Gregory L. Daniels
Stephen Tisdell

Several steps can help financial executives best determine risk retention levels for property and casualty insurance-and manage associated costs.

At a Glance  

  • Hospital and health system leadership should examine levels of risk retained within property and casualty insurance programs to ensure the right fit for the organization, rather than simply relying on past experience or basing decisions on a desire to reduce excess premiums.
  • Leadership should determine the maximum cost of risk that can be absorbed by the organization without violating key financial performance targets.  
  • Also important is using predictive models to identify expected losses or claims costs, which factor into cost-benefit analysis of retaining risk at various levels.  

When looking to contain costs, hospital and health system leadership may find it tempting to take on greater levels of risk to offset increases in excess premiums for property and casualty insurance coverage. And for some organizations, this decision may indeed be appropriate.

However, before pursuing such actions, it's important to evaluate the full range of potential effects. To give complete consideration to the organization's marketing issues, exposures involved, and propensity to take or avoid risk, a more comprehensive and financially disciplined approach is needed.

What's at Stake?

For most hospitals and health systems, total cost of risk (TCOR) consists of the costs related to the property and casualty insurance program, which typically have three components:

  • Costs of risk transfer (i.e., insurance premiums paid)
  • Costs of risk retention (i.e., costs of claims that are absorbed and paid directly by the insured through deductibles or other self-insurance mechanisms)
  • Administrative costs related to managing or controlling exposures to risk, and to managing claims once they occur)

For larger healthcare systems, the second component-cost of risk retention-is often the single greatest portion of their TCOR. Deciding how much risk to retain can have important implications. The resulting costs can be significant and, regardless of the predictive models used, can greatly exceed expectations.

These costs are often reflected on the balance sheet as reserves for future claim payments and can have an adverse affect on meeting certain ratios (for example, number of days cash on hand) required in most debt covenants. A single professional liability claim that is subject to a relatively high level of loss retention might warrant special disclosure in footnotes to the financial statements. If not properly managed and planned for, the costs can have adverse effects on both budget results and relationships with investors and creditors.

Both potential impact and degree of variability associated with these costs call for a disciplined approach to managing risk retention-one that uses many of the same techniques that are applied to other decisions affecting the financial performance of a healthcare system.

General Principles

In deciding how much risk to retain, two age-old axioms should be considered.

Do not risk a lot for a little. In other words, when substantial limits of protection are available at competitive premium rates, transferring the risk (i.e., buying true insurance) may be the best alternative, regardless of past retention levels or expected short-term premium savings.

Avoid swapping dollars with an insurance company. One way or another, an insured usually ends up paying all reasonably predictable losses. In most instances, these losses should be retained. If they are transferred, they will be included as an identifiable part of the insurance premiums (complete with built-in profit margins) that are paid to the insurance companies.

With these two principles in mind, risk managers have used other financial benchmarks over the years to set retention levels. Typically, the retention costs are limited to some percentage of one or more of the following:

  • Annual revenues
  • Net cash flow
  • Number of days cash on hand
  • Budgeted TCOR
  • Working capital
  • Net worth

Recognizing potential effects on the statement of operations, the balance sheet, and the cash flow statement is clearly a step in the right direction. However, this approach stops short of considering how risk retention decisions impact other goals, financial ratios, or measures of performance that are specific to the healthcare industry.

Financial Ratio Analyses

It is important to determine the maximum cost of risk that can be absorbed without violating financial performance targets. Often, these targets can be expressed by key financial indicators or ratios that are used internally as well as by investors, creditors, and sources of third-party payment.

A good first step is to establish pro forma financial statements that will incorporate TCOR projections for a reasonable period of time. Typically, the further into the future the cost projection, the less confidence the organization can ascribe. So if the time horizon is too long, the value of cost projections for later years will be undermined. However, if the time frames are too short, then the pro forma statements may not adequately account for the variability in losses from year to year or for the relative impact on key financial ratios. What may be a comfortable level of risk today could easily violate next year's financial ratio limitations.

