Alternative Risk Financing: Dividend, Small Deductible and Large Deductible Plans

Preston Cavignac, CPCU, CIC, CRM
As insurance costs increase, so does the need to find alternative solutions. Most insureds are accustomed to “guaranteed cost” plans. These plans are characterized by small, “maintenance” deductibles and standard limits of insurance. The benefits of guaranteed cost plans are fixed premiums, predictable cost (good for budgeting) and claim services which are provided by the insurance company.

The disadvantages are limited cash flow opportunities, inflexible rating and policy forms, and standardized services. Although most insureds will remain using guaranteed cost plans, some will grow to a size that requires alternative approaches. The purpose of this article is to describe the characteristics of a dividend plan, a small deductible plan and a large deductible plan (retrospectively rated plans, pooling arrangements and captives will be discussed in a separate blog) for those insureds that would like to save premium by assuming additional risk.

Dividend Plans

The logical next option other than a guaranteed cost plan is a dividend plan (note, dividend plans are not common but are available). These plans have the same characteristics as guaranteed cost plans, except there is a chance to receive a dividend at the end of the policy period. This promotes loss/risk control, which will be necessary as insureds graduate to larger “loss sensitive” plans. Assuming all other parts are equal, a dividend plan would be chosen over a guaranteed cost plan because there is a possibility of receiving a dividend. However, in most cases, the dividend plan has a higher “maximum premium” than the guaranteed cost plan. The carrot is the “minimum premium.” Assuming maximum dividends are paid, the “minimum premium” is usually lower than guaranteed cost plans. If dividend plans are being reviewed, the insurance company’s reserving practices should be analyzed. This will play a crucial role in whether or not a dividend is paid out. It’s also important to understand that dividends are not dependent solely on your losses. The insurance company takes into account their book of business to determine whether or not dividends are issued.

Small Deductible Plans

Small deductible plans are between $25,000 and $100,000 (subject to interpretation) per line of coverage. Often the decreased premium generated by switching from a maintenance deductible to a small deductible will not warrant the added risk an insured assumes. Insureds tend to see additional cost savings once large deductible plans are considered.

Large Deductible Plans

Large deductible plans are generally defined as $100,000 or greater per line. Here are a few terms insureds must understand if these options are being considered:

  1. Per Occurrence Deductible – the maximum deductible amount an insured will pay for one occurrence on one line of coverage.
    1. A general liability policy has a $100,000 per occurrence deductible. The maximum amount an insured will pay on one claim on this one line of coverage is $100,000.
  2. Aggregate Deductible – the maximum (aggregate) deductible amount an insured will pay for multiple occurrences on one line of coverage.
    1. A general liability policy has a $100,000 per occurrence deductible and a $200,000 aggregate (stop loss) deductible for multiple occurrences. The maximum amount an insured will pay on multiple claims in this one line of coverage is $200,000. So the insured could potentially pay for two $100,000 deductibles.
  3. Basket Aggregate Deductible – the maximum (aggregate) deductible amount an insured will pay for multiple occurrences on multiple lines of coverage.
    1. A general liability, auto policy and work comp policy all have a $100,000 per occurrence deductible, a $200,000 aggregate stop loss deductible and a $500,000 basket aggregate deductible. The maximum amount an insured will pay on multiple claims on multiple lines of coverage is $500,000. So the insured could potentially pay two $100,000 deductibles on one line of coverage, two $100,000 deductible on another line of coverage, and one $100,000 deductible on a third line of coverage.

Deductible levels are determined by actuarial reviews. Large deductible plans also require collateral in the form of a letter of credit or cash. Under these plans the insured has more “skin in the game,” so risk control activities and a safety culture are key. By taking on more risk, the insured has the ability to capture greater reward.

It’s important to note that these plans should be evaluated on a “risk management” spectrum. There is a logical progression that needs to occur to ensure the success of each plan. The underlying factor that drives a company’s success is the importance and emphasis they place on risk control. As we work down the spectrum, insureds take on more and more risk. As a result, the emphasis on risk control needs to increase. How are you preventing claims from occurring? How are you minimizing the side effects once they occur? Claim frequency and severity drive the cost of premiums. Fewer claims = more savings.