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Selecting the optimal retention level for your insurance program.

The optimal level of risk retention for a property manager's insurance program should provide a balance between premium savings and assumed risk.

A retention level ("retention" will be used interchangeably with "deductible") that is too low leads to "dollar swapping" with the insurance company and minimal premium savings, A retention that is too high can lead to financial ruin. The optimal retention level weighs the risks involved and the consequences of assuming that retention level.

The first step in determining the appropriate retention level is to examine your company's exposures, especially the frequency and cost of losses.

Determine the odds

Many times, the selection of a retention level by the property manager is driven by premium savings, but considering only premium savings can be a formula for disaster.

The risk management axiom, "never risk a lot for a little," has great meaning. The premium savings involved in assuming a certain deductible must be weighed against the possibility of eventually having to absorb that deductible once, or perhaps many times.

One of the factors to weigh against premium savings is the combination of loss frequency and loss severity. Those losses with low frequency may happen once every 10 years (a hurricane or fire), while those with a high frequency may happen 10 times or more in one year (trips and falls).

Loss severity refers to the dollar amount of a loss. A low-severity loss may be valued at $10,000 or less, while a highseverity loss may be over $500,000. The following combinations of loss frequency and severity are possible:

* low frequency/low severity,

* high frequency/low severity,

* low frequency/high severity, and

* high frequency/high severity.

Of these combinations, which losses should be insured?

The low frequency/high severity loss category generally refers to truly cardstrophic losses. These are the losses that are most effectively dealt with through the purchase of insurance and selection of an appropriate retention level. Property managers must first focus on this area to avoid situations of underinsurance.

An initial step for many managers should be to define what a "catastrophe" means to your owner from a financial standpoint. An uninsured claim of $500,000 may be catastrophic for some whereas that may be the retention level for others. Defining this level should involve the owner, asset and property managers, insurance and financial advisors, risk managers, and company bankers and accountants.

When retention levels are chosen, the types of potential loss involved should be considered both as to frequency and severity, to estimate the potential annual financial impact on your property's balance sheet. As an example, managers of shopping malls witness many trip and fall claims. These generally have a low per-claim value, but the aggregate value can be substantial.

Other combinations of loss frequency and loss severity can be thought of as part of the risk of doing business. They should be avoided or minimized by the use of risk management techniques, retained by the management company when they occur, or transferred through the purchase of insurance.

Other factors

The legal factors involved are also important in determining retention levels. Property managers should examine trusts, loans, leases, and mortgages in order to determine if there are any specified maximum retention levels. It is often a condition of a mortgage or lease that a certain limit of insurance be carried and a maximum retention level be maintained.

Also of importance is the psychological factor involved in selecting a retention level. What is ownership's comfort level with a given retention? A good rule of thumb is to retain only an amount that you can "comfortably" handle. If each loss becomes a roll of the dice with a property's financial stability, chances are the retention level is too high. There is no point in endangering a property to save small amounts in premiums.

Rule-of-thumb formulas

There are a number of general guidelines that property managers should review in order to determine a per-occurrence retention. These tests indicate an approximate amount that an organization should be able to retain for a single loss. In order to determine the annual impact of such a retention, the loss frequency should be considered.

In other words, if we assume a retention of $50,000 and the chances of an accident occurring as minimal, we may only have a $50,000 payout for that year. On the other hand, if the possible frequency is five times a year, we will have a $250,000 payout to address.

This is a very important factor in selecting the retention level and should not be underestimated.

In some cases, the use of an actuary to predict future expected losses based on a property's loss history and that of the industry as a whole will greatly aid in the decision-making process. The actuary can make predictions that can contain a confidence factor to suit your particular owner's philosophy on risk assumption. For instance, you may choose estimated losses at a confidence level of 50 percent, 75 percent, or 90 percent.

Within a given range of losses, the actuary can reasonably predict what you could expect for claims. Obviously, the high-severity, low-frequency type of claim becomes more difficult to accurately predict due to a low volume of data. However, in conjunction with industry information, financial estimates can become another valuable piece of data as you move toward making your retention-level decision.

The traditional financial types of tests used to determine retention capability can be classified into three main categories: balance-sheet, income-statement, and premium methods.

Balance sheet. The balance-sheet method takes balance sheet items and applies relative percentages to obtain rough guidelines for retention. The working capital method uses a percentage of the working capital to establish a retention level. A level between 1 percent and 5 percent of working capital is normally used. The total asset method uses a similar range of 1 percent to 5 percent of the total assets in order to determine a retention.

Income statement. The income-statement methods use several percentages of income statement line items. The earnings/surplus test utilizes 1 percent to 10 percent of the current retained earnings added to 1 percent to 10 percent of the average pre-tax earnings during the previous five years. The sales budget method takes 0.5 percent to 2 percent of annual sales or revenues in order to determine the retention.

Premium. This method takes the annual premiums for the type of coverage considered and applies certain percentages. The annual-premium method suggests that 10 percent of the annual premium of a policy be used as a deductible. The premium-savings method relates to the amount of premium savings obtained from selecting a particular retention level. Theoretically, a manager would take the premium savings generated from higher retentions and invest those sums to offset a larger deductible.

These calculations will develop a wide range of retention values. The final decision must be based upon the owner's business philosophy, risk management attitudes, and the cost of attachment points in the excess insurance program. These tests provide only a guideline for choosing retention levels and should not be the only factors considered.


The optimal retention level for a property can be defined as one that creates a premium savings that is balanced by consideration of the risks and consequences involved.

In selecting any retention level, the impact upon the financial stability of the property and the portfolio must be considered, along with the owner's comfort level in selecting that retention.

This philosophy can then be applied toward individual situations so that the optimal balance among premium savings, risk, and comfort level is achieved. This retention level will allow the assumption of the proper portion of the loss balanced against other corporate objectives.

Rchard Messick, AAI, is a senior consultant with the Deloitte & Touche Risk Management consulting practice in Hartford, Conn. Mr. Messick specializes in risk analysis and insurance program design.
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Title Annotation:Insurance Insights
Author:Messick, Richard
Publication:Journal of Property Management
Date:Sep 1, 1993
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