Many liability insurance policies incorporate a provision under which the insured retains a portion of the risk and provisions that establish the precise point at which the insurer’s defense and indemnity obligations arise. Common forms of significant risk retention are large deductibles, matching deductibles, and self-insured retentions (SIRs). These terms are often used interchangeably. While they share certain similarities, key differences exist. The distinctions between large deductibles and SIRs present themselves in connection with a variety of issues: the duty to defend, erosion of the insured’s retention by defense costs, “other insurance,” and allocation.
Understanding the differences and similarities paves the way toward the efficient handling of claims under policies subject to these provisions and defines the insurer-insured relationship under policies subject to these risk management and retention mechanisms.
In the 1980s, in response to declining interest rates and greater commercial and municipal liability exposure, liability insurers re-evaluated premiums, re-examined policy exclusions and withdrew certain types of insurance from the market, such as insurance for pollution liability. In light of the increased costs associated with certain types of insurance, a growing number of insured entities began to explore methods of self-insurance.
The adverse factors that surfaced in the 2000’s economy led many business entities to again consider methods of risk retention and cost-shifting. The most common arrangements to produce increased risk retention are large deductibles, matching deductible policies, and SIRs.
A deductible, of whatever magnitude, is the most common type of risk retention mechanism. Deductibles traditionally apply to indemnity only. Black’s Law Dictionary defines a deductible as “the portion of the loss to be borne by the insured before the insurer becomes liable for payment.” A deductible traditionally does not preclude or defer the insurer’s duty to defend. As a general rule, under a primary policy including a duty to defend, the insurer must defend a claim potentially within coverage from “dollar one.”
However, depending on the policy language, an insured’s defense expenses can satisfy its deductible. Consider the following language:
Subject to the limits of liability under this policy, the Company shall pay only that part of the damages and claims expenses which exceeds the deductible as stated in Item V. of the Declarations. The insured shall bear at its own risk and uninsured the sum stated in Item V. of the Declarations for each and every claim made against the insured during the policy period or during the extended reporting period. The deductible shall apply to all damages and claims expenses. The Company shall not have any obligation to make any payments under this policy for damages or claims expenses until the deductible has been paid.
Concerning indemnity, the deductible amount is typically within the policy’s limit of liability. For example, if the policy’s limit of liability is $1,000,000 subject to a $250,000 deductible, the insurer’s indemnity exposure is the $750,000 difference between the deductible and the policy limit. The deductible does not increase the primary layer of coverage. In this example, excess coverage would attach at $1,000,000, not at $1,250,000.
Advantages and Disadvantages of Deductibles (to Insured and Insurer).
A deductible that matches the policy’s limit of liability is typically referred to as either a “matching deductible” policy or a “fronting policy.” For example, in Dorsey v. Federal Insurance Co., the court explained “[i]n a fronting policy, the insured essentially rents an insurance company’s licensing and filing capabilities, but the insurance company does not actually pay any claims.”
Fronting policies allow an insured to purchase excess coverage, with the assurance for the excess insurers that the claims will be handled in a consistent and reliable fashion. Fronting policies permit insureds to conduct business without meeting the formal requirements for qualifying as a self-insurer. Fronting policies often are issued to satisfy financial responsibility laws by guaranteeing payment for third-party liabilities. The premium will be lower for the insured in a fronting policy arrangement than in traditional coverage. The insured generally will be responsible for the claims adjustment costs, but the insurer may reserve this authority.
One court tied these principles together and stated:
[A] “fronting policy” program is a legal risk management device commonly used by large corporations, operating in multiple states, in which the corporation pays a discounted premium to an insurer, which maintains insurance licensing and filing capabilities in a particular state or states, to issue and maintain an “insurance policy” covering the corporation in order to comply with the insurance laws and regulations of each state in which the corporation is required to maintain proof of insurance. However, through the use of self-insurance mechanisms, the corporation retains all of the risk covered under the “fronting policy.” In effect, the corporation “rents” the insurer’s licensing and filing capabilities in a particular state or states, and thereby becomes a self-insurer and is not subject to the requirements of [the statute].
