Insurance Value—Not Price—Matters
Gary Bausom | June 1, 2008
Price is nothing without value. Price needs to reflect equity of what is received in exchange. The impact of cheap prices will likely result that you get what you pay for, then again, maybe less.
Companies are in business to make a profit. As consumers hunt for the "big box" store "bargains," links along the supply chain will get squeezed. Throughout the supply chain, the quest for increased profits takes on at least two forms: price reductions (or flat pricing) and reductions in product/service quality (including a reduction of features or options available). As material and labor costs rise, pricing remains "attractive," and the quality will suffer. This means the utility value and/or useful product life have been reduced, which likely translates to increased replacement repurchases and, in the aggregate, greater cost.
The annual aggregate dollar outlay can be managed by consumers deciding what they really need and want. Before purchasing goods or services, consumers need to ask how will they be used and what is the real or perceived value. For purchased goods that fill a house or warehouse but that are not being used or monetized in terms of sales, what is the value? The same is true of underutilized purchased services.
In considering insurance, as a commercial purchaser, the key would be to determine the true need for any insurance. Purchasing a larger quantity than was done for the previous period does not mean the given exposures are adequately covered. If the type of exposures require insurance that is in short supply (more expensive), the organization is not necessarily better off by purchasing greater amounts of insurance covering nominal exposure.
Consider Market Price
When market prices reflect a buyers market (lower premiums), does it make sense to purchase more insurance because it costs about the same amount as when premiums were higher? As premiums go up, resulting from shifts in the supply of available capital and demand for insurance protection for transfer of risks, does one buy less protection because the price has increased? Are risk managers paid to manage the price of insurance or to identify risks and to buy protection for the most significant risks?
So what is insurance? There are a number of "moving parts" beyond risk transfer. If each premium dollar is thought of in terms of the following.
Claims . . . . . . . . . . . . . . . . .65%
Overhead & Profit . . . . . . . . 35%
Investment Income . . . . . . . .4%
To "insure" a dollar of loss, it is arguable that the cost is 35 percent of each "premium dollar" plus an investment opportunity cost of 4 percent. Is this efficient? In some cases, it may very well be, but in other incidences, no. In any 5-year period, it is difficult to imagine that an insurance company's overhead will experience notable reductions, so, purchasing greater quantities of insurance that provides marginal risk protection value does not produce effective results.
Risk is not equivalent to cash flow. Cash flow is a matter of a forecast and an accrual—there is no risk!
RISK MANAGEMENT "TOOLS"
Consider the Insurance Value
Insurance buying decisions should be made based on the net impact to the business. Further, these decisions should be segregated based on the balance sheet impact and those exposures where insurance is being used to manage cash flow. The considerations, in priority order, are the following.
- What is the potential balance sheet impact from an adverse event?
- What are the cash requirements?
- What is the cost of the protection?
Some of the important related issues are: customer continuity; the organization's cost of capital, as well as determining if it is a net investor or net borrower; and the insurance protection being obtained relative to the cost. If the cost of insurance is too great relative to the risks being transferred, then why buy it?
Just because goods or services are "on sale" does not mean that a buyer has a need for the price-driven offer. Insurance products that offer transfer of nominal risks/exposures in terms of balance sheet scale are too expensive. It's not cost effective to have your insurance company stand in for your banker. If an organization is a net investor, using cash wisely is important; however, it is unlikely that the cost of capital is 30 percent or more, which is the inherent cost being charged by insurance companies for overhead, profit, and investment income pickup.
Conclusion
The key is to focus on value, not price, when dealing with insurance. Manage cost by rethinking what are real risks, the demand for certain insurance products available, and the value received. If a risk manager or a broker is thinking in terms of cash outlay—look out! Here comes corporate procurement!
Value is more difficult to judge than price. Price-based evaluation assumes that all other variables are equal. In the world of corporate insurance, in the eyes of the boss, it is about the value risk management adds in the managing of corporate risk.
The risk manager's or broker's actions are focused on:
- Managing the value proposition—what is paid versus received?
- What are the risks versus cash flow considerations?
- When a major loss occurs, what is the recovery plan and what needs to happen tomorrow?
- Has counterparty risk quality been vetted along with corporate risk tolerance?
- Is risk management better equipped to assess value versus corporate procurement's pricing review?
A risk manager and the broker can buy based on price and convince the insured's management of the "value" of the market price paid for insurance. Taking credit for premium reductions, particularly in a soft market, is suspect. A corporate financial officer is highly unlikely to sell his/her ability to control interest rates.
A risk manager should be selling the tools being used to manage risk. An improved valuation model to quantify risk, engineering reports distributed to corporate audit providing added management leverage, and real means to shorten recovery time following a disaster are all tangible signs that value is being added by risk management. Elevate yourself above the "right price" fray … there is no such thing as the correct price. Demonstrate that risk management is truly managing and not looking for credit associated with market behavior.
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