Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime….
When the debt and equity markets flowed freely, Commercial Risk Management was barely on a company’s radar. When deal flow and credit was abundant, opportunities for operational improvement may have been a function of bidding the insurance, creating economies of scale, and eliminating some unnecessary insurance coverages.
Risk Management was given little consideration, pricing of the insurance program was often the primary motivation, and very little oversight was given to the organization’s actual claims performance or Risk Management Program results.
Brokers would bid on the basis of price, and deals were made with little consideration as to how the company’s actual losses would impact the insurer’s future pricing. In addition, little foresight was envisioned beyond the current insurance renewal process to determine how claims and their affiliated costs would impact EBITDA and future company valuations.
Today, credit has all but stopped flowing, and we must now look for unique opportunities to identify previously unidentified or ignored areas where operational performance can give us a significant advantage over our competitors. The question for your Risk Management program though is, how do you measure its performance?
Some companies measure performance for a Risk Management program based solely on price and service (annual cost of insurance, delivering policies, issuing certificates, returning phone calls, etc). Although these are the basic service standards that should be expected of all insurance and service professionals, they are not fundamental differentiators between providers, nor are they easily quantifiable or measurable. In addition, they cannot be measured against EBITDA or future valuations.
By putting a company’s property and casualty programs out to bid every two years, you may save up to 10-12% every few years by identifying insurers eager to write new business strictly on the basis of price. This trend however, cannot continue ad infinitum as pricing in the insurance market ultimately has a diminishing point of return when ROI for the seller becomes an unacceptable outcome of selling the product below cost.
In addition, if the trend of insurers of investment losses continues for the insurers themselves, the industry itself may begin to face its own financial challenges and begin raising its pricing on a collective basis.
Simply put, at some point in time the buyer and consumer must learn How To Fish Instead of Being Given a Fish. He/she must take ownership of the problem not necessarily by bidding his insurance each year, but by learning how to control and reduce the expenses (claims) that ultimately are financed by an insurer through the premiums it charges to its clients.
When you first learn how to fish, (Step 1 of our fishing lesson), you should gain knowledge of a basic analytical tool that is available to executives to help them measure the actual performance of their broker, insurer, and claims costs for the organization.
Measuring actual performance for a company’s workers compensation program is quite simple. Each state issues an Actual Experience Rating (AER) for its clients and insurers which compares a company’s actual claims against its expected claims. The equation of n/d is used where n is the actual amount of claims paid during the prior 4 year period, (skipping the current year’s loss and payroll data), and d is the expected claims to be paid during the same 4 year period.
Therefore a company that has $750,000 in actual losses (n), and $1,500,000 in expected losses (d), has a .50 AER. This correlating AER results in a credit to the client’s workers compensation bill of $500,000 per $1M.
On the flip side, a company’s whose actual losses were $1,500,000, but had $750,000 in expected losses, has an AER of 200%. This results in an additional premium of $1M per $1M.
If you could improve your income statement by $750,000 for every $1M paid in workers compensation premium by improving your corporation’s AER, would you?
Now in step 2 of our continued lesson on learning how to fish, you will learn how to cast and release the line in order that you can find out where the best fishing opportunities are located, and if the fishing pond is large enough to have a meaningful catch. By this I mean comparing and contrasting your companies’ AER against your Lowest Possible Experience Rating.
Determining your Lowest Possible Experience Rating (LPER)
Most organizations are unaware what their company’s LPER would be if they were claims free. Determining this LPER helps a company properly establish new goals for cash flow improvements, claims expectations, and what type of safety culture they want to take ownership of. It can also be used as a performance based tool for compensating an insurance broker or Risk Manager based upon the actual claims results from previous years.
Through a series of simple basic calculations, you can determine the impact the LPER will have on your organization. Once you have this information available, you’ll be able to gauge the magnitude of the potential improvements in cash flow if you are claims free from your Workers Compensation Risk Management Program. You’ll also be able to help identify the true results and costs of your prior year’s workers compensation insurance expense. You can compare and contrast the data like this:
If your average AER was 150% for the past 4 years and your average LPER was 75%, and your annual premiums were $1,500,000, you would have paid an additional $3,000,000 in premiums for the AER you incurred. (150% is to $1,500,000 as 75 is to $750,000). $1,500,000 - $750,000 = $750,000. 4X $750,000 equals $3,000,000.
However, if your average LPER was 75% during that same time frame, you would have improved your cash flows by $3,000,000 and improved your EBITDA (5X multiple) by $3.75M. To put it in simpler terms, a 3.75 to 1 return.
If you compare and contrast those savings to those in the 10-12% savings range from bidding the insurance, which one will have more long term impact to the organization? Let’s contrast the bidding process using the same premium arrangement, but with no improvement in your AER.
If your base premiums were $1,500,000 and your AER was 150% and as a simple result of bidding your insurance you reduced your total costs by 12% during the same 4 years, you would have saved $720,000, ($180,000 in annual savings X 4 years of potential impact). Do you recall the example above where the annual premium swing was $750,000 between your LPER and your AER?
Let’s do the math together, under the bid scenario you saved $720,000 in total costs over the 4 years. Under the reduction in claims approach you saved $3,000,000. Once again, a better than 4 to 1 return.
Compare the results of the bidding results to those of reducing your AER to your LPER, and you’ll get a better idea of which approach makes the most sense for your organization.
Secondly, if you or your board still requires bids on your insurance every few years, why not try to accomplish both objectives and have a truly meaningful impact on your company’s bottom line? Insurers today are looking to give even larger credits to client partners who prove that they have learned how to manage their risks better and have indeed seen the light and reduced their Actual Experience Rating.
Lastly, let’s look at the improvement in company valuation from an improvement in the AER. Using a 5X EBITDA multiplier, the improvement in cash flow from our previous example would have equated to $3,750,000 in increased valuation. Each organization has its own definition of what meaningful is, and for some companies $3,750,000 in valuation will not be significant. However, this analytical tool does provide a mechanism to identify a new way to improve the company’s bottom line without reducing expenses that may be necessary to the company’s basic operations.
With credit becoming more difficult to access, and deal flow significantly reduced, organizations should be looking to improve their operations now. This will in turn help them sell their Portfolio Companies for larger multiples when deals and credit again flow freely.
Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime….
