Expert Commentary

The Opportunity Cost of Price Shopping

Too much emphasis on price leads to procurement creep. How much can you reasonably expect to save? What are the opportunity costs?

September 2005

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.

Opportunity Costs

  • Procurement creep

  • Management's perception of a risk manager's value

  • Policy rescissions

  • Risk transfer cost versus financing expected losses and services

  • Availability of coverage not only determined by price

  • Cost of underwriter turnover in a world of short supply

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:

  • The Board of Directors, after a catastrophic loss event, asks, "How much would the insurance have cost?"

  • 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

    • The financial market's expected rates of return on capital is higher than the insurance industry, and

    • The investment community does not provide hazard risk support services


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.

  • Insurance is a future call, given an occurrence involving selected events valued at many multiples of any premium paid.

  • Pricing needs to remain in the "backseat"—remember to avoid procurement involvement.

  • 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?

  • Is there a mutual understanding of your firm's risk and risk transfer between you and your key underwriters?

  • 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.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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