Divisor Programs Revisited
December 2011
One of the great blues men of
the 1940s, Willie Dixon, wrote and recorded "You Can't Judge a
Book by Its Cover."
You can't judge an apple by lookin' at a tree,
You can't judge honey by looking at a bee,
You can't judge a daughter by lookin' at the mother,
You can't judge a book by lookin' at the cover.
by
Peter M. Polstein
Back in July 2005, I wrote an article on an alternative to
loss sensitive contracts, "Retrospective
Rating Alternative." The subject had some substantive
meaning then, and in this marketplace—and the potential future
one—it may play an interesting role in midsized to less than
Fortune 1000 insureds.
What has brought this alternative back has been a couple of
potential risks on which I have begun to consult, both of which
are vastly different in exposure, yet potentially similar as to
workers compensation loss content.
Divisor programs (which have all but been forgotten) are
simplistic, certainly easier to handle than retrospective
formulas, and can, under the right circumstances, be very
competitive with potentially extraordinary cash flow. The key is
not so much the class of business but the loss potential, where
the frequency and potential for severe loss are either at a
minimum or can be controlled.
As an example, assume a standard workers compensation premium
of $1 million and a divisor program of 75/25. The minimum
premium under the program will be $250,000, which covers boards,
bureaus, taxes, profit, and administration. Depending on the
insurer and underwriter, this may well be all the up-front cash
needed to convey inception.
The reciprocal of 25 is 75, which is the "divisor" utilized
for each dollar of loss. Therefore:
$250,000 of loss divided by 75 becomes $333,333.
$350,000 becomes $466,666.
$450,000 becomes $600,000.
$550,000 becomes $733,333.
$560,000, which is the loss break point of standard,
becomes $746,666, which added to $250,000 is $996,666.
This program works when losses are minimal. For example,
under this illustration, $350,000 would become a loss payment of
$466,666 plus the minimum of $250,000, which would make the
annual cost $716,666 against the standard of $1 million.
I can hear the questions now. Would underwriters simply
accept $250,000 without any guarantees? Maybe, but undoubtedly
they would ask for collateral, which, under the right
circumstances, might not be expensive. With or without
collateral, underwriters would undoubtedly expect loss funding
on a variety of negotiated terms.
On the other hand, if you had a risk that had some frequency
and the potential for occasional severe loss, then standard
premium would be an increased percentage of actual. Yet, if
losses were contained despite prior experience, the potential
for cash flow savings and possible expiration end costs would
provide a competitive program.
There are no long tail audits. These programs are usually
annual, but I've been involved with multiyear programs "a while
back."
Further, a divisor program is not necessarily limited to
workers compensation. In fact, I negotiated programs with a
combination of compensation and liability. You just don't want
to include any automobile coverage in the equation.
A majority of insurers had filed for this program, and the
potential for the filings being in force is considerable.
The
big question is, does anyone remember divisors? Or, "You Can't
Judge a Book by Its Cover."
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