Deductibles vs. self-insured retentions

Greg Lang (pictured), founder of the Reinsurance and Insurance Network (RAIN) examines the difference between a deductible and a self-insured retention.

Most of the insurance topics I write about appear straight forward until you get past the headline. The difference between a deductible and a self-insured retention (SIR) is another such topic.  It boils down to one question.  Who pays first.  Under a traditional deductible, the insurer pays first. The insurer then bills the insured for reimbursement.  The insurance company is extending credit, so collateral is often required. Under an SIR, the insurer owes nothing until the retention is exhausted.  No credit exposure to secure. 

That is the simple answer.  It gets complicated when we consider how deductibles and SIRs impact claims handling, policy limits and the paperwork to document both. It’s further complicated when courts and captives are involved. 

*Courts often look at the actual wording of a policy before making a ruling on who pays.  A document titled "deductible" that acts like an SIR (or the reverse) can be treated by the court according to what the paperwork says or what the action of the parties might be.

As you can see from the table, most of the operational and paperwork modifications occur when selecting an SIR over a deductible. Bankruptcy further complicates the SIR process.

Courts typically do not require excess insurers to drop down and fund an SIR for an insolvent insured.  Insurers often do to avoid default judgments and to secure a say in the claim’s outcome.  A default judgement is a ruling in favor of the plaintiff because the defendant failed to respond to a lawsuit or show up in court. This is the primary reason insurers step up to pay under an SIR even when they are not contractually obligated to do so.  Insurers also want to manage the claims process in the event the loss reaches their attachment. This creates a de facto credit exposure without collateral. 

When an insurance company is placed in liquidation, state guaranty funds will pay claims including deductibles up to a limit.  State funds respond if coverage was written on admitted paper.  If the policy was written on surplus lines paper, the insured is not entitled to reimbursement.  States differ over how deductible reimbursements are collected during an insolvency. Large deductible program failures have contributed to several insurance company insolvencies.  This helps explain why regulators and insurers care so much about collateral.

Deductible Confusion 

SIRs are not the only reason this topic gets complicated.  Deductibles play their part.  The problem with deductibles is there are so many types and little agreement on how to define them.  Straight, flat and fixed dollar deductibles all describe a fixed dollar deductible payment per loss regardless of claims size. A disappearing deductible can mean the insured pays the loss under a predetermined dollar threshold and the insurer pays 100% including the deductible if the loss reaches or exceeds the SIR amount.  A disappearing deductible can also be a formula that decreases as the loss size increases and disappears entirely at a specific dollar amount.

Deductibles most relevant to captives are deductible reimbursement policies and matching deductibles. A deductible reimbursement captive is an arrangement where a company uses its captive to fund and cover out-of-pocket deductible amounts from high-deductible commercial insurance policies. The term matching deductible and pure fronting are often used interchangeably by courts and industry sources.  It adds to the confusion.  

Matching Deductibles vs. Pure Fronting

There are differences in who the fronting carrier's counterparty is and what sits behind the collateral for both fronting and matching deductible structures. The degree of risk share and the purpose of selecting one over another can be different too.

• Counterparty.  In a matching deductible the carrier looks to the insured for reimbursement. In a classic fronting arrangement, the carrier cedes the risk by reinsurance and looks to the captive for recovery. The collateral sits behind a different obligor with different regulatory treatment.
• Structure and regulation. Fronting involves a reinsurance contract, ceding commission and reinsurance credit and collateral rules in the fronting carrier's domicile. A matching deductible is a single direct contract with a reimbursement side agreement and no reinsurance.
• Degree. Fronting can mean partial risk sharing such a quota share or excess of loss reinsurance provided by the front or a third-party reinsurer.  The purpose of a front is often to secure admitted paper needed to meet regulatory requirements, or nonadmitted paper to meet the credit requirements of a counterparty such as a bank or vendor relationship. A matching deductible is by definition 100% retention at the limit.

Most court cases treat fronting policies with matching deductibles as genuine insurance because the carrier bears the insolvency risk. A minority find the coverage only "theoretically available" or not valid and collectible insurance. The collateral that is often required undermines the insurance characterization by reducing risk transfer.  I recommend reaching out to counsel if you want more information on this. I am not offering nor am I trying to offer legal advice.

Other deductibles and retentions

The challenges don’t stop there.  It’s very Important to understand how your policy is going to respond and what you are ultimately on the hook for.

Deductibles can be applied per occurrence, per claim and per claimant.  Coverage can include protection for damages only or include defense costs.  Defense costs can erode the deductible and policy limit or be paid outside one or both.  These differences can impact the premium paid and put pressure on the insured to settle a claim.   

Policies can also contain coinsurance provisions where the insured shares a percentage of loss above a retention. This is common in Directors and Officers coverage, (D&O), professional liability and cyber policies.  Coinsurance can also be applied first dollar, which is common in property policies where wind coverage has coinsurance provisions of 5% or 10% of the limit.  Captives can be used to fund for these coinsurance exposures like the deductible reimbursement policies mentioned earlier.   

A Final Word   

Creative use of captives has led to significant innovation in risk transfer and the funding for loss.  Much of what was discussed is the invention of hard market negotiation and the search for coverage.  One final word of caution. Beware policy language that may contain a "who may satisfy the SIR" provision. When the insured's captive pays losses inside an SIR, some excess policies specify whether that payment counts. It is often negotiated wording.

Commercial excess underwriters structure SIRs with the assumption that the parent company has skin in the game. They want the insured to feel the direct financial impact of loss, so they remain incentivized to maintain rigorous risk management.

Standard commercial excess policy language often contains restrictive phrases like "payments made solely by you" or "from your own account," where "you" is strictly defined as the named insured. Strict interpretation of this language would argue the captive subsidiary does not legally satisfy the SIR provision. This can cause an excess insurer to refuse to attach, leaving a gap in coverage

The underwriter may argue that if a captive pays the loss, the operational company isn't truly "retaining" the risk on its corporate balance sheet. Furthermore, insurers worry that poorly funded captives can become insolvent, leaving the excess carrier with a choice whether to "drop down" and fill the gap.

The insured argues that the captive is simply a formalized, tax-efficient vehicle to fund their self-insured risk. The ultimate economic risk still rests within the corporate family.  The excess carrier faces the exact same attachment point and loss exposure regardless of which internal checkbook pays the claim.

As with most questions regarding contract language.  Get it worked out before the claim happens. Otherwise, it might be too late.  Let’s keep it “simple”!!!

Greg Lang can be contacted at: glang@rainllc.com

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