As the insurance market hardens, many large deductible programs are increasing their retention amounts. It is important for risk managers to understand the costs related to higher levels of retention when determining whether or not they are receiving adequate premium reductions.
…For a program that is large enough or has had a few claims each year that have penetrated or exceeded the proposed layer, a quick check is as simple as Method 1, figuring the average amount of losses incurred in that layer. For example, if XYZ Insurance Co. wants to increase retention from $100,000 to $250,000 and the insured has incurred losses in this layer as shown in Figure 1, then the premium decrease for accepting that additional $150,000 of risk should be at least $175,000. This quick and dirty estimate assumes the program has not changed in the last six years (i.e., business is the same, safety programs are similar, etc.). Method 1 also completely ignores loss trends and loss development, so in most cases it would understate the amount of premium reduction.
An improvement on this simplistic method is to exclude the two most recent years, as larger claims in those years haven’t had the chance to develop into the higher layers. By removing 2011 and 2012 from the average, the estimate increases to almost $220,000, which is closer to the answers utilizing the additional methods outlined next.
Method 2, while not as simple, does take into consideration loss development and loss trends. The losses incurred in the proposed layer are multiplied by the excess loss development factors (LDFs) and a 5.0 percent loss trend to calculate the ultimate excess losses for the layer $100,000 to $250,000. The results of Method 2 are shown in the table in Figure 2. The average cost of the developed and trended losses is now valued at almost $300,000. Because it is necessary to obtain excess factors and determine appropriate loss trends to apply to the losses in the proposed layer, this method may not be possible, but it does demonstrate the impact that loss development and trends have on the losses. This is the primary reason why Method 1 listed above tends to understate the premium reduction.