Fronting policies are generally interpreted as any other policy of insurance. For example, in discussing the obligations of the issuer of a “fronting” policy, the court in Fireman’s Fund Insurance Co. v. TIG Insurance Co. noted that the insurer owed payment obligations to its insured for claims potentially covered under the policy, notwithstanding the insurer’s right to immediate reimbursement from its insured of the amounts paid.
While the insurer may be required to pay claims in the event of insolvency, the insurer typically requires collateral in exchange for issuing the policy. Because the insured agrees by virtue of a side agreement that the insurer can use the collateral for such payments, some courts have found that this type of arrangement does not constitute a transfer of risk to the insurer.
Many courts observe that fronting policies are not risk-shifting mechanisms. In Pyramid Insurance Co., Judge (now Supreme Court Justice) Sotomayor observed that “insurance policies which do not actually transfer risk to the insurer but that serve other purposes are very much a custom of the industry.”
If a court finds that a fronting policy does not transfer risk, it will also likely conclude that a “true” insurer may not seek equitable contribution against an insured with a fronting policy. In Weyerhaeuser Co. v. Firemen’s Fund Insurance Co., the court explained that in cases involving continuous loss under Washington law, liability cannot be apportioned between an insurer and an insured that cannot collect for uninsured periods. The court extended this analysis to fronting policies and held that other insurers cannot seek equitable contribution from a fronting policy insured, because this would actually be an attempt to collect from the insured.
On the other hand, some courts conclude that fronting policies qualify as “insurance.” For example, in 2005, the South Carolina Supreme Court ruled that fronting policies do involve a transfer of risk. Other courts find that “fronting policies” qualify as “insurance” for purposes of traditional policies issued by other insurers. In Chicago Insurance Co. v. Travelers Insurance Co., the court held that a fronting policy qualified as insurance for purposes of an “other insurance” clause that stated that the policy was excess over all other insurance or self-insurance.
A SIR represents the amount of risk (defense and indemnity) that the insured retains before actual coverage applies. In 2009, the Massachusetts Supreme Judicial court observed,
[A] “self insured retention” is “the amount that is not covered by an insurance policy and that usually must be paid before the insurer will pay benefits. . . . .” The difference between a self-insured retention and a deductible is usually that, under policies containing a self-insured retention, the insured assumes the obligation of providing itself a defense until the retention is exhausted.
Therefore, the insured must satisfy its SIR before the insurer is obligated to respond to the loss.
Courts often analogize SIRs to primary insurance in discussing the insured’s own obligation to defend claims until the SIR amount is satisfied. As stated by one court recently, SIRs “are the equivalent to primary insurance, and . . . policies which are subject to self insured retentions are ‘excess policies’ which have no duty to indemnify until the self-insured retention is exhausted.” However, this general rule does not control over precise policy language that provides otherwise. For example, in Legacy Vulcan Corp. v. Superior Court, the court observed that a “retained limit” provision relieves an insurer of the duty to defend from “dollar one” only if the policy language so provides. The court stated that “the impact of a policy reference to a ‘self insured retention’ or ‘retained limit’ on the duty to defend will depend on the language of a particular policy.”
A commonly litigated issue involving SIRs is whether the insured’s defense costs exhaust the SIR. The answer depends on the particular policy language. However, as a general rule, an insured is obligated to exhaust the retained amount by payment of judgments or settlements.
A SIR sits underneath a policy’s limit of liability and, for this reason as well, the analogy to primary insurance is appropriate. For example, if a policy’s limit of liability is $1,000,000 subject to a $500,00 self-insured retention, the first layer of insurance excess of the retention attaches at $500,000, and the layer excess of the first layer of true coverage attaches at $1,500,000.
However, as the Forecast court noted, the analogy to primary insurance cannot be taken too far. A SIR does not qualify as primary insurance for all purposes. For example, under California law, an excess insurer that does not sit directly above a SIR cannot insist on satisfaction of the SIR for purposes of horizontal exhaustion. Other courts also find that self-insured retentions are not “insurance.”
