In the current economic climate, first-dollar coverage has become a luxury that many commercial insureds can no longer afford. Although policies with large self-insured retentions and deductibles have always been available, they were frequently overlooked in the past when bottom lines were healthier and insurance premium costs were subject to less scrutiny. As more insureds assume greater responsibility for managing the risk of smaller claims while relying on traditional insurance products for catastrophic protection, more policies are being issued with significant SIRs and deductibles.
While insurance limits attach above the primary layer of risk imposed on the insured in both self-insured retentions (SIRs) and deductibles, these types of coverages are otherwise very different. This presentation will focus on the differences between SIRs and deductibles and discuss various problems and issues that are encountered by both the insured and the insurer.
SIRs and Deductibles--What's the Difference?
True “self-insurance” involves a pure risk retention approach under which a company elects to assume full responsibility for any losses that may arise and insures none of its potential liability with a third party. As such, a corporation that truly self insures must pay all judgments and settlements for all claims asserted against it, as well as the related loss adjustment expenses including defense costs. All other forms of self-insurance, including the strategic use of deductibles and SIRs as part of an overall risk management strategy, represent a departure from true self-insurance.
SIRs and deductibles are similar in that both require the insured to bear financial responsibility for a portion of a loss and, in this regard, represent an exposure that is not covered by insurance. However, there are important differences in the way they operate.
Insurance policies written with deductibles provide that the insurer will pay the defense and indemnity costs in connection with a covered claim, and then charge or bill back the deductible amount to the insured. In other words, the “deductible” is a sum that is subtracted from the insurer's indemnity and/or defense obligation under the policy. Importantly, the responsibility for the defense and settlement of each claim rests solely with the insurer, and the insurer maintains control over the entire claim process.
Policies written with large self-insured retentions, in contrast, may place responsibility for claims handling, including the investigation, settlement and payment of claims, in the hands of the insured. Under a policy with a SIR, the insured is typically required to pay the defense and other allocated expense costs as well as indemnity payments until the amount of the retention has been exhausted. Once the SIR has been exhausted, the insurer responds to the loss and assumes control of the claim.
Self-insured retentions are distinct from deductibles in at least one important respect: the insured whose coverage is subject to a self-insured retention generally is obligated to retain its own defense counsel. Indeed, in a self-insurance arrangement the claims-handling generally is controlled by the insured, an independent adjusting company, or a primary insurer's claim department retained by the insured to assist it in claim management. In essence, a self-insured is the primary insurer. Not surprisingly, many insureds that employ self-insurance are major companies or commercial entities, sophisticated in matters of insurance, risk management, and loss control.
Another difference between a deductible and a SIR is that the SIR does not reduce available policy limits, whereas a deductible may reduce policy limits. Thus, an excess insurance contract with limits of $750,000 sitting above a $250,000 SIR will provide the insured with $750,000 in coverage once the SIR is satisfied. A $250,000 deductible, in contrast, may reduce the $750,000 insurance policy limits, leaving $500,000 in limits after the deductible is satisfied.
A “deductible” is a portion of an insured loss for which the insured is responsible. The deductible is generally a specific sum that the insured must pay before the insurer owes its duty to indemnify the insured for a loss. A deductible usually relates only to the damages sustained by the insured, not to defense costs. That is, the insurer is fully responsible for defense costs as long as the loss is potentially covered under the policy.
A SIR is generally a specific amount of loss that is not covered by the policy but instead must be borne by the insured. A SIR endorsement may provide that the insurer shall have the right, but not the duty, to assume charge of the defense and settlement of any claim, including those below the level of the SIR.
There is no dispositive case law differentiating deductibles from SIRs. However, one of the key characteristics of a SIR is that the insurer has no obligation to indemnify or defend a loss until the insured has paid the amount of the SIR. For purposes of analyzing the affect of “other insurance” clauses, this characteristic is the most significant characteristic of a SIR because it is this characteristic that transforms what would otherwise be a primary policy into an “excess” policy.
The magnitude of the difference between SIRs and deductibles depends upon the precise policy terms. Most significantly, the insured with a SIR generally assumes responsibility for claims handling and will report to the insurer only those claims that it considers likely to exceed the amount of its retained limit. By contrast, in the case of liability policies with a deductible, claims are tendered to the insurer for handling; the insurer provides for the defense of its insured and, to the extent of its limit of liability, the insurer pays on behalf of the insured the amount of any judgment or settlement of a covered claim. The insurer then bills the insured for the amount of the deductible.
Issues Re: Selection of Defense Counsel and Possible Conflicts of Interest
Policy terms dealing with provision of a defense or reimbursement of defense costs should be similar to those in conventional policies and should be similarly interpreted. One area of potential difference relates to the existence of a conflict of interest that might divest the insurer of the right to control the defense, even though that right is reserved in the policy.
What creates a conflict is an incentive for counsel retained by the insurer to defend in a way that serves the insurer's interests at the expense of those of the insured—for instance, by having any liability found only on non-covered grounds. The fact that the insured will be liable for payments below a certain level should not create a conflict any more than the fact that the insured will be liable for payments in excess of the policy limit. In neither case does the insurer have an incentive to direct the defense in a manner designed to do anything other than minimize liability.
