Kevin Quinley10.16.13
Medical device firms managing risks by setting appropriate retention levels may find some are too high, some are too low and some are just right. In managing risk for a medical device company, setting the appropriate retention level is a crucial skill.
Think of a retention as something akin to the deductible on your car or homeowners insurance policy. If you have, say, a $500 deductible on your car’s collision coverage, you are practicing retention. When you have a $5,000 deductible on your homeowner’s policy for damage to your house, you are practicing retention. In commercial insurance for medical device companies, we use the term retention more than deductible when it comes to liability coverage.
There are differences between the two. First, retentions are often larger sums of money (i.e., thousands or tens of thousands instead of hundreds of dollars). Second, retentions are more common in commercial insurance than in personal insurance. Third, in a retention, it is customary for the policy holder/insured to assume certain claim handling functions which might normally be handled by the insurance company.
Absorbing risk through retention has advantages for medical device companies. Foremost, they may be able to capture meaningful reductions in insurance costs. Insurance companies often give rate decreases and premium reductions for companies that are willing to pay for the initial layers of loss. In addition, some companies find it attractive to be able to manage their own claims closer and tighter than an insurance company might.
Setting the right retention level can be challenging, though. Pick one too low and you may not capture meaningful cost
reductions and be saddled with distracting administrative headaches. Pick one too high, and you may find that funds you earmarked for expansion and growth must be siphoned off to pay for losses. Setting one just right can blend the best of both worlds — the ability to control claims and achieving meaningful premium reductions, while reserving insurance coverage for the more catastrophic and rare losses.
What factors go into setting the right retention levels, however? Here are factors and considerations to weigh:
1. Degree of premium savings. How much premium discount will flow from each $5,000 the company retains? Trade-offs may exist between the level of retention and the lower rate per thousand dollars of coverage. Insurance underwriters determine the price break from a policy holder’s willingness to absorb an initial layer of loss. Generally, the higher the retention, the lower the rate per thousand.
However, insurance underwriters also insist that a device firm that assumes a sizable self-insured retention has the financial wherewithal to fund such a retention. Insurance companies worry that, in the event of a policyholder insolvency, a court may require it to “drop down” and pay losses in the self-insured retention layer, a layer that the insurance company never intended to cover.
So, it’s not simply a matter of “the sky’s the limit” in terms of what a medical device company is interested in retaining. This leads to the next consideration.
2. Company’s liquidity, cash flow and financial strength. A medical device company shouldering a self-insured retention must have the working capital to fund a self-insured retention. If, for example, it decides to pay the first $250,000 of each workers’ compensation loss or the first $50,000 of each product liability claim, the device company must have the financial capacity to pay those losses. This is where the device firm’s chief financial officer (CFO) plays a crucial role in working with the risk manager to select retention levels and keep sufficient funds to address cash calls.
3. Management risk tolerance. This factor is hard to measure but must be weighed nevertheless. Some management teams highly value a good night’s sleep, knowing that they are financially cushioned against most loss. Other managers and management teams may be comfortable with a degree of financial risk. Corporate introspection is necessary here—particularly in the C-suite, where CEOs and CFOs reside. The risk manager can successfully lower the cost of insurance by committing to an aggressive retention, only to find that management feels burned when claims arrive and the company must divert cash from new product ventures to fund claims within a self-insured retention.
4. Product-line risk profile. A company that makes tongue-depressors, bedpans, single use disposables and relatively benign products might consider a more elevated retention level. If something goes wrong with one of these products, chances are on average that it will not be a severe claim. By contrast, if a company manufactures life-support equipment or heart valves, the margin for error is smaller. A malfunction here may trigger a wrongful death claim or a catastrophic injury with a financially huge lawsuit. In such a case, the worst-case scenario this severe should be weighed and factored into the decision of a company’s optimum retention level. In other words, an assessment of claim frequency and severity will help firms decide whether to take on a $10,000 or a $500,000 retention, or somewhere in between.
Karen Kyer, executive sales underwriter at The Hanover Insurance Group Inc., says that much of the art of setting the right
retention level relates to “the use of the device, whether or not it is used in the clinical setting or home use, number of devices on the market, etc. Is the device implantable? Is it life-saving or commonplace—used by the general public and purchased at any retailer?” For companies in their early stages with little or no claims history, a challenge for both insurers and device companies is frequently a lack of loss history.
A related consideration is the jurisdiction where the company plans to sell the devices. U.S. products are still underwritten differently than many other parts of the world, due to the widely held perception of U.S. courts as congenial to product liability claims and suits.
5. Company’s life-cycle stage. A start-up firm may feel uncomfortable taking a large self-insured retention (SIR). For starters, it may not have enough operational experience to make credible forecasts of loss frequency or severity. Further, cash may be tight. A company in an early stage may lack the liquidity to self-fund an initial layer of losses. By contrast, a well-established company with a long track record and strong capitalization has flexibility in setting aggressive retention levels, thereby capturing rate reduction on its insurance costs.
