Options for Self-insurance

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All businesses face the risk of accidental losses. Many losses can be avoided or prevented through risk control techniques such as a workplace safety program. Despite management's best efforts, however, some losses are inevitable. Thus, management must decide how they will pay for them. Businesses have two basic options for financing losses: risk transfer and risk retention (self-insurance).

Risk Transfer

Many businesses transfer risk by purchasing an insurance policy. A business insurance policy transfers certain risks from the insured company to the insurer. The insured pays a premium and in exchange, the insurer promises to pay claims covered by the policy. The insurer assumes the risk that the cost of claims might exceed the amount of premium it has collected from the insured.

A business may also transfer risk via an indemnity agreement in a contract. An indemnity agreement is a promise by one company to indemnify (reimburse) another for the cost of certain types of claims. Indemnity clauses often appear in construction agreements, commercial leases, and other business contracts.

Risk Retention

Many businesses choose (or are forced by an insurer) to retain some risk and pay for resulting losses out-of-pocket. Risk retention is often referred to as self-insurance. Large companies have more options to self-insure risks than small firms. This is because large companies have a greater capacity to absorb losses. Yet, small businesses can still enjoy many of the benefits of risk retention, albeit on a smaller scale.

Advantages of Risk Retention

One main purpose of risk retention is to lower the cost of insurance. If you assume some risk, you can retain some of the funds you would otherwise have paid in insurance premiums. Self-insurance also affords you more control over the risks you have retained. For example, suppose you decide to forego contractors equipment coverage on construction machinery you own. If a company-owned backhoe is damaged in a hail storm, you can handle the repairs in any way you choose. You need not wait for instructions from an adjuster.

Self-insurance can be a motivator to practice good risk management. If you will be paying for some losses out of pocket, you may try harder to prevent them from happening and to mitigate those that occur.

Disadvantages of Risk Retention

Risk retention has some disadvantages. For one thing, your out-of-pocket costs may be larger than you anticipated. If you select a $5000 deductible on your commercial property policy, you probably don't anticipate a $4,999 loss. Secondly, risk retention requires more financial planning on your part. You must allocate funds in advance so money will be available to pay losses when they occur.

Risk Retention Methods Used by Small Businesses

Here are some options available to small businesses for retaining risk:

1. Deductibles

Deductibles are a common method of risk retention. They 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 policies providing first-party coverages like commercial property and auto physical damage. When a deductible applies, any losses that fall below the specified deductible will not be covered by your policy. When a loss exceeds the deductible, the insurer typically pays you the difference between the loss amount and the deductible. For example, suppose a vehicle you own incurs a $750 collision loss. If your business auto policy includes a $500 collision deductible, your insurer will pay you $250 for the loss.

General Liability or Auto Liability Coverages

Deductibles may also be used for property damage claims under commercial auto or general liability policies. For example, trucks used to haul gravel can generate numerous small liability claims for cracked windshields. Thus, a company that uses trucks to transport rock or other landscaping materials may purchase a commercial auto policy that includes a property damage deductible of say, $1,000. If a claimant demands compensation for a cracked windshield, the insured gravel company will pay the claimant directly if the amount sought does not exceed the deductible.

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 have approved the use of small deductible plans for workers compensation insurance. These programs 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 apply to loss adjustment expenses. Some states require insurers to offer a small deductible plan to any employer that qualifies for one. Other states permit, but do not require, insurers to offer such a plan.

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. Like a deductible, an SIR represents a specified amount of risk that you agree to retain. One difference is that an SIR may be reduced by claim expenses. Such expenses rarely reduce a deductible. Moreover, the insurer usually controls the defense of any claim that is subject to a deductible. When a claim is subject to a SIR, the insured may control the defense until the SIR has been exhausted.

Most policies purchased by small businesses do not include a self-insured retention. Two exceptions are umbrella and errors and omissions policies. Many 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. The SIR typically applies to damages only (not claims expenses).

Many errors and omissions liability policies include an SIR. The SIR 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. This allows smaller firms to obtain many of the benefits of self-insurance. State laws determine the minimum requirements for a group self-insurance program. Typically, employers in a self-insured group must operate similar types of businesses. To learn whether group self-insurance is an option in your state, consult your insurance agent or state insurance department.