Self-Insurance and Self-Insured Retention

 

An Overview

 

March 2005

 

Self-insurance and a self-insured retention (SIR) are two items that can be viewed as underlying coverages. Some may object to self-insurance being considered as insurance since the two requisite insurance components—transfer and pooling—are not included in such a plan; indeed, the majority view in today's courts is that self-insurance is not insurance. As for a self-insured retention, some may view it as simply a deductible under a different name. However, both self-insurance and SIRs play a distinctive and useful role in managing an insured's risk exposures, and both are used by many insureds (especially high-risk insureds and those insureds that are interested in embracing diverse alternative risk financing techniques) in the course of setting up insurance plans. So, it is appropriate to consider these two items at this time.

 

Self-Insurance and the Courts

 

Some insureds may completely self-insure all of its risk exposures. More often, however, insureds combine some elements of self-insurance with elements of traditional insurance (such as a general liability policy) to create a diverse alternative risk financing program. In both cases, conflicts can arise over whether self-insurance is “underlying insurance” or “other insurance” as the terms are used in umbrella policies and primary coverage policies respectively. The following two cases are examples of this conflict.

 

In NME Hospitals, Inc. v. American Casualty Company of Reading, PA, 132 F.3d 1454 (1997), the US district court ruled that the other insurance clause of a nurse's individual insurance policy was triggered by a self-insurance layer carried by her hospital employer. In this case, the nurse's insurance policy clearly stated that it was excess over any other insurance, self-insurance, self-insured retention, or similar programs, whether primary, excess, contingent, or on any other basis. The hospital's self-insured layer on the nurse was primary to her individual policy because of this wording.

 

In State Farm Mutual v. Universal Atlas Cement Company, 406 So. 2d 1184 (Fla. Ct. App. 1982), a Florida court determined that self-insurance did not constitute other insurance. Here, the court was looking at an auto policy that said that State Farm provided primary coverage for the insured's responsibility for injuries and damages arising out of auto accidents, but that the coverage became excess if other collectible insurance was available. The insured did have $1 million of self-insurance. The insured was involved in an accident and when a claim was made to State Farm, the insurer contended that the insured was primarily responsible for paying the claim and that its policy should be excess. The court disagreed and said that “other insurance” meant a contract in which one party indemnifies another against loss from certain specified perils; self-insurance did not fall within this definition.

 

These cases simply make the point that different judicial interpretations of self-insurance exist, and so, the cautious insured or risk manager must research court decisions in those jurisdictions where a self-insurance plan is contemplated. It is also important to review the wording of the other insurance or underlying insurance clauses of insurance policies since such wording can be used by courts to make their interpretations. The insured should also be aware that most states have specific regulations for self-insurance programs; for example, all of the states that permit employers to self-insure workers compensation have requirements that the self-insurers must meet.

 

General Considerations for Self-Insurance

 

There are several reasons why an insured would choose self-insurance: cost savings; cost stability; improved claims control; flexibility in structuring a risk control program; an inability to obtain primary coverage, or a desire to broaden the available coverage; and program ownership which encourages safety programs, supports loss control efforts, and emphasizes good claims management. These are all sound considerations upon which to build a self-insurance program.

 

Of course, insureds sometimes inadvertently self-insure because they are unaware of a particular exposure to loss. Such self-insurance by default should not be the norm; risk exposures should be assessed and appropriate action taken to either insure or retain those risks.

 

Self-Insured Retentions

 

The term self-insured retention refers to that portion of each loss that is not paid by underlying insurance, and is thus retained (paid) by the insured. This retained amount is sometimes referred to as the “retained limit”. In some umbrella policies, the retained limit refers to the limits of insurance for claims covered by underlying policies, whether or not those underlying limits are available or collectible. If the insured chooses to self-insure some or all of the underlying coverages, the retained limit refers to the amounts that are self-insured.