Satisfaction of a SIR, in order to access “true” coverage excess of the SIR, raises its own issues. Courts are willing to support an insurer’s position that only the insured can satisfy the SIR, and not payment by additional insureds, if the policy language effectuates that intent. On the other hand, where the policy language is not precise on this issue, payment from other sources can trigger the obligations of the insurer whose policy is subject to the SIR.
Advantages and Disadvantages of SIRs (to Insured and Insurer).
The similarities between policies including large deductibles, fronting policies, and policies incorporating a SIR can cause confusion at many levels: at the risk manager level within the insured account; at the claims administration level (third-party administrator); at the level of “true insurance”; and for courts, arbitrators, or mediators. All three mechanisms represent an intent to define the extent of risk that is retained by the insured. In all mechanisms of retaining risk, the insurer’s payment obligations come into effect at the point at which the insured’s own obligations have been met.
In light of the similarities, some courts use language that does not reflect an appreciation of the distinctions between large deductibles and retained limits. These courts, perhaps, focus on the title and not on the language chosen to effectuate the intended risk retention and transfer. Most courts, however, recognize that deductibles and SIRs differ significantly. As Judge Hellerstein of the Southern District of New York noted:
[A] self-insured retention (“SIR”) "differs from a deductible in that a SIR is an amount that an insured retains and covers before insurance coverage begins to apply. Once a SIR is satisfied, the insurer is then liable for amounts exceeding the retention less any agreed deductible. . . . Policyholders frequently employ SIRs to forego increased premiums where they face high frequency, low severity, losses. . . . In contrast, a deductible is an amount that an insurer subtracts from a policy amount, reducing the amount of insurance. With a deductible, the insurer has the liability and defense risk from the beginning and then deducts the deductible amount from the insured coverage.
| Self-Insured Retention | Deductible | |
| Duty to Defend | Insured generally responsible for its defense until exhaustion of retained amount | Insurer’s duty to defend arises at dollar one (assuming prompt notice of a potentially covered claim) |
| Indemnity | No obligation to pay until SIR is satisfied | Obligation to pay deductible amounts and seek reimbursement (“pay and chase”) |
| Policy Limits | Policy limits apply in excess of SIR | Deductible typically is encompassed within the policy limits. |
| Additional Insureds | Additional insureds cannot seek coverage from insurer for claims within the SIR. | Additional insureds can seek coverage under policy (defense) before deductible is satisfied. |
| Insurance | May be considered insurance for certain purposes | Generally will not be considered insurance for any purpose |
When a policy is subject to a deductible, the insurer has a duty to defend the insured from the time the claim is presented (assuming potential coverage and compliance with notice provisions). The insurer generally cannot wait until the insured pays its deductible.
With a SIR, the insurer generally does not have a duty to defend until the insured’s SIR is exhausted by payments of judgments or settlements. For this reason, courts refer to a SIR as akin to primary insurance, and the insurance over the SIR as excess insurance.
The discussion in Axis Specialty Insurance Co. v. The Brickman Group illustrates this general rule. As background to that case, the true excess insurer negotiated a settlement of the underlying claim that required payment of the SIR, the limits in excess of the SIR, and a portion of the true excess coverage. The insured argued, in order to reduce its exposure for the claim, that its defense costs satisfied the SIR. The court explained that the policy language controlled and, under the operative policy language, the underlying insurance, which included the SIR, could be exhausted only by payment of judgments or settlements.
