Risk retention is something we deal with in all kinds of insurance. In D&O matters, a self-insured retention ensures that an organisation’s policy is ready to respond when it’s needed most.
The self-insured retention (SIR) is an important component of a D&O policy. It represents the amount of risk an organisation is willing to absorb before its insurance policy will respond.
A SIR plays a similar role to an excess or deductible used in other classes of insurance. The main difference is that instead of being paid at the beginning of a claim or being deducted at the end, the SIR is the value of loss that must be first incurred by an organisation before its insurer will contribute.
A SIR involves an organisation paying the initial costs of a claim, such as early-stage legal expenses and settlements, until the level of retention is reached. Once this occurs, the policy will respond and the insurer will pay for all further expenses until the claim is finalised, up to the limit of liability.
If a claim is small, and can be settled for a amount less than the retention, an organisation’s D&O policy may not be required to respond at all.
Allowing insurance to perform its purpose
To understand the function of a SIR it helps to revisit the original intention of insurance. Insurance exists to indemnify an insured from significant or catastrophic loss.
If insurance companies were to cover losses of all values, an account could quickly become unprofitable. By insisting that an organisation retain some risk, its insurance coverage is reserved for larger, more significant claims.
A cleaner claims history
From an organisation’s perspective, the benefit of a SIR is that it protects its D&O loss history from claims contamination. Claims contamination means that an organisation can appear unattractive to prospective insurers if it has too many losses on its account.
By managing costs and paying for its own claims under the self-insured retention, an organisation will maintain a cleaner claims history, and reap the rewards of being a higher quality risk, such as better quality terms of coverage and reduced premiums.
Each and every claim
A SIR generally applies to each and every claim. This means that for each separate claim, an organisation must pay for losses up to the level of retention. However, many policies treat multiple claims, arising out of the same wrongful act, as a single claim; and therefore, only attracting one SIR.
An example of this is when an executive is sued by multiple claimants, following a single misdemeanour. In this situation, the costs of all claims against the executive for this incident are likely to contribute to one SIR amount, as the claims are related.
Does a self-insured retention apply?
Each insuring clause of a D&O policy is subject to a separate level of self-insured retention. Below is an outline of how retention is applied.
Retention applying to Side-A
Side-A coverage is typically not subject to self-insured retention. This means that directors and officers, who have not been indemnified by an organisation, can seek protection from an insurer without incurring any costs whatsoever.
The reason why executives do not have to contribute to claim costs relates back to the original purpose of D&O; to protect personal assets. Because executives seeking indemnity under insurance coverage are usually doing so as a matter of last resort, it is unlikely that they have the resources to incur any effective amount of SIR.
As a result, the absence of retention allows them to defend themselves without out-of-pocket expense.
Retention applying to Side-B
Side-B coverage is generally subject to a moderate level of self-insured retention. This is because an organisation is viewed as having the financial resources to contribute to the cost of claim, when defending directors and officers.
When an organisation indemnifies its executives in accordance with its indemnification provisions, it is responsible for incurring costs up to the level of self-insured retention. Only then will an insurer reimburse the organisation for its expenses.
Retention applying to entity coverage
Any entity coverage contained within a D&O is subject to self-insured retention. As with Side-B, an organisation with entity coverage generally uses such protection as part of a broader risk management strategy. As a result, it is expected that the organisation can afford to contribute to its own claim costs, thereby sharing some of the risk with its insurer.
The main difference between the SIR applying to Side-B and entity coverage, is its 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, which is exposed to large class action claims, and employment practices liability, which attracts frequent claimants.
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Selecting a self-insured retention
A range of factors must be considered when selecting the level of self-insured retention. For the most part, these focus on an organisation’s ability to bear the costs of claims, but also on its general risk appetite.
Too high, too low
If a self-insured retention is too high, an organisation may not be able to afford to finance claims to that level, especially if it is defending multiple claims at the same time.
On the other hand, if retention is set too low, the policy may respond too frequently, leading to underwriting losses for the insurer and a poor claims history for the organisation.
Premium benefits for high retentions
For an organisation with consistent cash flows and sound financials, electing a high SIR makes a lot of sense. As with other policy classes, underwriters generally provide discounted premiums for organisations willing to retain a higher level of risk.
However, sometimes organisations do not have a choice, as high retentions are often imposed on risky accounts and frequently claimed policy sections.
Important! An organisation considering a high level of SIR should consider all possible scenarios, as what might appear reasonable in good times can create problems if circumstances change. This is in line with the common observation that claims are more likely to occur when an organisation is performing poorly, which is precisely when there are fewer funds available for contributing to a SIR.
Everything is relative
An organisation’s level of SIR is usually relative to the size of its asset base. Minimum retention levels for Side-B coverage, for example, start at around $5,000 for small organisations. While for large organisations it’s not uncommon to see self-insured retentions of $100,000 or more.
At the end of the day, common sense should prevail. An organisation should consider its own ability to meet retention obligations, and select the highest level it can comfortably afford.
Self-insured retention is a necessary evil of carrying D&O coverage. While many may become frustrated when claims fall within the policy retention, it has its purpose. By selecting a SIR appropriate for an organisations risk environment and financial condition, management will ensure that its insurance coverage is reserved for when it needs it most.