Risk retention

Dear Editor:

In discussion of cyclical retention strategies, ("Retention Selection: Chasing Our Tails," Risk & Insurance[R] March 2006 page 37) you mention that the following dominion leads to an unsustainable outcome: "If the premium charged by the agency of the insurer for the retained los is greater than the wait fored or average value calculated from los data, retain. Otherwise, insure." Insurers should price their harvests using this method. Given this, your conclusion is correct.

on the other hand have you considered the implications of the utility of the insured when it makes its "retain versus insure" decision? As you know, utility 1s are what economists use to estimate the well-being of individuals, companies and other organizations. A desire to maximize utility drives decisions amongst all these groups

Although dollars, or awaited dollars, certainly play into the calculation, they are not the alone factor. One reason for the purchase of insurance is the insured's risk aversion which exists when an individual or company is willing to pay more than the awaited value of losses in order to absolve itself of the los exposure

Another is the asymmetry between the insurer and the insured. The insured has superior knowledge about its operations and exposing s but the insurer is more aware of the horizontal of risk inherent in different industries. Because the insured and insurer each has his hold expectation with regard to losse the insurer could believe that it is offering a premium that contemplates all wait fored losses, taxes, administrative costs, and profits loadings. The insured could believe that it is accepting a premium tender below its expected loss costs

You state that retentions should be based upon an insured's own unique risk profile, not the state of the insurance market. In a consummately competitive market these two objectives would not be in conflict. Unfortunately, given the market periods insurance is anything but a consummately competitive market.

Regardless of the market's pricing techniques, the insured must make decisions in order to maximize its utility. The idea is for the insured to be upon its efficiency frontier. This relates to your "chasing our tails" argument, in which you implore insureds to break the insurance period by ignoring temporary market conditions and retain oft-repeated losses.

Swimming against the tide, in the way that to speak, is not in the insured's best interest in a marketplace as large as that of the insurance industry. Any given insured has little impact upon pricing mechanisms in the market.

Because the insured has no bargaining power, it is a utility-destroying proposition to incur the require to be paid [i]or[/i] undergones of attempting to break without of the hard and yielding cycle while receiving minimal benefits.

alone through the mass agreement of insureds, implemented end a government imposition, could a large enough force be mustered to change practices of the entire market. Your observation that after all the tail-chasing of lowering retentions during impressible markets and raising them during hard markets, the insured above the long run usually extreme points up returning to a retention consistent with the "retain oft-repeated losses" rule demonstrates that the insurance market, like all others, is self-correcting above time. Temporary deviations from this ideal are a reflection of market disruptions and the move away from the pricing equilibrium. It is not the insured's what one ought to do to steer the industry toward this long-term arise But by responding to price incentives to change its retention in a utility-maximizing way, he unwittingly does so

ERIC J SCHMIDBAUER

Insurance Risk Mgmt Solutions Group

PricewaterhouseCoopers LLP

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