A problem can arise when the claim appears to be solely within the insured's deductible or other self-insured amount. If the contract so provides, the insurer may select and retain counsel to defend the claim. But the insurer's right to control counsel's actions to the exclusion of the insured depends on the fact that, in the usual situation without self-insurance as to the initial portion of the claim, counsel is defending the interests of both the insurer and the insured, so that both may be regarded as counsel's clients in the traditional “tripartite relationship.”
A similar problem or potential conflict may exist if the complaint by the third party contains counts that are covered and counts that are not covered. Generally the insurer has a duty to defend the entire claim. With a significant SIR, the insured can control the defense which may cause concern by the insurer who potentially will owe indemnity and can only reserve their rights as to uncovered counts.
If counsel is directed by the insured, but the insurer is liable for counsel's fees, then the insurer may challenge the amount of such fees in a fashion analogous to that applicable when a conflict of interest creates that situation. If the insured will be paying for counsel of its own selection but the insurer fears that the case will be mishandled in a way that will implicate the covered exposure, its remedy would seem to be to associate its own counsel to monitor the defense and question what appears to be improvident decisions. But control would appear to remain with the insured, and it is not clear that the insurer would be permitted to challenge those decisions as a defense to its duty to indemnify, even if they appeared wrong or unreasonable in retrospect, so long as they were made honestly and in good faith.
The insurer may have interests in choosing counsel to control expense and to realize efficiency or other economies. In addition, the insurer may have an interest in making sure assigned counsel is experienced in the particular area of law involved in the litigation. In many cases, however, the insurer has no ultimate involvement because many of the claims will fall within the SIR. Regardless of who selects counsel, however, the attorney providing the defense must place the interests of the insured first. As a practical matter, however, the issue of who chooses counsel can have implications, both real and perceived, for both the insured and the insurer.
Exhaustion of the SIR and the Impact of Bankruptcy
When the insured who files for bankruptcy maintains a SIR, many issues arise with regard to the payment and defense of claims that fall within the SIR and what constitutes satisfaction of the SIR. Even when the insured has filed for bankruptcy, an excess insurer will only be liable for any amount that exceeds the SIR. A SIR is not an amount that the debtor owes the excess insurer, but rather is the “threshold” of the excess insurer's liability to the debtor.
What constitutes satisfaction of the SIR is altered when the insured files bankruptcy. A typical policy provision provides that it shall be a condition precedent to the insurer's liability that the insured make “actual payment, by way of settlement or judgment of damages,” of the SIR. Not surprisingly, insurers maintain that obligation to fund the initial losses is an absolute precondition to coverage. Some insurance policies require “actual payment,” which includes the notion that the self-insurance constitutes primary insurance for purposes of the “other insurance” clause. On the other hand, policyholders argue that the bankruptcy provision should be construed as excising the deductible and SIR provisions from the policy altogether, which compels the carrier to “drop down.”
The majority view treats SIRs and deductibles similarly. Under this view, an insurer must provide coverage above the SIR/deductible amount and up to policy limits even if the policyholder cannot pay the initial amount. Some courts require the insurer to provide coverage in excess of the SIR/deductible, up to the policy limit and sometimes even require the insurer to pay proceeds into the bankruptcy estate for distribution to creditors. The insurer may also be treated as an unsecured creditor in the bankruptcy action with respect to unpaid SIRs or deductibles.
The minority view on this issue requires the carrier to drop down and cover the costs, then seek reimbursement of the SIR/deductible from the insured. This option usually makes the carrier a creditor in the bankruptcy proceeding for the amount of self-insurance.
A question frequently arising in the context of insolvent self-insureds asks what will constitute satisfaction of the SIR/deductible. In some instances, bankruptcy courts have granted claimants against the self-insured an unsecured claim for the portion of any eventual recovery that falls under the SIR/deductible. This has been found to be sufficient “satisfaction” of the SIR. See In re Keck Mahin & Cate, 241 B.R. 583 (N.D. Ill. 1999).
Courts also have wrestled with disputes over who must satisfy the SIR/deductible. Carriers often point to policy definitions of “you” and “your” to support the argument that the named insured must be the one to pay the SIR/deductible amount, contending that it cannot be paid by others. When the question is whether payment by additional insureds, as opposed to named insureds, will obligate the insurer, at least one court has adopted the carrier view--based on the policy definitions--and found that satisfaction of the SIR/deductible by an additional insured is insufficient to trigger the carrier's obligation to pay.
As the pressure to contain insurance costs by increasing the portion of the risk retained by the insured grows, larger SIRs and deductibles offer the commercial insured a series of advantages and disadvantages. On the positive side, SIRs allow the policyholder to control the defense and settlement of smaller claims and, depending on the reporting requirement in the specific policy at issue, may allow the insured to keep smaller claims out of its experience rating. On the negative side, administering claims within the SIR may involve more staff and resources than planned or may require the insured to hire a third-party administrator (“TPA”) at its own expense to handle claims within the retention amount. Under deductible policies, not only does the insured avoid the indemnity obligations it would have under a SIR, it also avoids the loss adjustment expenses. In addition to lower premium costs, one of the major benefits identified by many commercial insureds whose policies have larger SIRs and deductibles is that they provide the company with an entirely new awareness of loss control which, in turn, can translate into improved loss experience in the long run.