Retention Levels of Auto Insurance in Alabama | Drive your car

Auto insurance in Alabama, once adopted, is difficult to discontinue. This is so because there is a potential for a ?double cash outflow? when the plan is discontinued, since the self-insurer would be paying both the current year?s insurance premium and the loss runoff from the previous self-insurance years.

Reserves. The size of the reserve fund is essentially a function of the number and size of expected claims. In any event, reserve funds must be isolated from the other working capital of the firm and invested in savings certificates, treasury bills or other liquid money equivalents. Bank credit should be available in advance of need, and the self-insurer should know where other back-up financing can be obtained. Interest income is expected to be earned on the funds set aside to pay claims. Here the time value of money can be substantial since claims against a fund are not all paid at once.

Retention Levels. The criterion used to measure the potential impact of a self-insurance loss is currently based upon a set of general rules of thumb. These rules include: 0.17? of annual revenues; 17? of working capital; 17? of shareholders equity, and 57? of pr e t ax earnings. Non-profit institutions, such as hospitals, often fix the limit of retained losses at a percentage of their annual budget, since the figure accurately relates to their yearly financial operation.

Another method of determining risk retention levels is to select the insurance program which minimizes the risk-adjusted cost. This involves quantifying a company?s conservatism in a so-called ?risk aversion level,? which is based on an established theory known as the Risk Preference (Utility) Theory. A company?s risk aversion level is related to its self-insurance capacity (SIC), that is, the amount of unexpected aggregate loss it can absorb in one year, over all exposures. A company?s risk aversion level is determined according to the formula: r = 1/SIC. For example, where a firm?s self-insurance capacity is expressed in million dollar units, a $100,000 SIC equals $0.1 million, so r = 1/10 = 10 millionths.

Once a risk manager has quantitatively determined a firm?s willingness to bear risk, it is then possible to evaluate the Risk Adjusted Cost of risk retention. Risk Adjusted Cost is defined as a dollar quantity which measures how much a company would be willing to pay to remove its risk exposure. This would be greater than the Expected Loss but less than the Maximum Possible Loss, and includes unexpected losses to be paid, plus budgeted items such as the expenses of loss settlement. In that sense, it is roughly comparable to a premium.15

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