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February 22, 2011

Checking the Numbers

Paying the Premium

by Eric Seidman

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The Blue Jays' signing of Jose Bautista last week set off a frenzy of analysis in which authors attempted to determine whether or not his projected performance would live up to the value of his new contract. This is a common analytical template, as it allows the writer to determine whether the deal was more beneficial to the team or the player. From the standpoint of the player, as long as the performance-to-currency translation is sound, the calculation generally works. However, there are factors beyond the reported salary that influence whether or not the deal benefited the team. One of these factors is disability insurance. Granted, the amounts of the insurance premiums paid to take out a policy on a player are not common knowledge, but it is important to understand that a team is likely to pay more than meets the eye, and that the insurance introduces a new level of risk.

Why insure players? Well, they play a sport that can hobble them for the rest of their lives or require that they undergo risky surgeries. They also play a sport in which contracts are guaranteed, meaning that no matter what happens, players are going to be compensated. By signing a player, a team is already entering into multiple areas of risk—that the contract will prohibit it from making other moves, and that the player’s performance will not live up to the deal. The last thing a team wants to consider is that a player will not even stay on the field for the duration of his contract. Cue disability insurance, which comes into play under the notion that if a player is not physically fit to play, the team may not be liable for his salary during the period in question. So how does this all work?

For starters, what is insurance? At its most basic, insurance is a risk management technique designed to hedge against a contingent loss. In other words, insurance is a gamble—someone will pay a specific amount to take out a policy that will cover them should something extraordinary or unusual come to fruition. Ideally, the cost of the policy and its premiums will be less than the actual insured entity, so that the insurer can mitigate some of its risk and not incur a complete loss on its investment should these extraordinary circumstances arise. If nothing bad happens, the insurer will have an added cost on top of the face amount of the contract, which defines the risk; it is possible that the policy is unnecessary, but it is impossible to know that without the benefit of being Captain Hindsight. Accurately assessing the levels of risk associated with each player is the most integral part of the decision of whether or not to insure the deal.

We will use Cliff Lee as an example. The lefty signs an unexpected deal with the Mystery Team that will pay him $120 million over five years. Knowing that the position he plays is prone to injuries, the team decides to insure his contract. After he inks his name to the paper, the contract is shipped to an underwriter, whose job is to account for all of the relevant factors pertaining to Lee’s situation and craft a policy with premiums paid in based on the risk being undertaken by the insurance provider. Not every player carries the same levels of risk, and as a 32-year-old pitcher, Lee is going to be perceived to carry more risk than certain other players—the problem with 32-year-old pitchers is that they tend to break down, after all. In general, old players are riskier than younger ones; pitchers are riskier than non-pitchers; and catchers are riskier than other position players.

From a policy premium standpoint, the worst thing to be is an older pitcher (save for an older pitcher who moonlights as an old catcher). The likelihood that the provider will have to make a payout—to pay for Lee’s salary in the event of a catastrophic injury—is also taken into account when determining the premiums, because it would not make sense to offer a team a small premium if the potential payout could wipe away the profits generated from hundreds of other clients.

Unfortunately, many upstart insurance providers traveled down this road simply because it was cool to be associated with Major League Baseball. Most of these companies went bankrupt and are no longer operating, so there is certainly risk on both sides. In some cases, especially those with big-money contracts, multiple insurance companies will bear the burden in different increments. The team will need to gauge its level of risk against that of the insurance provider, because if the latter assigns premiums that are too costly, it would eat away at the value of a potential payout and therefore not necessarily be worth the coverage offered in the policy.

To return to the case at hand, the underwriter sees Lee’s age and position, as well as his history of injuries, and determines that the Phillies will need to pay, let’s say, $4 million per year in order to be covered by this specific policy. If the Phillies agree—and as we will explore later, not all teams do—they will make these premium payments and become covered by the policy. Should something happen to Lee, they would then be eligible for a payout under the specific terms of the policy. And this is where games can be played and the situation can get tricky. The terms of the policy are obviously the key to the deal.

Back at the beginning of the decade, the entire duration of a deal could be insured and the teams could take out policies that covered 100 percent of the player’s salary. Nowadays, insurance policies are limited to two or three years, may cover only 50-80 percent of the player’s salary, have qualifying deductible waiting periods that last half of the season, and can include provisions that help the provider avoid having to cover the cost in certain circumstances. An example of one such provision would be to safeguard against a pre-existing injury.

For instance, Lee has had issues with his back in the past, so an underwriter might craft into the policy that the insurer would pay out 65 percent of his salary if Lee were deemed physically unfit to play at all during a year covered under the policy, unless the diagnosis of the injury pertains to a specific area on his back that has sidelined him from play in the past. In a case like this, the insurance provider would be protecting itself by drastically decreasing the likelihood that it would have to make a payout. The qualifying deductible is a waiting period of 90 days before the benefits kick in if a payout is deemed necessary, meaning that the team still covers the salary expense during that span. As we discussed in my articles on taxation in baseball, there are 220 duty days over the course of a baseball season, so the waiting period is a bit less than half of the year.

