The Opportunity Cost of Price Shopping
September 2005
Too much emphasis on price leads to procurement
creep. How much can you reasonably expect to save? What are the opportunity
costs?
by Gary
J. Bausom
Bausom & Associates, Inc.
If a risk manager is able to realize reduced pricing for a renewal, what
are the implicit expectations of management for the following year? More importantly,
what is the risk manager "selling" his or her boss? Has the risk manager tied
the firm's future and their value proposition to pricing?
Considering comparable programs (limits, deductible, insuring agreement and
loss experience), within any industry group, the premium is likely to vary less
than 5 percent. As a risk manager representing a single corporation, how much
influence can be exerted over the pricing of insurance? Perhaps about as much
influence as a corporate treasurer, individually, has over interest rates.
Price concessions are more likely to be obtained by demonstrating that a
risk manager's team has a solid understanding of the firm's businesses and the
inherent risks, and that they can effectively communicate their risk management
strategy. Underwriters focus, with any degree of depth, on an account for approximately
2 weeks out of a year, so they want to know and be able to assess the capabilities
of those who are managing the account the other 50 weeks.
Shopping for underwriters who are willing to provide price reductions is
fraught with opportunity costs and inhibitors to career growth for the risk
manager. Time spent on pricing means less time for understanding your firms'
businesses, risks, and validation of the same with management. Pricing needs
to be within a market range for the risk factors and industry exposures and
can be validated without shopping the risk. Pricing is not the #1 priority.
The more time spent trying to control pricing, the greater the opportunity
costs.
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Procurement creep
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Management's perception of a risk manager's value
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Policy rescissions
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Risk transfer cost versus financing expected losses and services
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Availability of coverage not only determined by price
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Cost of underwriter turnover in a world of short supply
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Procurement Creep
Smart risk managers will not sell price to their management nor be deceived
by their direct and immediate influence over such matters. The key selling points
should be the risk manager's understanding of the corporation's risks and contribution
in helping to manage those risks; a small part includes insurance.
Insurance, e.g., risk transfer, is purchased to provide catastrophic financial
protection for the corporation and the price is tertiary. In an insurance context,
it would seem that large blocks of capacity from each participating underwriter
and the underwriter's credit quality are more important as compared to price.
Given a significant loss, $10-$100 million or more, the boss is not likely to ask, "How much did we pay
for insurance?"
A procurement function lines up vendors, qualifies them, and then conducts
some form of a reverse auction. Any risk manager who follows this prescription
using price only, regardless of the labels used, is likely to be quickly "out
gunned" by corporate procurement. This can and in some cases has led to corporate
procurement buying insurance.
Procurement lacks the knowledge and experience to navigate insuring agreements
(terms & conditions) or to be on top of the custom and practice for corporate
insurance matters. Even attorneys who do not specialize in insurance law find
insurance policies to be a challenge. Corporate insurance contracts are not
standardized like personal lines, homeowners, and automobile insurance.
By emphasizing the management of risk and opportunity, the risk manager will
be able to demonstrate his or her value well beyond price shopping. From a value
add and focus, management's contribution does not revolve around price and that
is why procurement still reports to general management. Put price in the "backseat."
Management's Perception of a Risk Manager's Value
Management's #1 question when a significant event
occurs: "Do we have an expense or a receivable?" Management's perception
of the risk manager's personal stock price revolves around the stated objectives,
deliverables, and priorities of the risk management function. What is the theme
of the conversations, e-mails, and correspondence from the risk manager to management?
Are the messages directed to understanding and helping to manage risk? Is any
reference to price a subordinated issue?
The common denominator between management and risk management should be the
understanding of the enterprise's various businesses, the associated risks and
the likely impact to the firm, and what management actions are prudent. A sound
process needs to be in place for selecting, using, and evaluating vendors' objectives
and deliverables.
Policy Rescissions
Circumventing insurance application questions is not a viable option to reducing
premiums as it could result in a rescission of the insurance contract. Obtaining
a lower premium based on limited disclosure may result in no recovery and is
not a bargain. The burden of proof is on the insured as it respects full and
complete disclosure and the courts do not accept a plea of temporary amnesia
on the part of the insured.
Most of us have read trade press stories of rescissions of D&O policies.
It is happening in other lines of insurance as well. (See James E. Mitchell et al. v. United Nat'l Ins. Co.—California
Court of Appeal, Second Appellate District, Division Five affirmed and enforced
California's Marine Rule).
Risk Transfer Cost versus Financing Expected Losses and Services
In the "heat of the battle" it seems to be all about price. So, what is driving
pricing? What about the insurers' costs for the rental of capital to support
risk transfer and services being rendered (claims, reporting, legal filings,
payment of taxes, loss control, etc.)? Cost of insurance should be judged considering
capital, expenses, and profit.
