Risk retention

Risk & Insurance, July, 2006 by Eric J. Schmidbauer

Dear Editor:

In discussion of cyclical retention strategies, ("Retention Selection: Chasing Our Tails," Risk & Insurance[R] March 2006, page 37) you mention that the following rule leads to an unsustainable outcome: "If the premium charged by the insurer for the retained loss is greater than the expected or average value calculated from loss data, retain. Otherwise, insure." Insurers should price their products using this method. Given this, your conclusion is correct.

But have you considered the implications of the utility of the insured when it makes its "retain versus insure" decision? As you know, utility curves are what economists use to estimate the well-being of individuals, companies and other organizations. A desire to maximize utility drives decisions amongst all these groups.

Although dollars, or expected dollars, certainly play into the calculation, they are not the sole factor. One reason for the purchase of insurance is the insured's risk aversion which exists when an individual or company is willing to pay more than the expected value of losses in order to absolve itself of the loss exposure.

Another is the asymmetry between the insurer and the insured. The insured has superior knowledge about its operations and exposures, but the insurer is more aware of the level of risk inherent in different industries. Because the insured and insurer each has his own expectation with regard to losses, the insurer could believe that it is offering a premium that contemplates all expected losses, taxes, administrative costs, and profits loadings. The insured could believe that it is accepting a premium offer below its expected loss costs.

You state that retentions should be based on an insured's own unique risk profile, not the state of the insurance market. In a perfectly competitive market these two objectives would not be in conflict. Unfortunately, given the market cycles insurance is anything but a perfectly competitive market.

Regardless of the market's pricing techniques, the insured must make decisions in order to maximize its utility. The idea is for the insured to be on its efficiency frontier. This relates to your "chasing our tails" argument, in which you implore insureds to break the insurance cycle by ignoring temporary market conditions and retain frequent losses.

Swimming against the tide, so to speak, is not in the insured's best interest in a marketplace as large as that of the insurance industry. Any given insured has little impact on pricing mechanisms in the market.

Because the insured has no bargaining power, it is a utility-destroying proposition to incur the costs of attempting to break out of the hard and soft cycle while receiving minimal benefits.

Only through the mass agreement of insureds, implemented through a government imposition, could a large enough force be mustered to change practices of the entire market. Your observation that after all the tail-chasing of lowering retentions during soft markets and raising them during hard markets, the insured over the long run usually ends up returning to a retention consistent with the "retain frequent losses" rule demonstrates that the insurance market, like all others, is self-correcting over time. Temporary deviations from this ideal are a reflection of market disruptions and the movement away from the pricing equilibrium. It is not the insured's duty to steer the industry toward this long-term result. But by responding to price incentives to change its retention in a utility-maximizing way, he unwittingly does so.

ERIC J. SCHMIDBAUER

Insurance Risk Mgmt. Solutions Group

PricewaterhouseCoopers LLP