Quantifying this idea, let’s say that Lee is covered in the third, fourth, and fifth years of his deal per the duration restrictions on the policies. The Phillies pay in $4 million per year for coverage that will pay out 65 percent of Lee’s salary in a covered year if he suffers a debilitating injury that sidelines him for the entire season, as long as it does not involve his back. Prior to the fifth and final year of his deal, his foot falls off and he cannot pitch anymore. The team files a claim, and the provider agrees to pay the 65 percent. Only, it isn’t 65 percent of his $24 million salary in that season, but rather 65 percent of the $12 million remaining after the qualifying deductible period ends, less the major-league minimum of ~ $400,000. The Phillies recoup $7.5 million (65 percent of $11.6 million), but have already paid premiums totaling $12 million—$4 million per year for three years. At the end of the deal, they would have paid a total of $124.5 million for a contract with a face value of $120 million. Was it worth the cost in this hypothetical? How fun are word problems?

As you can see, there are many factors that can influence the decision to insure a player beyond his own injury history or salary. And even if a player meets all of the checkpoints necessary for an insurance payout there is still the very good possibility that the provider will not need to pay. Look no further than Jeff Bagwell to see all of this put together.

Bagwell had signed a five-year deal worth $85 million back at the beginning of the millennium, but had fallen prey to an arthritic right shoulder by the time his deal was about to end. He was set to earn $16 million during the 2006 campaign, the final guaranteed year of the deal. His shoulder had been bothering him since the 2005 season, in which the Astros lost to the White Sox in the World Series, and it seemed like a long shot that he would ever be able to throw a baseball again without discomfort. The insurance policy that the team took out on Bagwell was set to expire on January 31, 2006, and so the Astros sent their stalwart slugger to Dr. James Andrews on January 12 for an examination. When the exam had concluded, the Astros felt that Bagwell had been proven to be a disabled player who was not physically fit to remain on the roster.

With the results of that test, the team filed a total disability insurance claim on January 27, looking to recoup $15.6 million—the $16 million less the minimum. The team also had to work around Bagwell’s desire to participate in spring training activities, because the policy clearly stated that if a player participated in playing or practices, benefits would be terminated. They found a loophole of sorts in that such participation would not trigger the cancellation of benefits if it was with the consent of the team physician. On March 13, Connecticut General Life Insurance Co. told the Astros that they were denying the claim on the basis of their opinion that nothing had changed between then and the end of the 2005 regular season, when Bagwell was still included on the roster. Outraged, owner Drayton McLane wondered what else it would take to show that Bagwell was totally disabled from playing, if a test by a world-renowned orthopedic surgeon who had reached the same conclusion didn’t do the trick.

Prior to Bagwell’s situation, the last big insurance payout went to the Baltimore Orioles, who had signed Albert Belle to a five-year, $65 million contract before the 1999 season. Belle played in the first two years of the deal, but suffered from a degenerative hip condition that kept him from performing during spring training of the following year. The Orioles successfully recouped between $27 and $35 million of the deal given the provisions of their policy. The situation with Belle began to scare teams, because even though the Orioles received a large payout, the disadvantages of big-dollar deals rushed to the forefront. Another example of a payout, albeit on a lesser scale—though the player in question certainly tipped some scales in his day—involved Mo Vaughn.

The Mets traded for the former MVP and the remaining three years and $70 million of his deal even though he was sidelined for the 2001 season with a torn biceps. He played in 2002, but saw his career come to an end in 2003 due to a knee condition. Fortunately for the Mets, his contract came with a disability policy, and while the team still had to pay most of his 2003 salary due to the aforementioned 90-day waiting period, the policy stood to cover 75 percent of whatever was left. Scarred by their situation with Vaughn, the Mets came up with a fairly creative offer to then-free-agent Vladimir Guerrero, which would pay $71 million over five years if he met several “stay-healthy” incentives.

The idea of insuring a contract had become increasingly prevalent with the skyrocketing salaries of players, but the trials and tribulations necessary to receive a payout made the decision to pay for insurance premiums less than clear-cut. This also led, in part, to the increased incidence of incentive-laden deals, as teams utilized this technique to protect themselves from guaranteeing large sums of money that might not be recoupable in an insurance claim. In these situations, the team might not pay in premiums to take out a policy on certain players, but these players would not earn their entire salary without staying healthy, a form of risk management similar to insurance.

Some teams, however, don’t use even this tactic and simply do not insure contracts. For instance, the San Francisco Giants opted not to insure the deals they agreed to with Barry Zito and Aaron Rowand, figuring that the contracts themselves carried enough risk. The Seattle Mariners are famous for not taking out disability insurance policies for their players, figuring that if underwriters would exempt the providers from payouts for injuries to a body part that was the specific reason they sought insurance, then why bother? When the team signed Richie Sexson in 2005, they shopped around for quotes, but every policy exempted coverage for his surgically repaired shoulder that had been injured the year before. Why take out a policy ifthe shoulder was the reason they began searching?

What everything boils down to is a team’s assessment and its tolerable level of risk. Some teams are willing to look past the restrictions and provisions of the policies, as well as the cost, if it means that they can cover themselves in some capacity. Others bypass disability insurance policies because they amount to substantial added costs for the strong unlikelihood of a payout, literally and figuratively. This means that certain teams will pay more for a player than others, even if they both offer the same deal. The costs of premiums are not known, and while that makes it difficult for us to factor them into the cost of a player, they are certainly a consideration on the part of the team, just as the market taxation is a consideration for the player.

Eric Seidman is an author of Baseball Prospectus. 
Click here to see Eric's other articles. You can contact Eric by clicking here

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