The self-insured retention is an important and often underestimated component of an insurance policy. It is in the benefit of an insured and insurer that it be set appropriately, so that an insurance contract can function as intended – as a protection for significant unexpected loss.
In this article, we will explore the concept of a self-insured retention within the context of the following coverages:
- Directors and officers liability insurance
- Employment practices liability insurance
- Management liability insurance
- D&O insurance for nonprofits
You may also find that similar concepts apply to a broad range of financial lines insurances, such as professional indemnity insurance, cyber insurance, and even crime insurance to a certain extent. Keep in mind, however, that each policy is strictly interpreted according to its own terms and conditions.
Self-insured retention: A definition
A self-insured retention, also known as a deductible or excess, is the amount of loss an organisation is required to sustain for a covered claim before its insurance policy will respond. In other words, it represents the risk an organisation must retain for managerial-related claims before seeking indemnity from its insurer.
A self-insured retention sits below the limit of liability. When an organisation incurs a covered loss, it is usually required to pay the self-insured retention before seeking reimbursement. Once the self-insured retention has been eroded, an insurer will pay up to, but not exceeding, the limit of liability.
Put another way, a self-insured retention is the amount of loss an organisation is willing to sustain per claim. Once a claim is notified to an insurer, and after the self-insured retention has been incurred, an insurer will be required to pay up to the limit of liability. Once the limit of liability is exhausted, an organisation and its management are no longer insured for further losses.
Does a self-insured retention apply
A policy’s insuring clauses are each subject to a self-insured retention. Below is an outline of how it may be applied.
Directors and officers liability coverage (Side A)
Side A coverage, also known as directors and officers liability coverage, does not typically attract a self-insured retention. In other words, the retention amount is Nil or $0. This means that individuals who have not been indemnified by their organisation, can seek coverage from their insurer without any cost to themselves.
Individuals seeking indemnity under Side A coverage generally do so as a last resort. Having not received indemnification from their organisation for one reason or another, this coverage provides an emergency life raft in troubling times. Without it, they would suffer the consequences of funding a defence from their own personal assets.
Organisation reimbursement coverage (Side B)
Side B coverage, also known as organisation reimbursement coverage, is generally subject to a moderate self-insured retention. This is because an organisation is considered as having the resources to contribute to the cost of claim An insurer is providing support to the defence of its management, rather than taking on the whole liability itself.
An organisation seeking protection under Side B coverage does so because it has indemnifed its management. When an organisation indemnifies an individual in accordance with a directors indemnification agreement, it is responsible for incurring costs up to the level of self-insured retention. Only after this, will an insurer begin to reimburse an organisation for its loss.
Entity coverages (Side C, EPL, ML)
Entity coverages, such as Side C coverage, employment practices liability insurance, or management liability insurance, are likely to be subject to a relatively high self-insured retention. Claims against the entity are much more common than against individuals, and an organisation relying on such protection usually does so as part of a broader strategy to mitigate loss.
The main difference between the self-insured retention applying to Side B coverage and entity coverage is size. Because an organisation is inherently more prone to litigation than its directors and officers, most entity coverage attracts a relatively high level of retention. This is especially true of Side C coverage, where the risk of shareholder class action claims can be significant.
The purpose of a self-insured retention
The purpose of a self-insured retention is sometimes misunderstood. It is not unusual for an organisation to think of it as an unreasonable penalty before seeking reimbursement from an insurer. This is simply not the case. To appreciate why a self-insured retention is important, we should consider the intention of what insurance aims to achieve.
An insurer offers coverage for the payment of a premium. From an organisation’s perspective, the premium is an exchange involving a small loss of known value, in return for the transfer of a larger potential loss of unknown value. For an insurer to continue to agree to such an arrangement, it must be allowed to make an underwriting profit in normal circumstances.
A self-insured retention aims to protect the underwriting profitability of the insurer by removing losses that that would otherwise erode its commercial viability. Importantly, however, it also provides an organisation with the opportunity and incentive to minimise these losses, while reserving its insurance for larger, more significant claims – benefiting both parties in the long run.
Applying a self-insured retention to claims
When an organisation or its management are subject to a claim, an insurer will need to determine how the self-insured retention is to apply.
Each and every claim
A self-insured retention generally applies to each and every claim. This means that for each separate claim notification, an organisation is responsible for incurring the equivalent of the self-insured retention before its policy will respond. If a claim is small, the matter may be handled entirely below this amount and the policy will not respond at all.
Multiple claims arising from a single wrongful act are likely to be treated as related claims – attracting a single self-insured retention. Related claims can arise against an insured when a single act results in more than one complaint. For example, consider an single error or omission that could affect a variety of stakeholders in different ways.
If an insured receives multiple claims as a result of an act conducted multiple times (over and over again), each occurrence is likely to be treated as a separate claim – and attract a self-insured retention. This can have significant consequences, as an organisation will be required to incur the cost of more than one self-insured retention concurrently.
An insurer will presume that an organisation has indemnified its management in accordance with any existing directors indemnification agreement unless there is a valid legal reason not to do so. This removes any ambiguity as to which insuring clause will respond when a claim is made against an individual (Side B), and that a self-insured retention does indeed apply.
During claim settlement, if there is a situation involving costs allocation, only covered losses will contribute to the self-insured retention. Costs allocation can occur when a claim includes both covered and uncovered losses – often attributed to an uninsured individual, entity, act, or cost. As a result, only covered portions of a loss will count.
