in their client's own insurance program. Insurers do this to protect their credit risk in the event of an insured default or inability to pay any claims assigned to the deductible layer.

As the commercial insurance market continues to harden and insurers begin to pull out of different industries, finding coverage becomes more and more difficult. Using a captive insurance company to take on more of a business's risks starts to make the business less reliant on the commercial market. The less reliant the business is on the commercial market, and the more control the business exerts over the programs, makes the renewal process less frustrating and a lot smoother.

Grabbing control of the business insurance program is not a short-term solution, and the business may not see immediate results. Being committed to controlling a business insurance program is a long-term play. Also, if the program is structured correctly, the business should start to see a decrease in its total cost of risk in the long run. Beyond lowering the total cost of risk and premiums, the business may take better control of its insurance program as well as its risk management program, allowing the business to share in the underwriting profits that the commercial insurance company otherwise would have kept.

Even as the commercial insurance market starts to soften, the business will still be able to take advantage of controlling the business insurance program and continue to enjoy a lower total cost of risk by constantly improving business risk management protocols.

Having a captive insurance company as part of the insured's risk management program can provide many benefits both in the short term and the long term. Using a captive insurance company to insure part of a business's commercial program can provide financial benefits as it can be used as an efficient tool to build up a surplus that can be used to pay claims in an adverse year. Captive insurance companies provide flexibility to insure risks for which coverage is not currently available in the commercial market or may have been deemed too expensive to purchase through the commercial market. Once the business has an established captive insurance company, it may be able to write insurance policies that are crucial to the business and may only be needed for 1 year or a short policy term.

Many companies that had a mature, well-structured captive were able to weather the storm of the most recent black swan event created by the COVID-19 pandemic. Having a healthy surplus enabled many of these companies to stay open while some had to shut down due to lack of resources.

Having an experienced team of advisers and the right resources is crucial to businesses making the decision to take control of their insurance program and begin the journey to lowering their overall total cost of risk.