Many organisations find purchasing D&O insurance challenging enough. But without understanding the purpose of insurance in the bigger picture, a company will not derive the full benefit from having executive protection in place. The reality is that D&O coverage only plays a part in the risk management process, as it is reserved for claims which exceed the self-insured retention.
By implementing appropriate risk retention into the structure of a policy, companies can ensure that their insurance will operate effectively, for not only them, but also the insurers who protect them. Below, we investigate the concept of self-insured retention, its application to D&O insurance policies, and the key considerations for management when electing them.
The purpose of self-insured retention
When we begin to discuss the concept of self-insured retention, to provide perspective, it’s always best to revisit the original intention of insurance. Insurance is the process of transferring the risk of financial loss, which would be catastrophic for a business or individual, to an insurer for the payment of an annual premium. The theory is, that through the payment of premium to an insurer, the policyholder is assuming a guaranteed, relatively small financial loss, in return for protection from the uncertainty of a large one.
Insurers seek accounts that will deliver them an underwriting profit, therefore insurance solutions are generally not effective for companies with high frequency losses, and instead are more suitable for organisations with exposure to infrequent losses of severe value. Insurance companies affect this preference for low frequency, high value losses by imposing a self-insured retention on the organisations they insure.
Also sometimes referred to as a deductible, the self-insured retention is a value of a claim, which must be first incurred by the insured company, before the policy will respond; thereby permitting the insurer to pay for claims costs exceeding the level of retention. The affect of risk retention is that it allows a company to absorb losses of relatively low value, ensuring that their use of insurance is for claims that could seriously impact the financial health of the entity, or it’s directors and officers.
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Application of risk retention on D&O coverage
Directors and officers relying on the Side-A insuring clause, generally do so because they have not received indemnity from the organisation they represent. Considering that the intention of D&O insurance is to protect the financial assets of executives, Side-A coverage is not generally subject to retention. However, as the majority of claims against executives result in indemnification by an organisation, insurers insist that self-insured retention apply to the company reimbursement insuring clause, Side-B. That being said, it is recommended that directors and officers review the presumptive indemnification clauses of a policy to understand their position if indemnity is wrongfully withheld by their company.
The level of retention on Side-B coverage will depend on the size of the organisation being insured, and can often be of substantial value. A typical retention can range anywhere from $5,000-$20,000 for small & medium businesses, to hundreds of thousands of dollars for large corporations. Self-insured retention applies separately to each and every claim on a policy, however multiple claims arising out of the same wrongful act are generally treated as a single claim, and therefore subject to only one retention. Companies should also be aware that if some part of a claim is not covered by insurance, and is subject to allocation, the total retention will apply only to the portion of loss covered by the policy.
Considerations when selecting a level of retention
Because self-insured retention is the amount of loss covered by a policy, which a company must first incur before an insurance policy responds, management must consider a range of factors when selecting its value. The strength of a company’s balance sheet and its ability to bear the costs of claims, play a significant role in determining how much risk a company should retain. Set the retention too high and a company may not be able to afford to fund costs to that level, especially if there is multiple on-going claims. Set the retention to low and the insurance will respond too frequently, leading an underwriting loss for the insurer and poor claims experience for the organisation. To put this into a practical situation, it would be unwise for a small business, turning over a only few million dollars, to elect a relatively high retention such as $100,000, as they would be unlikely to have the financial capacity to incur costs up to that value. A lower, retention of, say, $10,000 may be more appropriate.
For companies with solid cash flow and sound financials, higher retentions make a lot of sense, as insurers will often provide a discount on annual premiums. However, management should keep in mind that what can appear reasonable in good times, may create problems if troubles arise, e.g. poor company performance can impact cash flow and increase executive exposures at the same time. Further to this, insurers may impose a higher level of retention on particularly severe or frequent claim sources, such as those involving listed securities or employment practices.
Overall, when managing a company’s level of risk, common sense should prevail. Management should seek advice from an experienced insurance broker to guide them through the process of selecting an adequate level of retention, to ensure their company’s D&O program provides effective protection, not only for directors and officers, but also the company itself.