Large Deductible versus Self-Insured Retentions
So, you have a client who is interested in retaining risk. Assuming they are strong enough financially to accept greater risk and the premium savings ratio to risk retention makes sense, that is a good thing. Retaining risk is an effective way for insureds to reduce the net costs of their risk management programs.
There are several methods an insured can use to accept and retain risk whether it be through a large deductible, self-insured retention, retrospective rating plan or even a captive. It is important they choose the method that is right for them. While the method doesn’t necessarily have an impact on their overall claim level, the selected method will have an impact on expenses to administer the program, financial hoops they will need to jump through, and even their ability to get out of the program if they find retaining risk is not necessarily for them. Let’s go through some of the pros and cons of each method.
Sometimes the terms large deductible and self-insured retentions are used interchangeably. It is an understandable mistake. The structure of both large deductible plans and self-insured retention plans may look similar on a superficial level. First, they both have similar structure in they both usually have both a per loss retention and an annual aggregate stop-loss or aggregate deductible. They both charge a highly discounted premium to reflect the insured taking most of the working layer of risk. However, that is where the similarities end.
Under a deductible approach the insurance company is still responsible for claim payments to third-parties as if there is no deductible. In turn, they seek reimbursement from the insured for all claim payment and allocated loss adjustment expenses. Under a self-insured retention plan, the insured for the most part, is responsible for paying claims and paying administration costs for claims under the self-insured retention.
The result is insurance carriers are much more likely to focus on the financial strength of the client and usually require some level of collateralization to avoid taking a significant credit risk when providing a significant deductible. Collateral will typically be in a combination of cash equal to 30 to 60 days of expected claim payments to fund an escrow account. The escrow will be replenished monthly or sooner if claim payments significantly deplete escrow funds.
A letter of credit (LOC) is usually required for the balance of the security. The LOC’s will be required to be free and clear of any documents and contain an evergreen clause providing automatic renewal unless the insurance company is notified. In which case, the underwriter and CFO of the insurance company will drive down to the bank with a couple of briefcases and draw down on the letter of credit to avoid being left bare of security! Insured’s need to understand they carriers will hold on to collateral well into the future until they are assured no additional claim development.
The last point about security/collateral is it will compound. As the insured moves from one policy year to the next under a deductible program, they will need to collateralize each year. For example, assume the carrier requires $500,000 to secure them from a credit risk. When the deductible plan renews they will need another $500,000 for the new year to secure the new year and so on. The carrier may roll some of the existing collateral to the new year, but they will likely have to significantly increase the amount of security each year until the carrier deems they are already holding enough to cover the next year.
Self-insured retention plans generally require less concern with the financial strength since the client is taking responsibility for the retention. They will pay what they are obligated to pay within the retention. The operative word is less concerned. Carriers may still look at financial strength of a client to assure they are qualified to take on the responsibility for the level of retention. I have seen situations where the insured was not able to satisfy the retention and courts went straight to the carrier seeking reimbursement for immediately for payment.
Furthermore, since clients are responsible for the retention layer, they are also held accountable for adjusting the losses, though it is important to point out excess carriers often have clauses within the policy identifying when they need to be notified of a claim incident and stipulates they may immediately intercede and take over adjusting the claim. With the responsibility for adjusting claims within the retention layer, the client is responsible for the expense of adjusting those claims.
This points out one benefit to for a self-insured retention plan over a large deductible. Since a self-insured retention is basically excess insurance, there is a lower expense element as the carrier is not paying for claim adjustment and other services for the insured. However, it is a double-edged sword as ultimately someone will have to adjust the claims or provide loss control and safety services. They insured will have to pay for those services directly.
With compulsory lines such as workers’ compensation and auto liability, insureds will need to qualify to be self-insured in their state. The process will likely involve proving they have the financial capacity to cover claim payments and provide evidence they are qualified to adjust claims with the appropriate state governing body. In addition, states usually require the insured to post collateral, often in the form of a bond.
One method an insured can use to get around the issue of being a qualified self-insured, is to form a captive insurance company. In doing so they, arrange for a carrier to issue a policy that is a ground up fronting insurance policy which to all outside parties looks, acts, and feels like a first dollar insurance policy. But looks can be deceiving, as behind that policy there is a reinsurance agreement between the insured and the insurance carrier where the insured reinsures the carrier up to a specified retention level. Even though there aren’t any state requirements, the fronting carrier will require adequate collateral to be posted not unlike a large deductible program.
But before an insured should consider a captive insurance plan over a large deductible plan, they need to understand captives usually carry a higher expense load. Hence, requires a larger base premium to be an effective alternative.
So, there you have it. A rough and dirty explanation between the difference between a self-insured retention and a deductible. In a later blog post I’ll get into the retrospective rating programs which is another method an insured can use to retain risk.