Selecting a self-insured retention
There are a few factors that should be considered when selecting a self-insured retention.
An organisation’s size
An organisation’s size – with respect to revenue, and financial position more broadly – plays an important role in determining an adequate self insured retention. Generally speaking, the larger the organisaiton and the stronger its balance sheet, the higher its self-insured retention should be. This is not only for its benefit (improved risk management) but also for the benefit of its insurer (improved loss ratio).
An organisation’s risk profile
An organisation’s risk profile – with respect to business activities, industry, and experience – is a influencing factor when selecting a self-insured retention. Loss frequency and severity go somewhat hand in hand with industry wide-observations, and this can be overlaid with an organisation’s control environment, to arrive at a self-insured retention that both the organisation and its insurer are comfortable with.
An organisations risk tolerance
An organisation’s own risk tolerance does not play an insignificant role in selecting a self-insured retention. By selecting a relatively higher self-insured retention, an organisation can retain some of its risk and also achieve a modest premium discount. However, pushed too high, and servicing costs below the self-insured retention could be problematic – especially when multiple claims are involved.
What self-insured retention can be expected
While no organisation is a carbon copy of another, many share characteristics common enough that we can generalise about their self-insured retention requirements.
The requirements of a private company are likely to vary significantly – depending on the industry in which it operates and its relative size. It is not unusual for small and medium enterprises to carry self-insured retention $5-10 thousand for Side B. For entity coverages, as private companies become larger and more complex, higher self-insured retention, such as $15-25 thousand, may be more suitable for the additional risks they face.
A publicly listed company, by comparison, is much higher risk, and accordingly will carry significantly larger self-insured retention. $25-50 thousand is not unusual for Side B, to ensure that all its management are covered for the unique shareholder-related exposures that public companies face. For entity coverage, $100-250k is more appropriate as claims against the entity become more frequent and severe.
D&O insurance for nonprofits has a similar risk profile to that of private companies. A typical nonprofit will carry a self-insured retention of $5-10 thousand depending on its size and specific activities. One thing that makes nonprofit organisations distinct, is that they regularly contain volunteers with high-public-profiles. This can become somewhat challenging, if ego begins to become a driver of exposure.
How does a self-insured retention interact with defence costs
Defence cost often makes up are large portion of the total costs of a claim. A self-insured retention can operate in two ways with respect to defence costs.
Defence costs inclusive retention
A defence costs inclusive retention means that an organisation is responsible for defence costs as they are incurred. In other words, an organisation will incur defence costs from the first dollar onwards. Only once the self-insured retention has been exceeded, will the policy respond. After that, an organisation is eligible for reimbursement by its insurer up to the limit of liability.
Defence costs exclusive retention
A defence costs exclusive retention means that the self-insured retention is paid by the organisation when a claim is settled. Often this means an insurer will incur defence costs on behalf of the insured without the initial payment of the self-insured retention. Instead, this amount becomes due as a matter is finalised.
Generally speaking, it is reasonable to assume that a self-insured retention will be defence costs inclusive; i.e. that defence costs will be incurred by an organisation from the first dollar. However, each policy will include a duty to defend provision outlining how costs are to be handled.
Benefits of a correctly implemented self-insured retention
There are a number of benefits that arise from a correctly implemented a self insured retention.
Improved risk management
One of the primary benefits of a correctly implemented self-insured retention is that it aligns the interests of an organisation and its insurer. If an organisation has skin in the game – by incurring costs below the self-insured retention – it is incentivized to improve its risk management controls and mitigate any exposures before they get out of hand.
Cleaner loss history
If an organisation is retaining a suitable level of loss while also improving its risk management procedures, it should hopefully lead to less frequent claims. This will inevitably result in a cleaner claims history – as measured by its claims ratio (total value of premium divided by total value of claims) – making it a much more attractive risk for insurers.
An organisation with strong risk management control and a clean claims history, ultimately leads to lower premiums (market conditions willing). Insurers compete for business, and are encouraged to bid down the premiums of organisations that have a track record of managing risk. it is also likely to influence the quality of terms, and the limits available.
Self-insured retention: An example
Now that we have explored the concept of a self-insured retention and the various factors which can effect coverage, we can tie it all together.
An organisation purchases an insurance policy to protect its management from board of directors liability. The policy period is twelve months, from 31 December last year to 31 December this year. The limit of liability is $5 million any one loss and in the aggregate. The self-insured retention is $25,0000 for Side B coverage, defence costs inclusive.
The organisation has been operating for many years in the automotive industry. After a recent product launch, the board of directors becomes aware of an intent to claim by one of its competitors. They receive a letter of demand alleging that misrepresentations were made in a marketing campaign, constituting a breach of directors duties.
The directors make a claim notification to their insurer. Legal counsel is appointed and the organisation indemnifies its management from these costs – incurring the first $25,000. Once the self-insured retention is satisfied, it seeks reimbursement from the insurer. The matter is eventually settled for a total cost of $100,000 inclusive of defence costs – leaving $4.9 million of the limit remaining.
A self-insured retention is an important and often underestimated component of a policy. It is in the interest of both an organisation and its insurer that it be set correctly. By doing so, an organisation retains a reasonable degree of risk, and its insurance is reserved for significant claims and losses – as a protection for significant unexpected loss.