Take care when lowering premiums by combining higher deductibles with less coverage. You could be creating an explosive situation.
Editor’s note: This is the first article in The Cost of Risk series. Next month’s installment will address insurance policy options and alternatives.
Between 1999 and 2003, Burns Motor Freight’s primary liability premium rose more than 160 percent. Its umbrella premium soared 633 percent even though its liability coverage now is less than half what it was in 1999. During this period, Burns Motor Freight’s fleet remained the same size. “And we’ve had an excellent loss record,” says Fred Burns, president of the Marlinton, W. Va.-based flatbed carrier, which operates approximately 100 power units.
In 2001, motor carriers saw average increases of 32 percent for primary trucking liability coverage and 87 percent for umbrella coverage, according to a survey conducted by the American Trucking Associations’ Insurance Task Force, which Burns chairs. Increases continued in 2002, and while most observers envision smaller increases this year, premiums are, nonetheless, still rising.
Most carriers understandably measure the severity of the insurance crisis by the size of their premiums. Premium jumps have forced some carriers to reduce fleet size and even exit the business altogether. But the greater threat to carriers may lie in their response to the premium increases: increasing deductibles and lowering coverage.
Some carriers have raised deductibles and lowered coverage until their insurance policies are almost useless. They are covering the full cost of typical claims and are more exposed to big-ticket lawsuits.
Carriers with excellent safety records may find this approach acceptable, but it’s not for the faint of heart. Choosing the right program starts with an honest assessment of your loss history and ends with determining whether you would be better off financially by taking on greater risk or by keeping your risk as small as possible. You can’t take on maximum risk blindly and hope that everything works out.
Pick your losses
Determining whether to accept more risk depends primarily on your loss record. If losses are small and few, you probably will be better off financially if you increase deductibles to obtain lower premiums. A carrier with more losses begins to face unpleasant choices. Its premiums for first-dollar or low-deductible policies escalate, but taking higher deductibles might be even more expensive. A frank appraisal of your loss history and forecasted losses is essential before you even begin shopping.
Consider your loss record over several years. Before exploring changes to its insurance program, Helena, Mont.-based Mergenthaler Transfer & Storage analyzed its losses over five years. That review ultimately led to higher deductibles, a smaller fleet and aggressive accident investigation by the safety director, says Lance Zanton, vice president of compliance and safety. Jacksonville, Fla.-based Raven Transport analyzed four years of losses before deciding to increase its deductible from $100,000 to $250,000 and to drop physical damage coverage.
Although the process begins with a review of past performance, your real goal is development of a loss pick, a forecast of future losses based on prior losses and necessary adjustments, says Marcia Linton, assistant vice president for Wachovia Insurance Services. Linton performs cash flow analyses to help motor carriers determine their best insurance option. (See “What’s the bottom line?”)
“The idea is to consider losses by policy year,” Linton says. “But you won’t know for several years what the total cost of a loss today will be.” In the case of a lawsuit, for example, your cost may peak in the second or third year.
To estimate that amount, insurance companies adjust losses by a loss development factor – a number used to estimate the total cost of a loss. Insurance companies will have their own LDFs, which should be available to carriers, says Jim Millar, transportation division leader for Wachovia Insurance Services.
Don’t forget to consider growth. As your fleet or mileage grows, your losses surely will grow with them. By converting your loss pick to a normalizing number – per power unit or per mile, for example – you can predict losses more accurately.
Protection against the big one
Four years ago, Burns Motor Freight carried liability coverage of $11 million. Today, it is paying about $360,000 more for $5 million in coverage. “If we had retained our full coverage we would not have been able to stay in business,” Burns says. But Burns recognizes the implications of his decision. “The increased cost for half the coverage has impacted our bottom line and left us open to a large lawsuit.”
Multi-million-dollar verdicts in trucking accidents have become more common. In January, an Arizona jury slapped Swift Transportation with $7 million in compensatory damages and $4 million in punitive damages for one accident. The tab may exceed Swift’s coverage by more than $6 million. Heartland Express is facing lawsuits totaling $54.5 million in compensatory damages and $215 million in punitive damages for a multiple-fatality accident last June.
“Punitive damages is an issue because we have had limited availability of punitive damage coverage off-shore,” says Alan Shetzer, executive vice president in charge of the transportation division at Hobbs Group, which offers insurance brokerage and consulting services. “Now you are having insurance carriers exclude punitive damages.” That’s one of the issues in Swift’s predicament.
