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Managing Service Contract Risk – Insurance Rebates

You are the new manager of service contracts for a large manufacturing company.  Your program outsources the claims risk to a third party insurance carrier.  The agreement with the carrier stipulates that if loss ratios fall below 90%, then you are entitled to a portion of the savings.  The year is nearing close and you await the news from your carrier: if the forecasted loss ratio is high, then you may be faced with a rate increase;  if it’s low then you may be eligible for a premium rebate.

Your carrier informs you that claim costs fell well below expected.  You are encouraged by the product quality improvements.  Even better, the check is more than you imagined and you exceed your annual performance goals.  The news seems great – but is it?

A profit share rebate check in the service contract industry is akin to a personal tax refund.  On the one hand, you enjoy the year-end windfall; on the other hand, you may wonder why you let the government — or insurance carrier — hold your cash in the first place.   If your personal tax refund is too high, then in future years you may consider lower withholdings.  Similarly, if your rebate checks are substantial year after year, then you may want to negotiate lower premiums.

Large profit share checks could also be a sign that you are overpaying risk fees and premium taxes.   Typically these fees are calculated as a percentage of the target loss ratio, not the actual.  Therefore the effective rates you pay – that is, the amount of premium tax and risk fee as a percentage of actual claims – can be much higher if the loss ratio is low.  Furthermore, profit share rebates usually do not apply to risk fees and premium taxes.

In general, profit share arrangements are often mutually beneficial to both manufacturer and insurance carrier.  These agreements align incentives between the two parties so that they work together to find ways to reduce losses.   But similar to a tax refund, if the rebate checks become too large, then you may want to look more carefully at your current service contract risk structure.