The insurer controls claims adjustment when its coverage is subject to a deductible, even a large deductible. In Orion Insurance Co. v. General Electric Co., the insured airplane-engine manufacturer maintained three liability policies providing coverage up to $25 million, subject to a $5 million deductible. The policies gave each insurer the right to settle any claim that it “deems expedient.” The insurers settled a lawsuit against the insured for $13.5 million, over the insured’s objections. The insurers sued the insured after it refused to pay the deductible. The insured argued that the insurers’ right to control the settlement did not extend to amounts within the deductible. The court rejected this argument and held that the policy provided the insurers with the right to settle the case, with or without the insured’s consent. The court stated:
Under the terms of this contract, it is perfectly proper for the insurers to settle an action for a figure where G.E.’s contribution in the form of the deductible is considerably larger than the insurer’s contribution. That is in fact what happened here. It would even be proper for the insurers to settle for a figure within the deductible, thus spending G.E.’s money without its consent and at no cost to themselves. While either of these results might seem to be burdensome to G.E., particularly the latter, that is the contract which G.E. made with its insurers[.]
More recent case law reaffirms this principle. For example, in American Protective Insurance Co. v. Airborne, Inc., the court explained that even if the insured defends under a large deductible, the insurer controls the settlement, and the insured is obligated to contribute its deductible to the settlement reached by the insurer.
In contrast, when a policy is subject to a SIR, the insured is responsible for claims handling, settlement, and payment of claims within the retained amount. While the insured must act in good faith, it owes no obligation to settle within the SIR to avoid exposure to the insurer. In Commercial Union Assurance Companies v. Safeway Stores, the court held that an insured with a SIR has no duty to accept a settlement offer that would avoid exposing the excess insurer to liability. Courts have adopted the holding of Safeway. However, Safeway and its progeny acknowledge that “equity requires fair dealing between the parties to an insurance contract” and an insured cannot make unconscionable decisions in regard to the excess insurer’s liability.”
For claims that have a reasonable potential to exceed the retained amount, the general rule is that if the policy language gives the insurer the exclusive right to settle claims, the insurer controls the settlement despite the insured’s financial stake in the settlement. In N.Y. City Housing Authority v. Housing Authority Risk Retention Group, Inc., the court enforced an insurance provision that allowed the insurer to settle if there was a reasonable chance the loss would exceed the SIR.
Under a minority view represented by less recent opinions, where the insured has a financial stake in the settlement, the insurer must obtain insured’s consent before settling.
Two issues have emerged that relate to satisfaction of deductibles and SIRs. These issues are whether defense costs exhaust the insured’s obligation under a deductible or a retention, and who can satisfy the retained limit obligation in order to implicate true coverage.
Typically, an insurer bears the responsibility to defend under a policy that is subject to a deductible, but the insured is responsible for its own defense of claims within a self-insured retention until the retained amount is satisfied by payment of settlements or judgments. In neither case would defense costs satisfy the insured’s policy obligations. However, both of these general rules can be altered by policy language.
Sample Language––Defense Costs Satisfy SIR
You are responsible for the payment of the “Self-Insured Retention.” Under this option, any amount paid in “Allocated Loss Adjustment Expense” will be included toward the satisfaction of the “Self-Insured Adjustment Expense” you incur with our prior written approval, in excess of the “Self-Insured Retention.” We have the right but not the duty to defend any “suit.” If we do not assume defense or control of the claim or “suit,” we will reimburse to you all reasonable and necessary “'Allocated Loss Adjustment Expense” you incur with our prior written approval, in excess of the “Self Insured Retention.”
Sample Language––Defense Costs Satisfy Deductible
Subject to the limits of liability under this policy, the Company shall pay only that part of the damages and claims expenses which exceeds the deductible as stated in Item V of the Declarations. The insured shall bear at its own risk and uninsured the sum stated in Item V of the Declarations for each and every claim made against the insured during the policy period or during the extended reporting period. The deductible shall apply to all damages and claims expenses. The Company shall not have any obligation to make any payments under this policy for damages or claims expenses until the deductible has been paid.
Defense costs within a SIR or a deductible can benefit both the insured and the insurer, but can also present concerns. In terms of benefits, defense within the retained limit decreases the insured’s exposure, and removes the insurer’s obligation to defend from dollar one. If the insurer has concerns regarding the insured’s own ability to manage its claims, an accelerated obligation to defend can reduce the insurer’s ultimate indemnity exposure. On the other hand, an insured may determine that the time required to defend itself against suits argues in favor of permitting the insurer to control the defense. Likewise, an insurer may desire a decreased risk transfer based on the insured’s past loss history. In that event, defense costs outside the SIR decelerates the SIR’s exhaustion and the point at which the insurer’s obligations would arise.
