What Risk Retention Mechanism is Best for Liability Policies?
Occasionally, I think about the fundamentals of risk-transfer and risk retention. One of the risk retention methods I ponder from time to time is an insurance question I have answered numerous times throughout my insurance & risk management career. This is; “What’s the difference between using a deductible or a self-insured retention (SIR) on a liability insurance policy?” You may have been asked this same question. I thought it would be beneficial to provide an overview of these risk retention terms; “deductible” and “self-insured retention (SIR)” to others who may appreciate a clarification or a refresher. As fas as, what risk retention mechanism is best? The conservative answer is, that depends!
Risk Transfer or Risk Financing?
Although some insurance policies (risk-transfer mechanism) provide coverage from the first dollar of the policyholder’s (insured’s) loss or liability, many liability policies contain either a deductible or a SIR (risk retention mechanism) that requires an insured to bear some portion of the risk or liability before the insurance company’s (insurer’s) obligation under the terms of the policy are triggered. Deductibles and SIRs are often referred to interchangeably. This may be one of the reasons for the confusion. However, there are several important differences between a deductible and a SIR that could be significant in the event of a claim, or just from a cashflow and financial perspective.
What’s a Deductible?
A “deductible” on a liability policy refers to that portion of the insurer’s limit of liability that in the event of a claim will be deducted from the insurer’s payment of a claim. You may have heard the term, first-dollar coverage. This means that the insurer is responsible for paying a claim at first dollar. Although, the insured is responsible for reimbursing the insurer for the deductible amount to satisfy the insured’s deductible responsibility. Basically, the insured must bear the burden of paying any claim that does not exceed the deductible amount to the insurer. Let’s look at an example; A liability policy with a limit of liability of $1M with a $25K deductible would require that $25K be deducted from a payment by an insurer on a claim covered by the policy.
What’s a SIR?
A “SIR” on a liability policy refers to that portion of an insured’s limit of liability that the insured is directly responsible for until the SIR amount has been reached. In other words, with a SIR, the insurer has absolutely no obligation to either indemnify or defend the insured in the event of a loss until the insured has paid the total amount of the SIR. You could view this type of retention the same as if the insured is providing primary coverage up to the attachment point of the SIR. Once the SIR has been reached, the insurer steps-in like the mechanics of an excess policy. The SIR reflects the amount of loss or liability that must be incurred and paid by the insured before the insurer will respond to the indemnity or defense obligation under the policy terms.
Let’s look at another example; On a liability policy with a limit of liability of $1M with a $25K SIR, an insurer would not have to respond until the loss or liability exceeded the $25K SIR threshold. As the term “self-insured retention” denotes, the insured is basically self-insured for the first $25K of any loss or liability. In addition, with a SIR the insured is required to pay all the defense costs and any other allocated loss adjustment expenses, along with the indemnity costs until the $25K SIR has been reached. Once the SIR has been reached, the insurer will respond to the loss and will typically take control of the claim (if the claim handling conditions are specifically stipulated in the terms of the insuring agreement or in a duty to defend provision in the liability policy.)
What’s the Difference?
Deductibles and SIRs may appear to be functionally comparable, as respects establishing a retention, but there are several important differences between these risk retention mechanisms. First, the effect of a deductible on an insurance company’s limits of liability is much different from the effect of an SIR. In the example we used above, the insurer’s limits of liability are effectively reduced from $1M to $975K by payment of the $25K deductible. Basically, the $25K deductible erodes the limit of liability of the policy. Conversely, in the SIR example, on a $1M liability policy subject to a $25K SIR, the policy will continue to provide an insured with the $1M in coverage. However, the coverage doesn’t kick-in until the $25K SIR has been reached and payment on the loss or claim satisfied by the insured.
Second, many liability insurance policies that have a duty to defend provision may be effected differently under certain deductible provisions versus how they would be effected with an SIR. The liability policies that have a deductible provision typically are structured in a fashion where coverage attaches immediately and the insurer is required to respond and has a duty to defend the insured at the first dollar level. This is important to some insureds with limited claim management staff or resources because under a deductible, any claim or lawsuit submitted or filed against the insured is handled by the insurer. Depending on the terms of the SIR policy, the duty to defend may not be triggered until the insured has reached the SIR threshold and have made payments (indemnity and defense costs) for the claim on their own account.
Which One is Better?
Getting back to the question of, “what risk retention mechanism is best, deductible or SIR?” I think a lot depends on the insured’s risk appetite, risk tolerance, as well as the size of the organization. This includes, the organization’s staff and resources (or their ability to outsource to a TPA) for managing the claims administration process.
Deductibles are typically used by insureds who have a higher frequency of smaller claims, i.e. contractors who work on multiple jobsites who require more tangibility for the number of miscellaneous third-party property damage (PD) claims, e.g. airborne dust from construction jobsites, paint overspray onto parking lots. These are typical liability claims against projects and contractors. (I know what you’re thinking. Wouldn’t it be easier to give claimants vouchers to a local carwash to get their cars cleaned? Well, in some cases, contractors will do this so as not to affect their liability insurance to add to their loss experience. But, no all the time.)
Since deductibles are considered first-dollar coverage, this mechanism works well because deductibles typically include the indemnity costs, defense within the limits of the policy, and loss adjusting expenses as also included. An insured only needs to pay their premium on time to avoid policy cancellation, in the event of a claim, submit the claim to the insured within a reasonable time stipulated in the policy and to avoid prejudicing a claim during the claim adjusting process.
With SIRs, the insured has the responsibility for the indemnity obligation up to the established retention threshold of the SIR. The insured is also required to pay all the defense costs and any other allocated loss-adjustment expense until the SIR has been satisfied. Some major benefits for larger insureds are that insurance premiums can be lowered with an SIR. The risk/reward dynamic is in play.
Putting Some Skin in the Game
Purchasing higher limits of liability and taking a higher SIR is the equivalent to putting some skin in the game. Project owners are aware of this when it comes to working with many contractors on large capital construction projects. It gives a contractor a reason for being more safety-conscious on jobsites. They may even include additional loss control on their projects to drive down their loss experience. More importantly, because a contractor has skin in the game, a contractor will be more cognizant of keeping losses down to lower their insurance costs since these costs are all out-of-pocket with a SIR until they have reached the SIR attachment point before the insurance coverage kicks-in from the insurer.
This article should help provide a better understanding of the difference between a deductible and a SIR. As far as what risk retention mechanism is best? There really is no one right answer. They both serve their purpose given the risk under consideration, specific type of policy, size of organization, project owner, contractor, and particularly risk appetite.
Hope you enjoyed this post. I will look forward to your comments. I will share more Insights in future posts.
Thank you for visiting and reading C-Risk Insights.
Until next time…
David Grenier is the Managing Director and Principal Consultant at C-RISK, LLC.
C-Risk is a risk management consulting company that provides strategies and insights on wrap-up insurance programs to project owners in the public and private sector who are involved with large capital construction projects.
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