Executive Summary: In this article we focus on understanding indirect loss costs and how they impact a firm’s bottom line. Indirect loss costs are well established in the Fortune 500 world, but they don’t get much attention in the middle market, which is a shame. Indirect costs are just as significant (if not more so) in the middle market as they are in larger firms and deserve to be managed. We provide an example of an average manufacturer with 300 employees and compare the outcomes between traditional insurance thinking to our approach to indirect loss costs. This academic comparison illustrates how our process yields an eight-fold improvement in cost reduction over three years.
What is an indirect loss cost?
An indirect loss cost is any cost incurred during a claim which is typically not reimbursed by insurance. They can occur with any type of claim: Auto crashes, slip and fall liability claims, product liability claims, direct damage to property from a fire or flood claim, etc.
The indirect loss cost conversation is most common among risk managers and decision makers when it comes to work place accidents claims since these can incur the highest rate of indirect costs compared to direct insured costs.
Industrial expert opinions vary on what the indirect costs of workers compensation claims are, but they are often expressed as a multiple of the direct or insured costs. Depending on the size of the direct injury claim costs the multiple applied can be as low as 1.1 and as high as 10 times. Most industrial experts will settle on a multiple of 4. As an example, a worker injury that incurs $10,000 of direct costs of medical bills and replacement wages, will also incur another $40,000 of indirect costs which are uninsured and borne by the employer.
What are the types indirect loss costs incurred when a worker is injured?
- Lost productivity from an injured worker out on disability
- Production time – especially when a production line is shutdown to help an injured worker
- Administrative costs in filing workers comp claims and OSHA reports
- Overtime pay for non-injured workers to fill the gap left by the injured worker
- Time and money spent on hiring a temporary or permanent replacement worker
- Training costs to bring a new worker up to speed
- Damage to company reputation or brand due to unfilled orders or delays caused by impaired production
- Potential OSHA fines or penalties
- Waste – destroyed or damaged work in progress (common in food industries when injured worker’s blood is present) (gruesome but true)
- Higher workers compensation premiums
- Damage to employee morale/fear of themselves being injured and associated work slowdown
- Worry, frustration, anxiety of company decision makers relative to the industrial accident
- The deductible and/or co-insurance from an insured event, or the costs associated with under-insurance or lack of proper insurance.
These costs are all incurred by the company and we’re note even diving into the potential human, emotional and financial costs borne by the injured worker and his/her family. Those costs can be discussed in another article, but they can easily outweigh the costs incurred by the company/employer.
So, why are these important to understand and discuss?
Because they are very real and potentially significant costs which don’t get much attention in the insurance conversation. Most agents are focused on achieving slight premium reductions they may be able to negotiate but they ignore the indirect loss costs which CAN BE controlled and will have a much greater impact to a firm’s bottom line.
An iceberg is the common metaphor when comparing direct and indirect loss costs. For most insurance brokers and their clients, they see the tip of the iceberg above the waterline. These are the direct costs of claims – what their insurer is paying to remediate a loss. Yet below the waterline is the massive ballast of indirect costs which can sink any firm’s profit margin.
Here’s an example to prove this point:
The subject company is a cookie manufacturing firm in New York with 300 employees. Based on the Bureau of Labor Statistics this company will average 4.7 claims per 100 employees per year. To be conservative we’ll round that down to 4 claims per 100 employees, so each year this company can expect about 12 claims. For example purposes, only half of those claims are serious and involve lost days from work, so we’ve got 6 “major” claims and 6 “minor” claims.
The average cost of a lost time injury claim is statistically around $40,000 so that means this company will incur about $240,000 in direct loss costs (insured) and $960,000 of indirect costs (un-insured) based on the generally accepted 4 times multiple. Direct costs such as lost wages, medical and hospital bills are paid by the employer’s workers compensation insurer.
The average profit margin in the cookie manufacturing business is 5.2%. This means the subject company needs to create an additional $18 million in sales just to cover these indirect costs, not an easy feat in any economic climate!
This manufacturer pays about $900,000 in annual workers compensation premiums for a “guaranteed cost” policy.
On the company’s next insurance renewal, a typical broker competing to write this account is going to try and leverage the marketplace for a better premium. Unfortunately, this account is “average” in every way and the competing broker can only achieve a 6% reduction in premiums or a $54,000 premium reduction – nothing to sneeze at but let’s compare that to how we would approach this deal.
The first thing we’re going to do is be realistic about the time frames here. This is a long-term cost reduction project, and while we can secure the same 6% premium reduction, we’re going to focus on the $960,000 of indirect costs as our primary target. Reducing the number of serious claims each year will impact the indirect costs, but it will also give us greater leverage to negotiate more favorable insurance terms down the road.
At the end of year one, we can realistically achieve a 25% reduction in losses through an aggressive risk control program. That means indirect loss costs are cut by $240,000. That’s on top of the $54,000 premium reduction we also negotiated in year one. In year two we eliminate another 15% of indirect loss costs for another $108,000 reduction.
With an assertive risk control program working and claim performance greatly improved, the business owner has an increased level of confidence to move from a guaranteed cost insurance program to a high deductible program. Under a high deductible the business takes on a much greater share of risk, in exchange for a much lower premium. By the end of year three, the net cost difference between where he is in a high deductible program, and where he would have been under a guaranteed cost program is about $200,000 in annual savings.
In total it looks like this:
|End of Year||Typical Insurance Broker||Out Solution|
|One||$54,000 premium reduction||$54,000 Premium Reduction + $240,000 Indirect Cost Reduction = $294,000|
|Two||$54,000 premium reduction||$54,000 Premium Reduction + $240,000 & $180,000 Indirect Cost Reduction = $402,000|
|Three||$54,000 premium reduction||$200,000 Premium Reduction + $240,000 + $108,000 + $54,000 = $602,000|
|TOTAL||$162,000 TOTAL Cumulative Cost Reduction||$1,298,000 TOTAL Cumulative Cost Reduction|
An Eight-Fold Improvement in Cost Reduction!
The difference from the traditional insurance broker’s methodology and ours is EIGHT-FOLD multiple or over $1.1 million in this example. While this is a rather academic exercise, we have worked on real-world scenarios like this, achieving similar results.
For larger firms, especially in industrial settings, the concept of indirect loss costs and a strategy around managing these costs is critical to enhancing bottom line profits. This is achieved through our Strategic Risk Process and our advanced set of resources dedicated to helping larger firms identify and control risk.
In the M&A world, a buyer who doesn’t fully appreciate the concept of indirect loss costs puts their capital at risk and may overpay for a deal, that’s why we incorporate this analysis into our risk diligence offering. For buyers who understand the concepts of indirect costs, they can price their offerings more efficiently and for the right deal can accelerate their ROI when proper loss controls are implemented.
For more information on how we can help achieve these types of results for your company, please contact me!