The cases that address whether a person or party other than the named insured can satisfy the retained limit obligation underscore the importance of the precise policy language. Where the policy specifies that the insured must meet the obligation, the insurer has no obligations until the insured itself makes the payment. This same rule applies to both an insured’s deductible obligation and an insured’s SIR obligation.
The following cases illustrate this rule in the context of deductibles: Hartford Accident & Indemnity Co. v. U.S. Natural Resources Inc. (held only named insured, not employee who was an additional insured, was required to pay deductible to insurer because policy referred to “named insured’s” obligation to pay); Northbrook Insurance Co. v. Kuljian Corp. (applying Pennsylvania law and affirming lower court’s ruling that policy’s plain terms required both named insureds to pay deductible, including “innocent” named insured); Tidewater Equipment Co. v. Reliance Insurance Co. (holding that named insured must pay deductible because additional insured has rights under policy by virtue of contract between insurer and named insured).
Forecast Homes illustrates this rule in the context of self-insured retentions. In that case, the court held that additional insureds were not entitled to coverage unless and until the named insured satisfied the SIR. In reaching this result, the court relied on the language of the SIR endorsement and the policy explanation under which “you” referred solely to the named insured. Accordingly, in that context, an additional insured cannot pay the SIR to access true coverage.
Where the policy language does not expressly require the insured itself to pay the retained amount, the excess insurer’s obligations can be implicated by another person’s or business’s payment in satisfaction of the retained amount.
Insolvency of an insured that chose (pre-insolvency) to retain a significant amount of risk presents the issue of whether payment of the SIR or deductible is a condition precedent to coverage.
The obligations of an insurer under a policy subject to a deductible are not excused by virtue of the insured’s inability to pay its deductible. For this reason, insurers issuing coverage subject to a large deductible often enter into side agreements with insureds, under which the insured provides collateral to be drawn upon in the event that the insured is unable to reimburse the insurer for the deductible amount of a settled claim.
A few courts relieve the insurer of its obligations if the insured does not satisfy its payment obligations under a SIR. Other courts hold that an insurer providing coverage in excess of a SIR is obligated to defend and indemnify to the extent claims exceed the SIR, even if the SIR has not been paid. Many of these decisions are based on states’ statutory bankruptcy laws that provide “the insolvency or bankruptcy of the insured shall not release the company from the payment of damages for injuries sustained.” For example, in In re OES Environmental, Inc., the court held that the insurer was responsible for amounts in excess of the SIR even if the SIR was not paid. The court distinguished Apache because the policy at issue stated that the retained limit was to be “borne by” the insured and did not explicitly require exhaustion.
In Pak-Mor Manufacturing Co. v. Royal Surplus Lines Insurance Co., the SIR endorsement provided that actual payment of the SIR was a condition precedent to coverage. While the court held that the insurer had no obligation to pay until the SIR was satisfied, it explained that the insured “may satisfy the self-insured retention by making its payment in whatever form it wants [i.e., a promissory note issued to the creditors]. . . . so long as the Bankruptcy Court confirms that the payment is performed in a credible and reliable manner.”
The nature of deductibles and SIRs provides an extra layer of complexity to cases addressing how insurers are to allocate responsibility for losses that implicate multiple insurance policies. The “other insurance” issue arises where both the insured’s own risk retention mechanism and one or more policies providing for true risk transfer provide concurrent coverage, or would apply to the same occurrence or claim. In this context, a court will consider whether the insured’s retention mechanism qualifies as “other insurance.” In contrast, when a loss continues across multiple successive policy periods, courts must consider whether and how the loss should be allocated across multiple carriers, one or more of which may be subject to SIRs or large deductibles.