Russ Jones, president of Med/Tech Assure LLC, says that SIRs seem more prevalent today, perhaps because insurers want policyholders to have more “skin in the game.” He sees $10,000 to $25,000 retentions often. “Also,” Jones cautions, “for clients that are in an early stage with many pre-revenue companies still in R&D, any amount of SIR could be damaging, to both the company and its funding sources.”
6. Willingness and ability to assume insurance-type functions. The more you become self-insured, often the more insurance-type functions you may have to shoulder. These include claims handling, fielding calls from irate claimants who in the past were buffered by an insurance company claim department, regulatory compliance with unfair claim settlement practice acts, supervising defense attorneys, auditing and paying legal bills, filing requisite proofs of coverage or other filings with state insurance departments, etc. Some companies have an appetite for this and are willing to discharge these functions in exchange for the premium savings.
Other companies come to realize that there’s a lot more to self-insurance than they previously believed and that the burden chafes. Tip: Think it through before deciding to take on a self-insured retention.
7. Ability to “cap” your aggregate retention. This way, you have peace of mind knowing that there is a “cap” or ceiling on how much you will have to pay under your retention. If you hit the maximum after having a bunch of claims, at some point you have “maxed out.” At this point, the insurance company starts paying claims as if you had no deductible or retention. Mike Tanghe, vice president at Falcon West Insurance Brokers, recommends a “cap” or annual aggregate on the retention. He notes, “It’s important for companies to ask for an annual aggregate on the deductible.” Tanghe adds that there is no additional charge. In worst-case scenarios, it caps the out-of-pocket exposure.
8. What, if any, collateral does the insurer require? Bonnie Cachia, director of Risk and Insurance at West Pharmaceutical Services Inc., recommends that device firms determine the type and amount of collateral that the insurer require, if any. Insurers may want “collateral” to ensure that there are sufficient funds for a manufacturer to pay losses within a retention.
Goldilocks may have dithered in trying to decide which chair, porridge or bed was most attractive. Medical device executives and managers need not suffer from the same indecision, though, using these factors to decide which retention level is just right. v
Kevin Quinley, CPCU, is principal of Quinley Risk Associates, a risk management consulting firm in the Richmond, Va., area. He has more than 25 years of risk management experience with medical device companies. You can reach him at www.kevinquinley.com or at kevin@kevinquinley.com.
Think of a retention as something akin to the deductible on your car or homeowners insurance policy. If you have, say, a $500 deductible on your car’s collision coverage, you are practicing retention. When you have a $5,000 deductible on your homeowner’s policy for damage to your house, you are practicing retention. In commercial insurance for medical device companies, we use the term retention more than deductible when it comes to liability coverage.
There are differences between the two. First, retentions are often larger sums of money (i.e., thousands or tens of thousands instead of hundreds of dollars). Second, retentions are more common in commercial insurance than in personal insurance. Third, in a retention, it is customary for the policy holder/insured to assume certain claim handling functions which might normally be handled by the insurance company.
Absorbing risk through retention has advantages for medical device companies. Foremost, they may be able to capture meaningful reductions in insurance costs. Insurance companies often give rate decreases and premium reductions for companies that are willing to pay for the initial layers of loss. In addition, some companies find it attractive to be able to manage their own claims closer and tighter than an insurance company might.
Setting the right retention level can be challenging, though. Pick one too low and you may not capture meaningful cost
reductions and be saddled with distracting administrative headaches. Pick one too high, and you may find that funds you earmarked for expansion and growth must be siphoned off to pay for losses. Setting one just right can blend the best of both worlds — the ability to control claims and achieving meaningful premium reductions, while reserving insurance coverage for the more catastrophic and rare losses.
What factors go into setting the right retention levels, however? Here are factors and considerations to weigh:
1. Degree of premium savings. How much premium discount will flow from each $5,000 the company retains? Trade-offs may exist between the level of retention and the lower rate per thousand dollars of coverage. Insurance underwriters determine the price break from a policy holder’s willingness to absorb an initial layer of loss. Generally, the higher the retention, the lower the rate per thousand.
However, insurance underwriters also insist that a device firm that assumes a sizable self-insured retention has the financial wherewithal to fund such a retention. Insurance companies worry that, in the event of a policyholder insolvency, a court may require it to “drop down” and pay losses in the self-insured retention layer, a layer that the insurance company never intended to cover.
So, it’s not simply a matter of “the sky’s the limit” in terms of what a medical device company is interested in retaining. This leads to the next consideration.
