Options for Self-insurance
All businesses face the risk of accidental losses. There are two basic options for managing this risk: risk transfer and risk retention.
Many businesses transfer risk by purchasing an insurance policy. By paying a specified premium, a business may transfer to an insurer the risk that certain types of losses will occur. The insurer assumes the risk that losses might exceed the amount of premium it collects from the insured.
A business also has the option to transfer risk via an indemnity agreement in a contract. In an indemnity agreement, one company agrees to indemnify (reimburse) another for the costs of certain types of claims or lawsuits.
Risk Retention (Self Insurance)
Many businesses choose (or are forced by an insurer) to retain some risk. Risk retention is often referred to as self-insurance. Generally, large companies have more options with regard to self-insurance than small firms 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 major advantage of risk retention is a lower the cost of insurance. By assuming some risk, you can keep some of the money you would otherwise have paid to an insurer. Self-insurance also affords you more control over the risks you have retained.
Since you will be paying some losses out of pocket, moreover, you may try harder to prevent them from occurring.
Disadvantages of Risk Retention
Risk retention offers some disadvantages. One is that your out-of-pocket costs may be larger than you anticipated. For instance, if you select a $5000 deductible on your commercial property policy, you probably aren't expecting to incur a $4999 loss.
Secondly, risk retention can generate administrative hassles. Suppose you decide to self-insure physical damage coverage on your fleet of trucks. If a truck is damaged you'll have to deal with repair-related tasks (like locating a reliable repair shop) yourself rather than relying on an insurer to perform those tasks for you.
Types of Risk Retention Used by Small Businesses
Here are some options available to small businesses for retaining risk:
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. Deductibles are used in many types of policies.
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.
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 transports rock or other landscaping materials on trucks may purchase a commercial auto policy that includes a property damage deductible of say, $1,000. When a claimant demands compensation for a cracked windshield, the insured gravel company pays the claimant directly if the amount sought does not exceed the deductible.
Note that liability policies covering small business owners are unlikely to include a deductible that applies to bodily injury claims. Claims seeking compensation for bodily injury can spiral out of control if not managed properly. Thus, insurers prefer to handle such claims themselves.
These programs vary from state to state. In some states a "small" deductible may range from $500 to $75,000. The deductible may apply to medical benefits, indemnity or both. It may or may not apply to loss adjustment expenses. Some states require insurers to offer a small deductible to any employer that qualifies for one. In other states, insurers are permitted but not obligated to offer a small deductible 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.
A self-insured retention (SIR) is used in liability and workers compensation policies. Like a deductible, a SIR represents a specified amount of risk that you agree to retain. One difference between the two has to do with claim expenses. Such expenses do not usually reduce a deductible but may reduce a SIR. Also, when a claim is subject to a deductible the insurer usually controls the defense. 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 a SIR that applies to claims covered by the umbrella but not by underlying insurance. For example, a claim alleging mental anguish might be covered by your umbrella (via the definition of bodily injury) but not by your general liability policy. A SIR under an umbrella policy typically applies to damages but not claims expenses.
In some states small and medium-sized employers are permitted to self-insure their workers compensation obligations on a group basis. This option enables 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 self-insured group insurance is an option in your state, consult your agent or state insurance department.