Insurance is a pooling device for transferring risk and not necessarily a
vehicle for funding expected losses and/or services. Insurance companies, like
other businesses, have overhead and are generally interested in making a profit.
As a result, they need to recapture their costs and load an allowance for profits
into the premiums charged. Financing expected losses through an insurance company
might not be the most efficient solution. There are other reasons for purchasing
insurance: to obtain a buffer from third parties, compliance with business contacts,
as well as meeting financial responsibility laws.
The ultimate objective is to secure large blocks of capacity, with mutual
understanding, from the fewest number of underwriters with the highest credit
quality available. Credit quality is a key factor in an underwriter's ability to pay and there is no discernable
up-charge for better credit quality. A mutual understanding (the insured and
the insurer) of the risks transferred translates into an underwriter's willingness to pay. Risk managers also need
to consider the "DNA" match between their own organization and each of the underwriting
firms with which they choose to do business.
Upward insurance market pricing, to a degree, factors in large losses but
not necessarily events like Hurricanes Katrina and Andrew, the World Trade Center,
Bhopal, etc. A significant event or two will precipitate a general price increase
in a segment of the market, if not the entire market. Downward pricing of insurance
is precipitated by higher interest rates. Generally, the higher the interest
rates, the lower the premiums. This is due to the insurance company's greater
"pick-up" on investment income, which translates directly to bottom-line profits.
Availability of Coverage Not Only Determined by Price
In numerous court cases and testimony, spanning decades, insureds have suggested
that insurance was unavailable. What is not stated is the implicit expectation
on the part of the insured that insurance, to be available, should be offered
for the same limits, deductible, terms/conditions, and pricing regardless of
whether the loss experience and/or the risk factors have notably changed. Availability
of insurance in light of changes to risk factors and/or loss experience is a
matter of modifying the proposal to the insurance market in the form of higher
deductibles, possible insurance form amendments, seeking alternative insurers
and perhaps an increased price. Price increases are directly attributable to
the global insurance market and not associated with a risk manager's lack of
influence or control.
Cost of Underwriter Turnover in a World of Short Supply
Shopping for underwriters that are seeking market-share growth will result
in a lack of continuity of understanding exposures and grants of coverage provided
by past underwriters. A risk manager can find himself or herself re-educating
new underwriters or reselling them to get the coverage previously granted. A
change in a primary underwriter will likely trigger a complete review of the
insuring policy and anyone who has been through this exercise knows the time
demands involved.
The other key factor is that quality underwriters and underwriting firms
are in short supply. It is difficult, at best, to avoid delegation of duties
within an insurance organization, not to mention the movement of underwriters
from one firm to another. Risk managers will need to obtain personal commitments
from underwriters of their involvement and support for adequate lead notifications
and follow-up time to make for smooth transitions, should it become necessary.
To the extent possible, it is beneficial to develop a working relationship with
the most senior underwriters who are likely to be well compensated and stable.
Additionally, a common understanding of coverage between the underwriter and
the insured, at the time of a claim, is paramount.
Alternative Strategies
Risk managers can become frustrated with insurance companies. As alternatives
go, the opposite end of the spectrum is to cease purchasing all insurance. This
would reduce the cost of buying insurance but there can be some other challenges.
The problems are compounded when:
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The Board of Directors, after a catastrophic loss event, asks, "How much
would the insurance have cost?"
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Questions arise of dealing with accruals for expected or future liabilities
relative to GAAP accounting issues, for example of FAS 5, 113, etc.
- Considering financial market hedges in lieu of insurance
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The financial market's expected rates of return on capital is higher
than the insurance industry, and
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The investment community does not provide hazard risk support services
Conclusions
Accept only half of the credit for premium reductions in a "soft" market.
Avoid being blamed for the lack of control you are able to exert over the insurance
pricing in a "hard" market.
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Insurance is a future call, given an occurrence involving selected events
valued at many multiples of any premium paid.
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Pricing needs to remain in the "backseat"—remember to avoid procurement
involvement.
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Any communication with your senior management needs to be focused on
your firm's businesses, associated risks, and your risk management strategy.
Remember, insurance and pricing is only one aspect. How do you want to be
perceived?
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Is there a mutual understanding of your firm's risk and risk transfer
between you and your key underwriters?
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Make the distinction, when reviewing insurance cost drivers, to differentiate
between risk transfer versus financing expected losses and risk services.
The continuous message you want to convey to management is that you are helping
to manage risk with studied knowledge of the business/industry, and insurance
and pricing is a subordinated function.
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