What business insurance deductible should we be offering?

It has become apparent to me that there is little logic applied to both the deductible offered and bought by clients.  It’s also quite clear deductibles are usually viewed as a negative feature as something that should be negotiated down or out.  Its logic is severely flawed.

Before you can truly determine what an appropriate deductible is, you need to first understand that insurance is purely a necessity.  It is something you must have to protect you from fortuitous events you cannot prepare for.  Premiums are money spent to help you sleep at night, not to allow you to eat well.  Therefore, premiums need to be minimized, reduced to the lowest possible level while providing the protection to avoid financial catastrophe.  Money spent on insurance is poorly spent money because there is no return on it.  Once it’s paid you never get it back.  It is water over the dam, gone for good without any positive benefits provided.  That is unless you have an unfortunate incident and then the role is to put you back where you were before.

Conversely, deductibles are things to be maximized and not minimized!  Yes, I said maximized.  It sounds weird or insane, but it’s true.  Let me explain.

I’ve spent countless hours counseling agents and insureds about this concept.  Often insurance is not the best risk management tool.  In fact, it should be the last option to protect against risk, except for avoidance.  Other methods of risk financing need to be considered before insurance.  If other methods can be used to finance protection against risk, they are inherently more effective than insurance.  The reason if insurance is purely an expense.  Once a premium is paid, it’s gone like water under the bridge!  In addition, insurance also carries a significant expense load.

Potential losses can be financed through a variety of options.  Potential losses can be budgeted for.  Clients know a risk exists.  Money can be set aside for potential loss.  They can be included within operating budgets.  Losses can be financed through loans to be paid back over time.  Any of these options is better than purchasing insurance for a couple of reasons.  The first is if the loss does not occur, they are not out of the money.  Secondly, the insured is not incurring the expense loading of an insurance contract.

Consider this.  If a business incurs $25,000 property loss every 5 years, insurance companies will in theory charge for that loss to occur every 5 years and build expenses on top of it based upon an expense & contingency ratio of 35% to 45%.  Therefore, the insurance company is going to need to charge between $38, 462 (=25,000/(1-.35) and $45,455 (=25000/(1-.45) producing an average annual premium of between $7,692 and $9,090.  Conversely, if they simply budget for the loss they’ll only need to set aside $5,000 each year, but with the benefit, if they prevent the loss from happening, they’ll still have the money.

In this example even if it happens early in the 5-year period and they need to finance it through a loan of some sort it’s going to be less.  If the company borrowed $25,000 with a 10% interest rate and amortized it over 5 years, the cost would be significantly less as the sum of those payments would only be $31,871.  So, the point is, if you can handle risk in another fashion do so.

This is an important concept when you consider what size of the deductible and insured should select.  As agents and underwriters, we are charged with creating the most cost-effective manner to manage risk.  So, I return to the statement I made before, deductibles need to be maximized to help clients get the most cost-effective risk management program.

However, many agents and underwriters would argue with m, saying the savings don’t justify the higher deductibles. While larger deductibles do generate premium savings, the discounts don’t seem large enough to justify selecting a larger deductible.  This is a frequent and strenuous argument against an insured purchasing a higher deductible. However, it is an argument that is based on a common misunderstanding or incorrect view of the facts.

Here are a few truths about property deductibles.  Smaller businesses get a higher percentage discount than larger property risks, but large insureds risks get a larger premium discount.  To illustrate this let’s consider two different risks located in the same building.  Assume they are both clothing retailers.  The first is a small boutique with $250,000 in stock. The second is a large retailer with $5,000,000 in stock.  Let’s assume the combined property rate is .200 per $100 of value with a $500 deductible and a 50 percent split between the fire portion (Group I) and other lost causes.  Both insureds want to consider a $5,000 deductible.

Based on ISO rating, the first account (the boutique) would receive a 21% credit on the group I (fire) and 41% credit on the rest of the property premium.  They will receive a $155 credit which represents an overall rate credit of about 31%.  The marginal rate for the lower property deductible is 3.44 per $100 of insurance.  Can you really recommend a limited amount of property insurance for such a high rate?

The large clothing retailer would receive a 5% rate credit on the group I and 16% credit on the balance.  Their premium would drop from $10,000 to $8,950, which represents 10.5% premium credit.  The marginal rate for the $500 deductible is 23.333 per $100 of insurance, while the rest is at a rate of .179 per $100 of insurance.

Both examples demonstrate why we need to be recommending higher risk retention levels.  If we were to look at various layer pricing of casualty lines, we would see a similar pattern emerge.

Our goal as insurance and risk management professionals is to help our clients manage risk in the most cost-effective manner available.  In some and probably most cases, insurance is usually the best way to go.  However, in others, it is not.  Therefore, our discussions with clients should be centered around creating a structure that reduces net costs.  In order to do so, we need to dig into their financial condition because without a clear understanding of how much could they afford to lose if an unfortunate event occurs, we are not truly designing programs that best deal with risk.

 

About Richard Faber

Richard thinks of himself as the underwriter’s underwriter. For almost 40 years, He has underwritten and managed commercial lines underwriting departments for a variety of organizations including large national carriers, MGA’s, specialty carriers and surplus lines carriers. He has helped major organizations develop cost-effective risk management programs through the use of captives, large deductibles, self-insurance and retrospective rating plans for high profile organizations such as Major League Baseball teams, NFL teams, major automobile manufacturers, consumer electronics companies, and national retail chains. In 2018, Richard retired from active underwriting to form Underwriter’s Resource, LLC, an organization dedicated to enabling agents improve their delivery of commercial insurance though improving skills and by creating computer programs to reinforce those skill. Richard enjoys sharing his knowledge, wisdom and expertise and can be contacted via email at Richard.uwresource@cox.net.

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