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Self-Insured Retentions vs. Deductibles: Your Skin in the Game

Self-insured retentions (SIR) and deductibles are the two conventional mechanisms insureds use to reduce both premiums and loss ratios in liability policies.  Those insureds must strike several careful balances in order to sustain affordable coverage while protecting assets.

First, an insured must analyze cash flow and balance sheet statements in order to make an informed decision as to which approach, if either, is best.  Using either simply to reduce premiums is foolish, and could prove to be very dangerous.

A self-insured retention means that the insured carries a fixed amount of risk, including adjusting and legal expenses.  The insurance policy, whether a primary or umbrella contract, is excess coverage above the SIR.  The insurance carrier will impose reporting requirements on the insured in order to monitor the development of claims that may impact the liability limit to which the company is exposed.  For example, the insured, typically, must report claims that involve fatalities, amputations, third-degree burns, brain injuries, and any other claim for which the insured sets a reserve of 25% or more of the SIR amount.  The carrier will require that adequate, proven risk management staff be in place, whether native or contracted.  SIRs are rarely smaller than $100K, and can be $1M, $3M or higher for large companies with good controls and substantial liquid assets.  Some states have legislation in place to regulate such “attachment point” business.

Finally, the SIR normally has no effect on the amount of insurance available under a liability policy.  Such tools are available, though, with permission for company intervention, in which case the form-they are unique as to carrier and insured-may provide for loss adjusting and defense expenses that do not erode the insured’s liability.  In other words, if the carrier chooses to “drop down,” and take over management of a given claim, those expenses fall on the carrier even though the claim may settle within the SIR.

A deductible, on the other hand, is a portion of an insured loss borne by the insured.  The carrier will typically pay the entire claim, and then be reimbursed by the insured.  Unlike an SIR, a deductible erodes the limit of liability in the insurance policy.  A policy with a $1M limit of liability and a $25K deductible, then, exposes the carrier to $975K.  Loss adjusting and legal expenses typically further erode the limit.

Deductibles are commonly used with risks that have a frequency of smaller claims.  Daily auto rental or taxicab fleets (lots of minor fender benders), contractors with multiple job sites, supermarket chains (lots of slip-and-fall activity)-are typical of the kinds of risks that can benefit from deductible treatments.  Deductibles almost always include loss adjusting and defense expenses.  All claims are reported per the policy’s terms, and the carrier is involved in the adjusting process immediately.

Collateral instruments for these management tools include escrow accounts, by which the insured maintains a cash reserve with the insurance company (which may or may not pay interest on it), and evergreen letters of credit.  Escrow accounts are more frequently used with frequency-prone risks (think deductible), while a letter of credit is typically more suitable to an insured that carries a substantial SIR.

While the fine points these mechanisms provide differ in practice, their common goal is to reduce loss ratios and premiums for quality insureds who pay attention to their own risk/reward postures, and who share the character and values of the carriers that provide their coverages.  An insured that has the ability to manage claims, and to therefore manage risk, should be very attractive whatever the condition of the insurance market.