Managing Service Contract Risk – Insurance Risk Fees

Published by Dan Adelsberg, Group Director Analytics, After, Inc. on April 29th, 2016.

Many OEM’s and retailers outsource their service contract claim risk to third party insurance carriers. As part of these agreements insurance carriers charge a risk fee.

What is a risk fee?

A risk fee is a payment to an insurance carrier in exchange for participating in a risk structure. It’s essentially the insurance carrier’s base wage:  it covers their cost of administration, legal filings, IT systems, labor, and so on.  Unlike reserve funds, risk fees are not invested in a trust and the insured is not eligible for a rebate.

How are risk fees calculated?

In most cases, risk fees are calculated as a percentage of net premium, or predicted claim losses plus a safety margin.  To illustrate, suppose the predicted losses for a program are $1,000,000, the safety margin is 10%, and the risk fee is 8%:

Net Premium = $1,000,000 / (1 – 10%) = $1,111,111

Risk Fee = Net Premium x [(1/(1-8%) – 1] = $96,618

You may wonder why the predicted losses are divided by (1 – 10%) instead of multiplied by (1 + 10%). This difference in math – or what we at After, Inc. refer to as “insurance math” – results in more net premium and greater fees.  Most insurance carriers would argue that 90% of $1,111,111 is $1,000,000, which translates to a 10% safety margin.  In any case, it’s important to understand these nuances for budgeting, and if you compare costs from different underwriters, you’ll want to know if the fees are calculated by regular math or insurance math.

It’s also important to note that fees based on predicted losses require even greater scrutiny. After all, if the claim estimates are too high, then your effective risk fee could be significantly more than 8%.  For more details on this point, check out Paul Swenson’s recent post about one of the biggest mistakes we see.

What is a reasonable risk fee?

Generally between 5% and 8%, but it can vary widely depending on the situation and the industry.

How can I reduce risk fees?

Insurance carriers negotiate risk fees based several factors, such as the perceived risk of the product, the amount of historical data available to make a risk assessment, the negotiated safety margin, the length of the service contract terms, and the length of the insurance deal.

As a general rule, the better your data and knowledge of historical claims, the lower your fee. In addition, insurance carriers are often willing to lower risk fees in exchange for a longer deal, which allows for more time to raise rates in the event of unforeseen losses.

As you can see, an in-depth knowledge of risk fees can make a significant difference in the financial success of your warranty program. If you would like to speak with After, Inc. regarding your warranty program, please give us a call at 800-374-4728.  We’re always available for a conversation!