INTRODUCTION
Every profit-making organization assumes certain business risks every day it is in operation. Many businesses have begun to realize that they can also profitably assume some of the risks that they have in the past, transferred to an insurance company. In fact, there is greater predictability with some insurance risks than most business risks encountered.
The reasons risk retention can be beneficial are:
- There is a charge for risk transfer to an insurance company, which is generally 40% to 50% more than is paid in losses, depending on the type of coverage and the amount of premium involved.
- It is inordinately expensive to document and settle relatively small losses, particularly when management time is considered.
- The collection of small losses can frequently have an adverse effect on future insurance costs.
RISKS ALREADY RETAINED
Most organizations already retain some insurance risks. For example
- They have deductibles applicable to portions of your existing property and income coverages.
- Have self-insured retention on some of their Liability coverages.
- They have no insurance coverage on various catastrophes such as flood and earthquake
Financial Ratios explained section to assist in your understanding of these retention guidelines. This may not be for the financially faint of heart, but it should give you some idea of the care with which we analyze and assess our clients risk management.
RISK RETENTION LEVEL DETERMINATION
Only your executive and financial officers can determine the extent to which you should retain insurable risks and the extent to which your firm can comfortably absorb financial fluctuations in any given year. They can consider sales projections, cash flow requirements, shareholders’ profit expectations, loan covenants, legal and accounting tax position, etc. All of these factors influence your ability (and willingness) to assume rather than insure given exposures to loss.
RISK RETENTION LEVEL GUIDELINES
To date, no precise formulas exist to determine a firm’s proper risk retention level, but there are several guideline formulas or “rules of thumb” that have been developed. These guidelines are as follows:
[a] Accountants’ Materiality Test
- A guideline used by accountants as a. measure of materiality is 5 % of net income before taxes from continuing operations.
- Based on an organization’s pretax income from continuing operations of $250,000 for example, this guideline suggests they can safely retain up to $12,500 per year in unexpected losses.
[b] Net Working Capital. Method
A guideline used to determine a company’s ability to quickly fund an unexpected loss, rather than its long-term financial ability to absorb loss, is 1%-5% of net working capital (The retention selected should not reduce a firm’s current liability ratio below 2:1.)
Based on a hypothetical firm’s financial information, this guideline could produce the following results:
- Total Current Assets: $1,000,000
- Total Current Liabilities: $500,000
- Net Working Capital of: $500,000
- Amount of Risk Retention
- (1%) low range $5,000
- to (5%) high range $25,000
[c] New Quick Method
This guideline measures a firm’s ability to cover a sudden emergency using assets that can be quickly converted to cash. It calculates current assets less inventories and current liabilities to determine a firm’s “net quick” and then assumes that 1%-5% of that amount can be absorbed.
For example, based on a firm’s financial information, this guideline produces the following results:
- Total Current Assets: $1,000,000
- Less Inventories: $100,000
- Less Current Liabilities: $500,000
- Net “quick”: $400,000
- Amount of Risk Retention:
- (1%) of Low range: $4,000
- (5%) of Low range: $20,000
This method may provide an indication of the appropriate “per occurrence” retained amount.
[d] Earnings/Surplus Method
This guideline sets the annual amount of losses to be retained at a percentage (usually 1% -5%) of current earned surplus and an equal or lower percentage of the average pretax earnings for the past three to five years. This approach logically assumes that retained losses are payable from either pretax or retained earnings.
Based on the following hypothetical financial information, this guideline produces the following results:
- Current Earned Surplus: $500,000
- 5 Year Average Pre-Tax Earnings: $250,000
- TOTAL: $750,000
- Amount of Risk Retention:
- (1%) Low Range: $7,500
- (5%) Low Range: $37,500
This guideline suggests a range of possible risk retention amounts equal to one-tenth of one percent to one percent of annual sales. The HIGH range is normally associated with retention capacity for the sum of all retained occurrences in one 12-month period.[e] Percentage of Sales Method
For example,
- Annual sales: $25,000,000
- Amount of Risk Retention:
- Low Range .1%: $25,000
- High Range 1%: $250,000
Some firms regard the impact of uninsured loss on earnings per share as a valuable guideline for determining the upper limits of annual loss retention.[f] Earning Per Share Method
- A range of $.10 to $.20 per share is normally acceptable on an after-tax basis. (When dealing with earnings per share figures, you should bear in mind that a decision to retain risk rather than transfer it to an insurance company would eliminate most elements of normal premium expense, which would otherwise be charged against earnings. Therefore, it may be possible to consider higher earnings per share variances than those used here.)
By example, based on the current number of outstanding shares for a hypothetical company, this guideline produces the following results:
- $.10 X 250,000 shares = $25,000 (Low Range Retention)
- $.20 X 250,000 shares = $50,000 (High Range Retention)
RECOMMENDATIONS
- Annual Review – The principle single measure of a firm’s loss-absorbing capacity is its revenues, its “financial bulk.” When a sudden expense such as a loss occurs, expenditures are shifted, projects deferred, or finances juggled to accommodate the change. Most budgets have a certain degree of flexibility, which is one measure of the “tolerable loss level.”
- Earnings/Surplus – In Long and Gregg’s Property and Liability Handbook, Bernard Daenzer states that the minimum risk-bearing capacity “certainly should be 1% of its average annual net earnings during the last five years.” “Free surplus” may be the amount of surplus available for dividends, and the figure obtained would be an annual, rather than per-loss, figure.
- Aggregate Allowable Cost Variation – Some finance officers establish limits within which the risk retention level may vary–say, to a maximum of 150 percent of budgeted costs. The risk retention level should be that with the highest probability of remaining within the established limit, with the addition of total premium.
- Materiality – In general, 5 percent of net earnings is considered a material impact, which should be specifically footnoted in the financial statement.
5. RISK RETENTION SUMMARY
The risk retention guidelines indicate that organizations can retain risk in varying amounts, and we use these guidelines to assist in determining what makes sense in different situations.
- Once those levels are determined, they can be incorporated into your insurance and risk management program through the selection of individual deductibles, self-insured retention, self-insurance and/or non-insurance.
6. RISK RETENTION APPLICATION
- In the various sections of our survey, we discuss the desirability of deductibles, self-insured retention, self-insurance and non-insurance as they apply to specific risks or types of insurance. The size of these deductibles, retentions etc., should not be solely a function of your firm’s ability to retain risk. Other factors must be considered.
- For example, if insurance is too costly, the perils of earthquake and flood may be retained, even though the loss potential is beyond generally desirable retention limits, or the amount of a deductible on a specific coverage may be less than your risk retention capacity if the premium savings offered on larger deductible amounts are too small to justify their acceptance.