“One million dollars is no longer sufficient,” says Ron Chipman, executive vice president of risk management for Watkins Motor Lines and vice chairman of ATA’s Insurance Task Force. “It’s probably more like $2 million to $3 million.” And large trucking companies probably need more.
Excess, or umbrella, coverage has become expensive because so few companies are willing to write it, Chipman says. Only half a dozen underwriters offer such coverage to motor carriers, he says.
Carriers are in a bind because they are under pressure simultaneously to increase liability coverage to guard against accident litigation and to lower coverage to keep premiums affordable. Sometimes the additional insurance just isn’t there.
“A new contract required additional liability limits, and the [insurance] carrier refused to increase our limits,” says Herb Manley, operations advisor, for Frenchville, Pa.-based M&M Enterprises Transportation. The company lost the business.
When setting coverage limits, don’t overlook the value of your company. The only change Choudrant, La.-based Hercules Transport has considered is umbrella coverage. “We may increase this or decrease this based on cost solely for the risk benefit of the owners,” says Billy Cox, chief financial officer for the 65-truck operation. “We have reduced this over the past two years, but never below what we feel the value of the company is.”
Declining coverages have many carriers feeling vulnerable. “We decreased our umbrella from $5 million to $2 million, and premiums still doubled,” says Ron Rudolph, president of Olsen Brothers Inc. in Rolling Meadows, Ill. “We had no choice but to reduce it and see what happens.”
Covering the first dollars
Another way to assume risk is to take responsibility for losses up to a certain amount. Many trucking companies are upping their deductibles to keep premiums affordable. Some increases have been astounding. In 2000, for example, Covenant Transport’s deductible was $5,000.
Today, it’s $1 million. Many smaller carriers are taking on even greater risk relative to their size. Central Point, Ore.-based TP Trucking, which operates 135 trucks, raised its deductible from $10,000 to $100,000.
“We knew the financial effect would cost us more money if we had any claims over $10,000,” says Andy Thomas, general manager of TP Trucking. “However, to keep our premium the same we had to raise our deductible to $100,000, and we would have to experience claims exceeding over $150,000 for it to cost more than the premium would be with the same $10,000 deductible.”
“Look at your appetite for assuming risk,” Chipman advises. “If you can carry a large deductible, it’s certainly to your advantage to do so.”
But in the hard insurance market, higher deductibles may not always be worth the effort. “We have not been able to get enough premium reduction to justify a deductible [on liability insurance],” Burns says. Burns Motor Freight did, however, raise its deductible on physical damage from $5,000 to $25,000.
The appropriate deductible for your company depends on your loss record, financial strength and other factors that come to light in a cash flow analysis. Many carriers find that keeping deductibles low ultimately costs money, says Wachovia Insurance Services’ Millar. They pay a significantly higher premium to get low-deductible or no-deductible coverage when it would be cheaper to cover those small losses themselves.
Millar refers to this practice as “trading dollars.” In effect, the motor carrier is just paying the insurance company extra money – perhaps 30 to 40 cents on a dollar – to pay claims the trucking company could have paid itself. “Trading dollars is not a good way to properly manage your insurance and risk management program,” Millar says.
Chipman agrees. “When people start looking at loss history, if they realized they could save 20 percent by taking a deductible, they could bank that. Why pay that extra 25 to 30 percent when you can pay it yourself?”
Higher deductibles do introduce risk, however, even though the risk may not be unlimited the way it is on the other end. No amount of forecasting can eliminate this risk.
To make premiums more affordable, Columbus, Ohio-based FST Logistics was forced to raise its deductibles for liability, the tractor and the trailer to $25,000 each.
“We looked at the last eight years experience and figured the cash flow impact for the worst year and for the best to see what we might be up against,” says Susan Seever, vice president of human resources and safety. “We made a decision on the changes in the policies hoping the actual year’s outcome would be somewhere in the middle. We then crossed our fingers!” Seever says that in some ways, the higher deductible means FST might as well be self-insured. “It puts a tremendous strain on cash flow.”
First-dollar, or guaranteed-risk, polices are alluring because you make one payment based on the number of power units or miles run. But few carriers can afford a guaranteed-risk policy today, so deductibles are a fact of life.
