The insurance equation: Does it make ‘cents’ for you?

Premium equals losses plus expenses minus investment income and profit

Revenue for every business is divided between costs of goods sold, expenses and profits. Insurance is no different.

The “insurance equation” is this:

Premium = Losses + Expenses – Investment Income + Profit.

This is a fairly simple formula. Let’s break it down and see where your dollars and cents are going and what difference
it makes.

  • Premium. The premium piece is what you see as you pay your bills. You pay a relatively small amount in return for the promise to pay any loss agreed to under the provisions of your insurance contract. You pay a few thousand dollars for the promise to pay a $1 million or more for a claim. You have to make sure that you get the promise right. Do you have the right coverage? Insurance coverage is complicated with unfamiliar language and a policy that is composed of base coverage forms with exclusions and endorsements that add, remove or change coverage. You have the best chance of having the proper coverage when you need it by using an agent who understands your business and your risk appetite, and who works with a company that understands the equipment rental industry.
  • Losses. You might look at losses as an insurance company’s cost of goods sold. The majority of premium collected by an insurance company is used to pay losses and the costs to adjust them. It varies by type of insurance — such as property and liability — but roughly 50 percent of all premium collected is budgeted for expected losses. Expected losses are the common everyday types of losses, such as theft of equipment, fires or auto accidents. It is important for you to know your loss ratio, which is paid and reserved losses divided by premium paid. If it exceeds 50 percent, a red flag is raised and the underwriter will tag you for a rate increase.

In addition, you will be on the watch list if you have a high frequency of claims. The underwriter knows that a lot of small losses can mean the big claim is coming. Some insurance companies distinguish between preventable and non-preventable losses. An underwriter who understands the equipment rental industry will know the difference and will not penalize you for the unavoidable losses.

Another 10 to 15 percent of the total premium is budgeted to pay for extraordinary or catastrophic losses, such as tornados, hurricanes, earthquakes, snowstorms and floods.

It’s important to note that the claims practices of an insurance company have an impact on loss costs. For example, what is the company’s claims philosophy? Some companies expend more resources looking for ways to deny claims than those who look for coverage and ways to pay. Also, does the company understand the finer points of your industry and your business in order to properly defend you? There is no time to learn on the job when defending a lawsuit. You need the best defense available. Does your agency have a claims advocate to help you through the rough patches?

  • Expenses. The next largest piece of the premium pie consists of operating expenses, such as overhead and taxes. As a percentage of the premium, expenses can range from 20 to 40 percent, sometimes less and sometimes more. Since insurance companies are regulated by each state, premium taxes can vary widely and, like any other business, some companies operate more efficiently than others and have a lower expense ratio. Count the corporate jets and golf courses, and you might get a feel for a company’s expense ratio.
  • Investment income. Investment income is a deduction in the insurance equation because it reflects earnings rather than expenditures. It can be substantial and lower the amount of premium a company needs to collect to meet its loss and expense obligations. Investment income is earned from two sources. First, states require that insurers have surplus capital to protect policyholders in the event losses exceed expectations. Interest is earned on that surplus. The second source is interest earned on claim reserves, which are dollar amounts expected to be paid on claims, but set aside until the claims settle.
  • Profit. Profit is the final factor in the equation. What does your insurance company do with its profits? Does your service suffer, so your insurance company can pay larger dividends to stockholders or are profits reinvested to help you and fellow policyholders control losses and stabilize premiums?

One last consideration is the presiding principle of volume. All insurance companies operate on volume. Theoretically, the greater the volume the better losses can be predicted and large losses absorbed. Expenses can be spread over a larger base, which means that the expense ratio is lower and your premium could be lowered. To best serve you, your insurance company should write a substantial amount of business in the equipment rental industry. — Phil Kelling

As an insurance buyer, you want to understand the process and ensure you are getting the best deal available. What things impact price and what can you do to influence your insurance costs?

1. Look at your coverage and terms in each of your policies. Not all insurance policies provide the same protection. Have your agent tailor your policy to fit your needs.

1.1 Consider higher deductibles. There are significant premium credits if you can move from a $1,000 property deductible to a
$2,500 or $5,000 deductible.

1.2. Don’t buy redundant coverage. Many policies have extensions of coverage that provide a basic level of protection that may be adequate without purchasing additional coverage. For example, your property coverage may have an employee dishonesty coverage extension that makes purchasing separate crime coverage less valuable. Or, you may be purchasing auto insurance in a “no fault” state. If so, do you need to purchase medical payments coverage, too? When in doubt, ask your agent.

2. Know the underwriter’s hot buttons from a risk profile standpoint. For rental operations, that means having a strong and enforceable rental contract, keeping good maintenance records, and having good building and rental yard security. Share what you do in these areas with your agent/company.

2.1. Know your loss experience. Underwriters know that losses are random, but they also know one of the key predictors of future losses is historical loss experience. Just like you should know your credit score, you should know your loss experience. Ask your agent for loss runs regularly. Understand why losses happened and what you can change to prevent reoccurrences.

3. Understand the insurance market on a macro level. The insurance market, like the equipment rental industry, is affected by supply and demand. As the economy struggled, the insurance industry had excess capacity and companies reduced margins to maintain market share. In 2011, it was a tough year for insurance companies due to the number of natural disasters with deadly tornados leveling towns, rivers flooding, a very costly blizzard and Hurricane Irene. The United States had a record 10 weather catastrophes costing more than $1 billion in 2011. Between increased demand and reduced capacity, insurance costs are likely to increase slightly in 2012.

Finally, understand that your insurance agent is your expert in these matters. Use your agent’s expertise to help you manage those costs.

— Harvey Felzke