Understanding Your Total Cost of Risk: A Dog’s Tale
Now that businesses can see a light at the end of the COVID-19 tunnel, we should celebrate our victories — such as welcoming employees back to the workplace — while facing the serious challenges that remain. The pandemic’s repercussions include many new risks and heightened insurance issues.
As businesses reopen, employees will return to a changed workplace, both physically and culturally, and companies will face a different risk landscape. Many businesses have experienced dramatic insurance premium increases, especially within certain coverage lines.
I see the striking impact rising insurance premiums have left on our customers and prospects. We don't know if the market will continue to harden, but that's not the theme of this article. This article shows you how to best weather the storm during hard insurance markets.
To frame this conversation, it is vitally important to understand the concept of TCOR (total cost of risk). Total cost of risk is the sum of all aspects of an organization’s operations that relate to risk, including retained (uninsured) losses and related loss adjustment expenses, risk control costs, transfer costs, and administrative costs.
Peter Drucker, considered by many to be the single most important thought leader in the world of business management, coined the phrase, “If you can’t measure it, you can’t improve it.”
When evaluating the effectiveness of your risk management program, TCOR ensures that you are not only measuring the success of the program but also uncovering areas in need of improvement. Far too many organizations in the middle-market space judge their success based on insurance premiums paid. The truth is that insurance premiums only account for 28% of the total cost of risks, so we must change our focus to win.
I’ll use a silly story of a dog walking the beach to illustrate this philosophy.
A Dog’s Tale
Suppose you have a dog, and go for a walk, just you and the dog. You go to a beach where the dog can run free and you can walk a few miles, from point A to point B. Your partner is at point B, where you two will meet.
You walk along the shore at a steady pace. What will the loose dog do? It will run and play. It will chase birds, then stop to sniff something. It will be far behind you, and then, with a sprint, pass you and run far ahead.
The dog in this story represents your total insurance premiums. You and the resulting risk management process, measured by TCOR, represent the fundamentals. If you stop, you won't reach your goal. Generally, the dog goes in the same direction that you do, but not at the same pace. Therefore, the fundamentals and associated premiums are not at the same place too often, only every now and then.
The most important thing to know is that the dog will follow you if you keep walking. In the same way, the premiums (more importantly, TCOR) will follow the fundamentals of your risk process over time. You can panic that you will lose the dog, but the more you have taken that walk with the dog, the more you know that it will ultimately stick by you.
Why does the dog sniff around and stay so far behind while you keep your steady pace? Why does it run so far in front of you, keeping up that sprint for a very long time until you wonder if it will ever get back to you?
The answer is: it's a dog. It is how it is, and it does what dogs do. In the same way, insurers charge prices today that they anticipate will pay for future claims. That's what they do.
And that's what is happening right now. We’ve experienced an extended hard market, mostly property in catastrophic-convective exposed areas, cyber-liabilities, auto fleets, and many litigious-ripe liability targets. A major driver is a continuing increase in the severity of losses. Social inflation continues to drive up jury verdicts and ensuing casualty losses. A rising number of shareholder class actions has had a similar effect on D&O. Ransomware losses are increasingly difficult for the cyber markets to manage. Property losses continue to escalate with the steadily rising accumulation of insured property in catastrophe-prone areas. Many also believe that we will see a rise in the frequency of catastrophic events, including those we can anticipate and model (e.g., hurricanes) and those we can’t (e.g., tornadoes and wildfires).
Learning From History
While we’ve experienced a season of heavy impact, honestly, this is to be expected. Given the set of facts, why would any insurance buyer expect anything positive in the current marketplace?
We come back to the insurance cycle. After a few year-on-year increases, rates are approaching technical adequacy in some lines for some sectors. This has attracted new capital to enter the marketplace — $23 billion of new capital in the last six-months. Start-ups are sprouting in Bermuda and London, and established carriers are expanding their available capacity and starting to deploy it a bit more for some risks. While broadly speaking, the market remains hard, but it is undoubtedly more orderly and predictable.
To me, the bottom line is that most middle-market companies are what I refer to as community-rated (borrowing a concept from my health insurance counterparts). My experience says that the insurer evaluates the risk factors of market population (community rating), and not enough characteristics of any one company when calculating premiums.
If you want to win, you and your advisor must focus on a risk management process that is measured by what matters. Most companies implement policies and procedures to lower their insurance premiums. The leaders in the clubhouse follow a process that yields results to TCOR, not just compliance.
If you want to lower your TCOR over the long term, you should not worry about the dog. In other words, don't watch the price action too much. Short-term rate increases, even substantial ones, often don't say that much about the underlying fundamentals, especially not if a whole industry or the whole market is up. Many businesses change carriers and brokers every few years and end up losing in the long run.
My customers who follow our process have benefited by paying a TCOR of 29% less than the market over 10 years. The customers unwilling to focus on our process averaged 15% more than their peer average total cost of risk.
Try not to be that average buyer.