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Mar 11, 2009

Waving The Magic Wand

EBITDA and Your Company’s Actual Experience Rating-

If you had the ability to wave a magic wand and improve your company’s EBITDA with a few waves of the wand would you? Of course you would unless you knew that your EBITDA was top drawer and couldn’t get any better. But, since you don’t live in a fairytale where the magic wand is likely to suddenly appear, you have to sort it all out for yourself.

You’ve hired the turnaround experts, accounting and forensics auditors, interim operating officers, and you’ve done everything possible to increase EBITDA, or have you?

That’s the question we’ll address here, have you done everything you can to improve EBITDA?

Let’s look at insurance in one of those exercises.

Under the traditional approach you invited three brokers to interview, and selected two to help you entertain bids from the respective insurers who were eager to quote your account if you sent them information.

What information will they want to look at? What does it mean to them? What does it mean to you? How does it affect your premium? You have claims, what exactly does that do to your premiums? How are claims impacting your current EBITDA?

In simpler terms, let’s go through the benefits and pitfalls of bidding insurance through the most conventional method. We’ll then contrast those results against one of reducing claims and reducing risk.

You are contacted by your current insurance broker’s largest competitor. You’re torn because you’ve always liked your broker, you play golf with him, and he coached your son’s soccer team to the winning championship this last season. The competitor is eager to talk to you though, and meet with you to show you how much money he can save you compared to your existing program. You of course, eager to improve your EBITDA, please your Board of Directors and other stakeholders, agree to meet with him 90 days prior to your current renewal. The competitor explains how his company has an exclusive program for companies just like yours and you are a good fit for him.

You accept his invitation to bid, you provide him the necessary information on your company and other collateral information. He asks you for loss runs and you advise your assistant or CFO to secure the loss runs. Your assistant procures the loss runs and you provide them to the competitor. He goes to bid as does your son’s soccer coach. Simultaneously they both approach the insurers and inadvertently, or intentionally they select the same insurers to procure a bid.

Your broker calls you irate with your decision to shop with other insurers. He’s adamant that he has the competitor’s insurer as a market and wants a letter assigning that insurer to him. You are now in a battle controlling WHO IS CONTROLLING YOUR INSURANCE. Isn’t this process a little disconcerting to you? Does this sound familiar?

Did you ever consider the tangible results of the current program as a jumping off point to see what losses and various controls were put in place by your current broker to reduce the long term expense affiliated with insurance costs? When was the last time you analyzed your claims and future claims the same way the seller (insurer) would analyze them? Have you always relied on the broker to just get you the best price without considering how the results of your existing Risk Management program stacks up against insurance industry expectations? Wouldn’t you like to know what information insurers use to determine how they look at losses and how they expect your current and future losses to impact you?

Here’s the good news and the bad news…..

The good news first: Each state issues an experience rating factor which compares your actual losses against your expected losses. This numerical equation of n/d where n represents your actual losses, and d represents your numerical losses results in a debit or credit against your actual premiums paid each month. For example where n=$500,000, and d= $1,000,000, you receive a credit of 50%. Where n=$1,000,000 and d=$500,000 your account is debited 200%.

The bad news:

The average experience rating factor in California is just over 100% which means the bidding process may be simply masking the underlying claims problem that exists. If you are one of the many organizations whose experience rating is over 100%, you are leaving valuable dollars on the table not because of bidding, but because of claims.

Claims are what drive premiums, and premiums are what impact EBITDA. This is somewhat like the equation of A=B, B=C and therefore A=C. Let A represent claims, B represents premiums, and C represents EBITDA. Therefore, if claims (A) impact future premiums (B), and premiums impact EBITDA (C), should we focus our efforts on the root cause of A, or B?

The answer is probably a little bit of both. Certainly having an RFP every few years keeps brokers on their toes. However, if the company’s ongoing actual results of the Risk Management Program are poor, bidding will only push the claims problems into future years. In addition, premium reductions through bidding most typically are only in the 10-20% range over a 4 year period.

The Good News

Let’s contrast the 20% savings example using the bid process to the scenario when you reduce your losses from 200% to 50%.

We’ll assume two organizations pay $1,000,000 in standard premium. In other words, all things being equal (no underwriting credits or debits applied) both companies begin with a manual premium of $1,000,000. Company A has 50% of their expected losses during a 4 year period, and company B has 200% during the same 4 year period.

Company A will save $800,000 (4 X $200,000) if they achieve the expectations of the typical company bidding its insurance every 2-3 years. Remember the 20% bid savings approach?

Company B cognizant of the necessity to reduce losses and mitigate risk, doesn’t bid their insurance but every 6-8 years, and continues to maintains a consistent record of recording losses at 50% of insurance industry expectations. Their annual savings is $500,000 X 4 or $2,000,000 during the same 4 year period.

The Present Value of Company A’s bidding approach at a 10% rate is $697,340. The Present Value of Company B’s approach is $1,743,426. The resulting difference is striking at just over $1,000,000.

Let’s look at the EBITDA results using a 5X multiple. Company A improved its 1 year EBITDA by $1,000,000, whereby company B improved it by $2,500,000.

The sales necessary to offset these differences are as follows: Company A would have to earn $17M more during the 4 years to offset the savings from Company B’s actual savings from their claims control approach.

You may not be able to waive the magic wand over all of the problems, but understanding the root cause goes a long way towards fixing them.

Colin D. Baird is the Managing Director of Private Equity Risk Managers and helps companies create, implement, and monitor Strategic Risk Management and Related Plans. He conducts due diligence , and helps companies identify new EBITDA opportunities through changing the way risk is managed at the Portfolio Company. In addition, he conducts risk related audits and reviews for privately held corporations, C-Level Executives, and their Corporate Boards of Directors . He also helps Private Equity identify economies of scale which helps reduce their risk related expenses. He can be reached via email at