Therefore, setting the number of financial periods to be evaluated requires a degree of judgment. Generally, three to five years should provide for an adequate planning horizon.

The next step is to identify performance measures that will be affected most by variations in TCOR as they relate to the levels of risk retention that are being considered. Although traditional measures of performance include ratios from income statements and balance sheets, other measures, such as total expenses per adjusted admission and the amount of debt per hospital bed, may be just as appropriate. For demonstration purposes, the table shown in the exhibit below provides examples of key ratios and target values for a hypothetical hospital system.

See Exhibit


Predictive Models

To properly evaluate the effect of risk retention decisions on the ratios provided in the table, the analysis should include the most accurate projection of expected losses or claims costs that can be prepared. The more significant the potential cost, the more important that credible predictive models be used. In many cases, the historic frequency and severity of claims allows for use of sound actuarial techniques to prepare loss forecasts. For each line of coverage where this is true, actuarial forecasts should be prepared.

An important factor in any actuarial forecast is the degree of variability that exists in the loss projections, or the ranges of aggregate loss that the hospital system can sustain within each alternative retention level being considered. Through an aggregate loss probability study, the likelihood of having aggregate losses less than specified levels can usually be calculated. For example, estimates can be provided at various confidence levels ranging from very low levels (10 percent) to very high levels (nearly 100 percent). The greater the confidence level, the greater the likelihood that losses will not exceed the forecasted number.

In theory, the "expected" level of losses occurs at the 50 percent confidence level. This means that 50 percent of the time, losses will be less (or more) than the amount of the forecast. At a 90 percent confidence level, the projected losses would be sufficiently higher, so that 90 percent of the time, the losses will be less than the amount of the forecast, and 10 percent of the time, the losses will be more than the amount of the forecast.

The degree of variability can be determined by examining actuarial results at other confidence levels as well (65 percent, 75 percent, 80 percent, and so forth). Using actuarial projections at higher confidence levels builds in a certain degree of "conservatism" by reducing the risk that forecasts will be exceeded.

Since payout patterns of certain casualty losses can extend well into the future, it is important to account for the time value of money. Forecasted losses should be discounted at an appropriate rate and expressed in "net present value" terms before they are used in direct comparisons with other current expenses.

Cost-Benefit Analysis

A critical factor in the analysis is the price of transferring the risk above the levels of retention being considered (i.e., the excess premiums). Estimates can often be obtained from informed brokers without involving an insurance company. However, if insurance market participation is necessary, the hospital system will be required to furnish loss data and, probably, the most recently completed actuarial studies.

Once premium estimates are obtained for different coverage attachment points, the amount of premium savings can be computed as the loss retention levels are moved progressively higher. Then these savings can be compared with the incremental cost of losses being assumed. For the most accurate results, the discounted or net present value of losses (as determined at each confidence level being evaluated) should be used.

The best or optimal level of risk retention is not necessarily the one that produces the lowest combined cost of retained losses and excess premiums. Rather, it is the one that provides an acceptable compromise between the financial constraints as measured by key financial indicators and the hospital system's appetite for risk. Determining the extent to which financial requirements are violated and envisioning worst-case scenarios will aid in the evaluation process.

A Comfortable Fit

Deciding how much property and casualty risk to retain is becoming a more significant factor in the overall planning process for all organizations. Given prevailing financial imperatives in the healthcare industry, a more thorough analysis of risk-retention levels should replace more narrow rules of thumb, antiquated benchmarks, and decisions that simply maximize short-term savings.

The appropriate retention level is the one that provides a comfortable fit with the organization's own appetite for risk while at the same time satisfying predetermined financial performance indicators. A disciplined methodology that properly quantifies financial exposure and downside risk implications will facilitate a more informed decision-making process.

Gregory L. Daniels, CPA, is senior vice president, Aon Risk Services South, Franklin, Tenn., and a member of HFMA's Tennessee Chapter (

Steve Tisdell, CPA, is principal, Tisdell Associates, Brentwood, Tenn. (

Publication Date: Thursday, July 01, 2010

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