Options for Self-insurance

You Can Save Premium Dollars By Retaining More Risk

Manager Chasing Flying Money With A Net

While businesses can prevent many workplace accidents by implementing a well-designed risk control program, some losses cannot be avoided. Thus, business owners must decide how to pay for losses that occur. They have two basic options: risk transfer and risk retention (self-insurance).

Risk Transfer

Many businesses transfer risk by purchasing a business insurance policy. When a company pays the premium, it transfers to the insurer the risk that certain types of losses may occur. In exchange, the insurer promises to pay claims that result from future events covered by the policy. The insurer assumes the risk that future claim payments might exceed the premium collected from the insured.

Businesses also transfer risk via contracts. Many business contracts contain an indemnity agreement, which is a promise by one company to indemnify (reimburse) another for the cost of certain types of third-party claims. Indemnity clauses are commonly found in construction agreements, commercial leases, and equipment rental contracts.

Risk Retention

All businesses retain some risks. These include risks excluded by insurance policies and those retained by the company voluntarily. Risk retention is often referred to as self-insurance. Large companies have more financial wherewithal to absorb losses than small firms so they have a broader range of options for self-insuring risks. Nevertheless, small businesses can still enjoy many of the benefits of risk retention, albeit on a smaller scale.

Advantages

One primary advantage of risk retention is reduced insurance costs. By assuming more risk, you can lower your insurance premiums. Another benefit is the ability to handle losses as you choose. For example, suppose you decide to forego contractors equipment coverage on construction machinery you own. If a company-owned backhoe is vandalized you can immediately transport the machine to your favorite repair shop. You need not wait for an adjuster to inspect the damaged machine and approve the repairs.

Self-insurance can also motivate you to practice good risk management. You will try harder to prevent accidents if you know you'll have to pay for the resulting losses out of pocket.

Disadvantages

Risk retention has some disadvantages. One is that your out-of-pocket costs may be larger than you anticipate. For instance, you save money on a commercial property policy by choosing a $5,000 deductible. Two months later, you sustain a $4,999 loss. Secondly, risk retention requires considerable financial planning. If you decide to pay for losses yourself you must allocate funds in advance so money will be available when you need it.

Risk Retention For Small Businesses

Here are some ways a small business can retain risk.

1. Deductibles

Deductibles can be an effective tool for lowering your premium if you have the financial resources to pay some losses out of pocket.

Property Coverages

Deductibles are often used in first-party coverages like commercial property and auto physical damage. The most common type is a flat deductible, which represents the amount of each loss you must pay. If a loss exceeds the deductible, your insurer pays you the difference between the deductible and the loss amount. For example, suppose a vehicle you own is insured under a business auto policy that includes a $500 collision deductible. If the auto incurs $750 in collision damage, your insurer will pay you $250 for the loss.

General Liability or Auto Liability Coverages

A property damage deductible can help you save money on auto liability or general liability insurance. This is especially true if your business is likely to generate numerous small property damage claims. For example, suppose you own a landscaping company that uses trucks to deliver decorative rock to job sites. Rocks that escape from your trucks while they're on the highway could damage other people's vehicles. To save money on your commercial auto liability coverage, you request a $1,000 property damage deductible.

If a third party demands compensation for vehicle damage caused by a rock, your company will pay the claimant directly if he or she seeks less than $1,000.

Liability policies covering small business owners are unlikely to include a bodily injury deductible. Small bodily injury claims can quickly become large ones if not managed properly. Thus, insurers prefer to handle such claims themselves.

Workers Compensation Coverage

Many states allow (or require) insurers to offer all workers compensation policyholders a small deductible plan if they meet eligibility requirements. Plans vary from one state to another. Depending on the state, a "small" deductible may range from $500 to $75,000. The deductible may apply to medical benefits, indemnity (disability), or both. It may also include loss adjustment expenses.

A small business owner that wishes to purchase workers compensation coverage with a small deductible may be required to provide evidence of financial security such as an irrevocable letter of credit. The deductible is typically added to a standard workers compensation policy via an endorsement.

2. Self-insured Retention

A self-insured retention (SIR) is used in liability and workers compensation insurance. A retention is a specified dollar amount that you agree to pay for each claim or occurrence. Unlike a deductible, an SIR may apply to claim expenses as well as damages. Another difference is that you may be responsible for handling claims that fall below the SIR. Claims that fall within a deductible are usually administered by the insurer.

Most policies purchased by small businesses do not include a self-insured retention. Two exceptions are umbrella and errors and omissions policies. Some umbrellas contain an SIR that applies to claims covered by the umbrella but not by underlying insurance. An example is a claim alleging mental anguish that is covered by your umbrella but not by your general liability policy. An umbrella SIR typically applies to damages only (not claims expenses).

Self-insured retentions are common in errors and omissions liability policies. They may apply to damages only or to both damages and claims expenses.

3. Group Self-insurance

Some states permit small and medium-sized employers to self-insure their workers compensation obligations on a group basis. Typically, all members of a self-insured group must operate similar types of businesses. Group members pay premiums to cover losses, legal fees, and administrative expenses. If premiums exceed losses and expenses, members share the surplus as dividends. If losses and expenses exceed the premiums collected, members must cover the shortfall. To learn whether group self-insurance is an option in your state, consult your insurance agent or state insurance department.