 

Self-insured retention amounts are commonly in the range of $5,000 to $25,000 for smaller businesses, but may be as high as $500,000 to $1 million or more for large corporations. The amount of an SIR required by an umbrella insurer (or desired by the insured) often depends on the size and nature of the insured's business and the insured's claims experience; of course, the business and claims experience of the insured may be such that the umbrella insurer does not require the insured to have an SIR. And, there is an interaction between the SIR and the excess exposure to loss, which means the premium charged for umbrella coverage can be affected by the amount of the SIR. As the size of the SIR increases, the umbrella insurer's exposure decreases, and the premium should show a corresponding limit.

 

Deciding on the size of an SIR is more an art than a science. If the umbrella insurer itself does not set out strict guidelines, the following suggestions can be used as guides for the self-insurer interested in establishing SIR limits.

 

The first consideration when selecting an SIR level can be the attitude of management toward risk. The company president may view the company's risk exposures as quite manageable and may want an SIR to match this low risk; the company risk manager may take a different stance. In any case, an organization should develop a written statement reflecting its attitude toward risk and the amount it is willing to assume. The statement should be compared to the actions of the company to see if the statement and the actions are compatible. Company representatives should not be surprised when losses that qualify for the risk tolerance must be paid directly by the company.

 

Another consideration is the net worth and financial strength of the company. And equally important is the liquidity of the company. An organization can have a strong net worth and still be cash poor. Liquidity is extremely important when claims must be paid quickly.

 

The tax rate is also a consideration. Insurance premium payments are tax deductible; reserves for losses a firm retains cannot be deducted until they are actually paid. Tax deductions will decrease as the SIR and claims falling within the SIR increase.

 

Some firms like to maintain the current and debt-to-equity ratios at certain prescribed levels. When deciding upon an SIR, it is important to estimate how the SIR will impact financial ratios. It should be noted that debt holders (such as banks) can place restrictions on the financial ratios and operations of the companies to which they lend money. These restrictions often can limit the size of the chosen SIR.

Finally, the method of reserving self-insured losses must be considered carefully. A logical approach is to include a reserve for losses in a company's financial statement. Prudent accounting firms normally require such reserves be included in the balance sheet. Since losses are not tax deductible until actually paid, loss reserves increase current liability, thus reducing working capital and the current ration without providing a tax offset.

 

SIR Compared to Deductible

 

A self-insured retention is often confused with a deductible. These items, however, refer to distinct concepts and there are major differences between them.

 

One major difference is that low-value claims that do not exceed the SIR are usually handled by the insured (or the insured's claims administrator) and need not be brought to the umbrella's attention until the amount of loss threatens to exceed the SIR. Indeed, an excess insurer usually does not provide services such as claims handling and record keeping for losses that fall within the retention. Where there is a deductible provision, each claim is to be reported to the insurer for processing and payment; the insurer has agreed to handle claims against the insured, and keeps a record of claims and losses paid for use in determining the loss experience of the insured (and ultimately, the premium to be paid).

 

A second difference between an SIR and a deductible is that the insurer has the right to settle claims that fall within an insured's deductible, even if the insured prefers the claim be denied or litigated. If the claim totally falls within an insured's SIR, the insured usually has the right to decide whether the claim is paid or denied (and if it is to be paid to a third party, the insured may be expected to make the payment directly). Most umbrella insurers reserve the right to participate in the defense of any claim that is within the insured's SIR, but which may potentially involve the umbrella policy. However, they will usually consult with the insured before accepting or denying the claim.

 

A third significant difference between retentions and deductibles is that payments made within an insured's SIR have no effect on available umbrella policy limits, whereas amounts paid within a deductible usually reduce policy limits. For example, under a policy with limits of $1 million and an SIR of $100,000, the insured will still have $1 million in available policy limits after the SIR is satisfied. A $100,000 deductible, on the other hand, would reduce the $1 million policy limits available, leaving only $900,000 in available coverage after the deductible is satisfied. Fortunately for the insured, most commercial umbrella liability coverage is subject to an SIR and not a deductible.

 

Umbrella policies often state that the amount of loss subject to the insured's SIR is not to be insured under any policy of insurance. A possible reason for the inclusion of this statement is that the insurer wants the insured to be motivated to control losses. When present, the statement is usually contained in a separate self insured retention or retained limit section of the umbrella policy. An example of this wording (from a 1992 Gulf Insurance Company commercial umbrella policy) is as follows: