Probability, Risk and Winning the Lottery!

Robert D. Wurtz, CPCU

John Dirkse, my partner, recently related a point which arose out of a discussion he had the other day with the finance director and corporation counsel for a Wisconsin county which shall remain nameless. Essentially, these county officials, for a county which happens to be totally self-insured, were relating with some justifiable pride, the fact that they had been handling their own liability and workers’ compensation losses since 1986, and had not sustained any loss the county could not easily handle financially and legally since they took over the responsibility. They have built up a sizable seven figure reserve over that period to handle the large loss, should it come. They opined that this gave them the experience and confidence to continue in this manner for the foreseeable future as they could see little value in spending money for insurance overhead when they have been so successful for the past several years.

This started me thinking because we have counseled many counties to take responsibility for their exposure to financial risk from liability loss to a greater or lesser degree through the use of higher deductibles (self-insured retentions), proper loss control procedures, and other risk management techniques. We have advised counties that, by banking the savings in the cost of their insurance, they can safely accept greater responsibility through higher self- insured retentions which, in turn, further reduces their real insurance costs. Were not the county officials John had met with essentially taking this idea to its logical conclusion? Does not the experience of Wisconsin Counties, overall, with the protections of Wisconsin statutes the state legislature has provided and Wisconsin courts protected, mean that there is some level of self-insurance that a county, especially a large county with sizable financial resources, may reach where insurance, or risk sharing, is not necessary? In other words, if a county can stand a deductible that is equivalent to the necessary level of insurance, what need for the insurance? This is a very good question but maybe not as amenable to an easy "yes" answer as it may first seem.

To attempt to answer the question we have to look at three elements; "How much insurance is necessary?", "What is the right deductible?", and "Why should we insure for a catastrophic loss that will probably never happen?" We should investigate these questions to provide us insight into the primary question.

How much insurance is necessary?

We have devoted a lot of time and energy to the exploration of this question in the past so we will not dwell long in it here but, complete financial security for the county requires an unlimited policy, such as is provided under a workers’ compensation policy. The legally required benefits provide the limits, not the policy. Under liability, “reasonable” financial security requires a compromise between the possible, the probable and the cost.

Something may be possible but not probable. Whether or not you insure against a highly improbable event depends on the cost. Insurable events, by their nature, should be improbable. We will talk more about this under the discussion of the right deductible but with regard to the right limits, suffice it to say that trial lawyers love high limits because juries generally have less concern giving away an insurance company’s money than a person, business or taxpayer’s money. If the situation causing loss is bad enough, if the culpability is overt enough, then the policy limits set a nice target for the plaintiff’s lawyer to set up as a goal for the jury.

There is a point where the size of the limits are an exercise in self flagellation. That point varies but in Wisconsin, most counties (66 of 72) carry about $5,000,000 of liability coverage when they can. This would seem to be a safe compromise number.

That is not to say the loss could not be higher. At least one county in the state has suffered a loss significantly in excess of this amount but they were totally self insured for the loss at the time and are a major county (a real big pocket!). Limits are not the only target that a plaintiff’s lawyer can create! For the sake of argument and recognizing the pragmatic opinion of so many let us accept the $5,000,000 figure for the right amount of limits for liability.

What is the right deductible?

Going back to our statement on the compromise between possible, probable and cost of coverage, this has direct application to the appropriate level of deductible. As we discussed above, generally, improbable events should be insured for while common events should borne as costs of doing business.

The level of probability, therefore predictability, and your ability to cover the cost of the event taking place out of operating funds should determine what you insure for and what level of self insurance, or deductible, you accept. If events are fairly predictable, that is, regular and you expect a certain level of them to occur over your budget period, you incur the extra cost of insurance overhead by insuring for them. These types of events include a certain level of damage from auto losses to your fleet, a certain amount of weather damage or vandalism to your property, and so on. Above this expected level, you should also expect a certain amount of irregularity in the number and size of these claims year to year, say fifty percent, for an event that happens six times a year and budget 150% of expected costs for these deductible losses. Keep in mind that this is an example of your thinking process and not a hard or even good example of actual costs.