The majority of courts hold that that a self-insured retention does not qualify as “other insurance” for a particular claim or occurrence. In Wake County Hospital System, Inc. v. National Casualty Co., a bodily injury claim was asserted against a hospital and the treating nurse. The hospital’s coverage (through St. Paul Fire & Marine) was subject to a $750,000 SIR; the nurse maintained a liability policy with National Casualty that was not subject to a deductible. The claim settled for an amount within the SIR. National Casualty argued that it had no duty to defend or indemnify because, under its “other insurance” clause, the National Casualty coverage was excess to the hospital’s SIR.
The court agreed with the hospital that National Casualty was obligated to pay the claim. The court stated:
Because Wake [the hospital] had a self-insured retention of $750,000, it was essentially uninsured for that amount. As a result, Wake cannot be viewed as having “insurance” as that term is plainly and ordinarily used, since it had no insurance for valid claims made which were under $750,000.
Contrary to the majority, a number of decisions hold that a SIR qualifies as other insurance. These cases fall into two categories. The first category consists of cases in the auto liability context. In this context, states’ financial responsibility laws regard internal insurance programs as the functional equivalent of true coverage.
The second category involves cases in which courts addressed and enforced policy language specifying that the coverage is excess over insurance, including a deductible portion or SIR. In Warren Hospital v. American Casualty Co. of Reading, PA, the facts and issues paralleled those presented in Wake County Hospital. In the context of a bodily injury action against a hospital and a nurse, the nurse’s liability insurer asserted that it was excess over the hospital’s SIR. The court agreed with the nurse’s insurer based on the language of its “other insurance” clause. That clause stated in relevant part, “[i]f there is any other insurance policy or risk transfer instrument, including but not limited to self-insured retentions, deductibles, or other alternative arrangements (‘other insurance’), that applies to any amount payable under this policy, such other insurance must pay first.“ The court enforced the policy language as written.
Few courts address the issue of how deductibles apply where a loss is prorated among multiple policies. The majority approach holds that that the full amount of the deductible established by each policy must be satisfied. These courts reason that to prorate a deductible in the context of a continuous loss would upset the balance of risk to which insureds and insurers previously agreed. Specifically, “[d]eductibles constitute a bargained-for aspect of the insurance contract that affects the premiums the insured pays. . . . Insureds purchase policies with deductibles that are directly related to their premiums, risking the possibility that the loss will be low and that the deductible will equal or exceed it. When that occurs, the insured gets exactly what it has bargained for.”
A minority of courts hold that only prorated deductibles or self-insured retentions must be satisfied for each policy in a situation involving pro-rate allocation. These courts have declined to set forth a thorough analysis, and instead reason that prorating the deductible is “equitable” where the policies are “at best ambiguous as to what happens when the insurer is held liable for only part of a continuous occurrence.”
With respect to SIRs, several cases hold that an insured is required to exhaust each SIR applicable to a loss before it can access its excess coverage.
Other courts reject the premise that an insured must exhaust multiple SIRs over multiple triggered policy years. According to these courts, the principles of horizontal exhaustion are not applicable because a SIR does not qualify as primary insurance, and thus each SIR did not need to be exhausted before the insurers had any duty to indemnify. In Bordeaux, the court emphasized the importance of particular policy language, noting that the policy said “nothing about whether or not Bordeaux’s obligation to pay the American Safety SIR is satisfied when it fulfills a similar obligation under another policy.” These courts focus on the policy language, noting that the subject policy did not contain any language regarding whether the insured’s SIR obligation is satisfied.
To determine the precise point at which an insurer’s rights and duties arise, claims professionals and their counsel should focus on the specific language used to describe the retention and the events that implicate the insurer’s obligations. Courts consider the language defining the retention, rather than its title, in determining whether it should be treated as a deductible or SIR. If questions arise, claims professionals and their counsel can involve the underwriter to confirm that the policy language captures intended risk retention and risk transfer, and to implement the proper risk-management protocol. Risk-transfer mechanisms can be complex but can benefit the insured and the insurer, and foster successful insured/insurer relationships.