2. Company’s liquidity, cash flow and financial strength. A medical device company shouldering a self-insured retention must have the working capital to fund a self-insured retention. If, for example, it decides to pay the first $250,000 of each workers’ compensation loss or the first $50,000 of each product liability claim, the device company must have the financial capacity to pay those losses. This is where the device firm’s chief financial officer (CFO) plays a crucial role in working with the risk manager to select retention levels and keep sufficient funds to address cash calls.
3. Management risk tolerance. This factor is hard to measure but must be weighed nevertheless. Some management teams highly value a good night’s sleep, knowing that they are financially cushioned against most loss. Other managers and management teams may be comfortable with a degree of financial risk. Corporate introspection is necessary here—particularly in the C-suite, where CEOs and CFOs reside. The risk manager can successfully lower the cost of insurance by committing to an aggressive retention, only to find that management feels burned when claims arrive and the company must divert cash from new product ventures to fund claims within a self-insured retention.
4. Product-line risk profile. A company that makes tongue-depressors, bedpans, single use disposables and relatively benign products might consider a more elevated retention level. If something goes wrong with one of these products, chances are on average that it will not be a severe claim. By contrast, if a company manufactures life-support equipment or heart valves, the margin for error is smaller. A malfunction here may trigger a wrongful death claim or a catastrophic injury with a financially huge lawsuit. In such a case, the worst-case scenario this severe should be weighed and factored into the decision of a company’s optimum retention level. In other words, an assessment of claim frequency and severity will help firms decide whether to take on a $10,000 or a $500,000 retention, or somewhere in between.
Karen Kyer, executive sales underwriter at The Hanover Insurance Group Inc., says that much of the art of setting the right
retention level relates to “the use of the device, whether or not it is used in the clinical setting or home use, number of devices on the market, etc. Is the device implantable? Is it life-saving or commonplace—used by the general public and purchased at any retailer?” For companies in their early stages with little or no claims history, a challenge for both insurers and device companies is frequently a lack of loss history.
A related consideration is the jurisdiction where the company plans to sell the devices. U.S. products are still underwritten differently than many other parts of the world, due to the widely held perception of U.S. courts as congenial to product liability claims and suits.
5. Company’s life-cycle stage. A start-up firm may feel uncomfortable taking a large self-insured retention (SIR). For starters, it may not have enough operational experience to make credible forecasts of loss frequency or severity. Further, cash may be tight. A company in an early stage may lack the liquidity to self-fund an initial layer of losses. By contrast, a well-established company with a long track record and strong capitalization has flexibility in setting aggressive retention levels, thereby capturing rate reduction on its insurance costs.
Russ Jones, president of Med/Tech Assure LLC, says that SIRs seem more prevalent today, perhaps because insurers want policyholders to have more “skin in the game.” He sees $10,000 to $25,000 retentions often. “Also,” Jones cautions, “for clients that are in an early stage with many pre-revenue companies still in R&D, any amount of SIR could be damaging, to both the company and its funding sources.”
6. Willingness and ability to assume insurance-type functions. The more you become self-insured, often the more insurance-type functions you may have to shoulder. These include claims handling, fielding calls from irate claimants who in the past were buffered by an insurance company claim department, regulatory compliance with unfair claim settlement practice acts, supervising defense attorneys, auditing and paying legal bills, filing requisite proofs of coverage or other filings with state insurance departments, etc. Some companies have an appetite for this and are willing to discharge these functions in exchange for the premium savings.
Other companies come to realize that there’s a lot more to self-insurance than they previously believed and that the burden chafes. Tip: Think it through before deciding to take on a self-insured retention.
7. Ability to “cap” your aggregate retention. This way, you have peace of mind knowing that there is a “cap” or ceiling on how much you will have to pay under your retention. If you hit the maximum after having a bunch of claims, at some point you have “maxed out.” At this point, the insurance company starts paying claims as if you had no deductible or retention. Mike Tanghe, vice president at Falcon West Insurance Brokers, recommends a “cap” or annual aggregate on the retention. He notes, “It’s important for companies to ask for an annual aggregate on the deductible.” Tanghe adds that there is no additional charge. In worst-case scenarios, it caps the out-of-pocket exposure.
8. What, if any, collateral does the insurer require? Bonnie Cachia, director of Risk and Insurance at West Pharmaceutical Services Inc., recommends that device firms determine the type and amount of collateral that the insurer require, if any. Insurers may want “collateral” to ensure that there are sufficient funds for a manufacturer to pay losses within a retention.
Goldilocks may have dithered in trying to decide which chair, porridge or bed was most attractive. Medical device executives and managers need not suffer from the same indecision, though, using these factors to decide which retention level is just right. v
Kevin Quinley, CPCU, is principal of Quinley Risk Associates, a risk management consulting firm in the Richmond, Va., area. He has more than 25 years of risk management experience with medical device companies. You can reach him at www.kevinquinley.com or at kevin@kevinquinley.com.