Automobile physical damage (damage to your own vehicles) provides an excellent example of how you might go about increasing your level of self insurance and decreasing your insurance overhead. Let’s imagine you have a fleet of 25 highway trucks, six squad cars, and five other vehicles. Their individual unit costs are $75,000, $20,000, and $12,000, respectively. You have a little over $2,000,000 in vehicle values at risk. The trucks take dynamite to cause over $1,000 damage and the others a "spit in the wind". If you are an average county, you have two auto and one truck physical damage loss a year for a total of $15,000 in losses, all individually under $10,000. With $1,000 deductible APD coverage, the county pays $3,000 of deductible cost and the insurer $12,000. This coverage, using the $12,000 of losses as average, will cost the county about $18,500 a year. This is because most insurance companies peg for 50-65% loss ratios.

Let’s also assume that your county has averaged one sheriff’s vehicle total loss every four years and one truck total loss every ten years. In today’s dollars, that is average losses of $5,000 a year for sheriffs vehicles and $7,500 a year for highway trucks. The coverage for this average loss costs about $19,200. Your auto physical damage is costing you about $37,000 ($18,500 + $19,200) for average losses of $24,500 per year. This means your auto physical damage costs for each year are $3,000 plus $37,000 or $40,000, your deductibles plus insurance cost. Keep in mind this could have been the year we took a truck total loss for $75,000 (or had two of them collide with each other for $150,000 as has happened in some counties) but we are assuming this is a good year.

How does the picture of our costs change if we have a $10,000 deductible? Well, first of all we are going to eat the $15,000 of regular losses but out insurance cost drops to $13,900 (one $75,000 loss less a $10,000 deductible, or $65,000, every 10 years for a $6500 average and one $20,000 less $10,000 deductible squad loss every four years for a $2,500 average yielding $9,000 in average total loss a year plus company cost). This means we are saving $11,100 a year ($40,000 above verses $28,900 made up of the $15,000 of deductible losses and $13,900 of insurance cost). Over ten years we save $111,000 to pay two ten thousand dollar large loss deductibles. This is self insurance.

The county could have a great year with no APD losses and insurance cost of $28,900 or the kind of year you have when there is a revenue freeze on where you total three trucks, four squads and get major dear hits on four of five other vehicles for about $60,000 in deductibles plus insurance costs. That is why you buy stop loss coverage which limits your deductible losses to say $25,000 at nominal cost, less than a thousand dollars in our scenario.

Keep in mind that when you look at deductibles, total losses could have high probability of including an auto liability loss and a workers’ compensation loss. A single accident, if you are self insured on work comp and have a $10,000 liability deductible could cost you $120,000 or more (assuming a $100,000 WC loss) or if you were totally self insured on APD, WC and carried a $50,000 liability deductible, $225,000. And keep in mind, these things come in three’s! (But not in Oconto County, Everett and Gene!!)

Why should we insure for the catastrophic loss which will probably never happen?

This gets us to the lottery. Almost no Wisconsin county has had a loss over a million dollars. In fact, as far as we are aware, only two counties have had three losses over a million in there entire histories. If we go back through the entire history of the tort liability explosion that plaintiff’s attorneys refer to as "the happy years", it has only been about thirty years but that yields a probability of less than five hundredths of one percent (0.05% or 0.0005)!

Now, frankly your chances of winning the lottery are significantly less and, given the circumstances of the three cases, we would estimate your chances of suffering one of these catastrophic losses at ten times less than the counties who did, but if your own past history was a perfect indicator of your future, no one would ever win the lottery! The amazing thing is, that someone always wins who has never won before. I know most of us realize this because that is why so many of us spend money on the chance that our past does not necessarily reflect our future. Insurance for the unexpected loss rests on the same idea.

For this reason, we recommend that unless you can stand one or two or even three $5,000,000 losses, you should insure (the chances of one county suffering three major losses in one year based on our history are still better than winning the lottery). Your self insured retentions should be no greater, in the aggregate for all types of loss (all stop losses combined), than your county has reserves for.