The ‘hidden’ costs
Besides introducing risk, deductibles typically come with additional costs that a savvy carrier must consider. First is collateral. Under a liability policy with a deductible, the insurance carrier is responsible for the claim even if you can’t pay your deductible due to bankruptcy or other problems. The insurance company generally seeks security, usually in the form of a letter of credit.
Collateral is becoming a huge problem, says Hobbs Group’s Shetzer, citing increases from 150 percent to 200 percent.
Collateral problems start with the growth in deductibles, which has increased the amounts that need to be collateralized. Reduced competition has also had an impact. “As we came off a soft market, the insurance companies had been giving greater discounts on collateral,” Shetzer says. For example, an insurance carrier might have required collateral only for the first year of each claim. On average, only 45 percent of the dollar value of a claim is paid in the first year, Shetzer says. “There’s no discount now.”
Another problem is that carriers with deteriorating financial conditions can’t get financing to cover collateral, Shetzer says. The crash in equipment values a couple of years ago magnified the problem.
Also, poor negotiations by motor carriers’ brokers over collateral provisions have led to problems, Shetzer says. How the collateral is calculated, when and how it will be returned and how it will be adjusted in the future often aren’t specified. A letter of credit for collateral also may carry a fee.
Another significant cost is claims handling, which is not an issue in first-dollar policies. When there is a deductible, the insurance company typically handles claims within the deductible and charges the motor carrier for the service. Larger trucking operations may choose to outsource claims handling or build the capability in-house.
The problem with claims handling isn’t just the additional fee, Shetzer says. Given that the insurance company won’t have to pay the claim, they may not put their best people on the task. “If they don’t have any skin in the game, what’s their incentive to do a good job?” Shetzer asks. “They are charging you for handling claims, so someone needs to watch them.” That’s a service a broker can provide, he says.
Once you go beyond a first-dollar policy, you share in the risk. Shetzer believes that trucking companies often are overly concerned with the cost of insurance when they should focus on the cost of risk.
“Many carriers are raising their deductibles to keep their premiums even,” Shetzer says. “That doesn’t do anything for your total cost of risk.” Unless you focus on reducing losses, taking more risk simply means shifting the cost from the insurance premium to alternatives that put your business in peril.
What’s the bottom line?
Cash flow analysis cuts through the ‘what ifs’
When you look at levels of deductibles and assumptions regarding future losses, picking the best financial deal can seem overwhelming. But whether you use a broker experienced in trucking or try to handle the task through your own accountants, a key tool is cash flow analysis.
“Cash flow analysis is useful if you are taking risk and you have a deductible,” says Marcia Linton, assistant vice president of Wachovia Insurance Services. “The timing of when things are due – as well as how much is due – can have an impact on cost.”
A cash flow analysis revolves around the loss pick – a forecast of future losses by year. The quality of the cash flow analysis rests squarely on the quality of the loss pick. Claims typically pay out over several years, and insurance companies use differing loss development factors to estimate annual losses. Then you must take into account factors that could change loss experience, such as fleet growth or contraction. “If you have five people doing loss picks, you can get five different numbers,” Linton says. “It’s really more of an art than a science.” Most other items in the analysis are either certainties or quite predictable.
The cash flow analysis takes into account the opportunity cost of capital. “Depending on the internal rate of return, it may be worth something if there is a higher rate of return to delay payment,” Linton says. With equity markets in a slump and interest rates near historic lows, this won’t be a big issue in the near term. “In today’s economy, the cash flow is not as valuable as it was three or four years ago.”
Other factors that go into the cash flow analysis include claims handling fees, taxes and surcharges, escrow requirements, collateral and collateral fees and fees for online claims monitoring.
You could settle on a single loss pick and base your decision on it, but it’s smart to look at more troubling scenarios, Linton says. A loss sensitivity analysis considers the total cost of risk at various loss pick assumptions. That’s useful for company owners who may be especially adverse to risk. The right choice in that situation might be an alternative that offers greater protection at higher loss picks.
In the end, most owners will choose the option that fits their risk tolerance even if another option may look better on paper. But you still need to know the numbers, Linton says. “If you don’t do the cash flow analysis, you are just taking a shot in the dark.”
Two sessions on containing insurance costs that were presented at ATA’s annual meeting last October are available to ATA members online at the National Accounting and Finance Council’s website.