Combining insurance and self insurance: issues for handling claims.

• Author: Barker, William T.

THE traditional insurance mechanism is complex, but its basic structure can be simply stated:

An insurance policy is a device for the transfer

of risk. A number of such risks are accepted,

some of which inevitably involve losses. How-

ever, such losses are spread over all the risks

assumed so as to enable the insurer to accept

each risk at a slight fraction of its possible liabil-

ity. Thus, the insurance policy defines the risks

transferred from the insured to the insurer in re-

turn for payment by the insured of a specified

premium.(1)

But, for a variety of reasons, shifting and spreading of risk is not always possible or desirable. In such cases, parties faced with a risk of loss may resort to other mechanisms instead or in combination with conventional insurance.

WHY SELF-INSURE?

Where the size of the prospective insured and the frequency of losses is such that a certain level of losses is fully predictable, the losses are a certainty, not a risk. They cannot be transferred without paying another entity the full cost of those losses, plus something extra to make the transaction worth its while.

Even if losses are not fully predictable, the risk of loss may be one the prospective insured can afford to bear itself. Because most insurers are not charitable institutions, risk transfer is not free of cost. Insurers also may be forced to subsidize residual market mechanisms, further increasing voluntary-market premiums above the cost of risk shifting. If the insured can afford to bear the risk, it may be more economical not to insure it. Deliberate risk retention by failure to purchase insurance is commonly referred to as self insurance, although it involves none of the elements of the traditional insurance relationship.(2) On the other hand, insurance premiums are ordinarily deductible for income tax purposes on a current basis,(3) while reserves for uninsured liabilities are not.

Moreover, while the general type of losses expected may be predictable to some extent, there also may be a risk of losses larger than the predictable amount, so that the unpredictable component is a candidate for insurance. Especially where the potential magnitude of such losses may be catastrophic, a portion of the risk may exceed what the prospective insured can afford to bear. Use of the insurance mechanism may trigger additional obligations or liabilities which could be avoided, thereby saving on costs, if the prospective insured refrained from insuring.

For example, automobile insurance may be required to provide coverage for the liabilities of uninsured motorists to occupants of the insured vehicle, while self-insurers may not be obliged to provide equivalent protection.(4) Similarly, automobile insurance may be required to provide omnibus liability coverage for permissive users in circumstances where a self-insured vehicle owner would not be liable for injuries caused by the user or, if liable, would be legally entitled to indemnity from the user.(5)

In some states, insurers may have duties to attempt reasonable settlements with third-party claimants, duties that do not apply to self-insurers.(6) When this is true, a self insurer may be able to take a more aggressive defense/settlement posture than would be cost effective for an insurer. (Insurers would argue that this anomaly should be avoided by not subjecting them to any obligations to third parties, but plaintiffs would argue that obligations to settle should be imposed on both insurers and self-insurers.)(7)

INSURANCE/SELF-INSURANCE HYBRIDS

As applied to claims of liability to third parties, the traditional insurance mechanism serves functions other than shifting and spreading losses. The insurer administers and adjusts claims, including litigation of their validity and amount. Legal or business obligations may require that insurance be in force as a means of assuring a solvent source for payment of claims.

To respond to these economic realities, insurers and larger insureds have developed a range of hybrid mechanisms that combine various features of the traditional insurance mechanism with various aspects of risk retention by the insured. Some of these mechanisms include:

* Fronting, whereby a policy of insurance is issued, but the insured is left to administer all claims and agrees to reimburse the insurer for all payments it must make. Essentially, the insurer functions purely as a surety for the insured's ability to pay claims.

* Claim administration agreements, whereby the insured retains all of the risk of loss and, perhaps, some decision-making authority, but retains an insurer to administer and adjust claims.

* Retrospectively rated policies, whereby the risk is insured, but the premium is determined partially by the claim experience. There is a wide and potentially unlimited range of possible arrangements. At the extreme, this can be a form of claim administration agreement coupled with a fronting relationship, which leaves the insurer with no risk other than the continued solvency of the insured. Or it may involve self-insurance up to a point and traditional insurance for larger losses. Or there may be risk sharing on some types of claims or in some range of loss amounts.

* A traditional insurance policy may incorporate a deductible, which the insured must pay on each claim, on all claims in the aggregate, or on some other defined class of claims.

* The policy may provide that the insured retains the risk of loss up to some amount, commonly referred to as a self-insured retention or SIR, and that the insurer's liability attaches only with respect to larger amounts.

The last three types of relationship are the topic of this article. They involve a range of divisions of responsibility for claim payment, claim administration and decision-making authority. They are economically similar and need to be considered together. Courts frequently treat deductibles and self-insured retentions as interchangeable terms, so descriptions of the policies at issue in decided cases may characterize those policies inaccurately, adding to the difficulty of interpreting available precedents.

To be distinguished from true self-insurance are situations in which one party agrees to indemnify another but does not insure (or only partially insures) that liability. From the standpoint of the party indemnified, the arrangement may be regarded as a form of insurance, with some of the legal consequences which attend that relationship.(8)

HYBRIDIZATION MECHANISMS

Precisely because these arrangements are designed to respond to a variety of circumstances, they vary widely. There has been little or no standardization of policy forms among insurers, and particular arrangements may be individually negotiated. As a result, it is especially important to study the particular policy language at issue in each case. Typically, the language used to implement a combination of insurance and self-insurance is a modified version of one of four types of traditional policy:

1. Primary insurance, where the insurer usually controls defense and settlement and pays all covered claims up to the policy limit.

2. Excess insurance, which assumes that some primary insurance is in force and that the primary insurer will do all or most claim administration and adjustment, with the excess insurer having no responsibility to act unless the primary coverage is insufficient.

3. Umbrella insurance, which is excess over some primary insurance and provides primary coverage for some risks outside the coverage of the primary policy.

4. Reinsurance, which typically insures some portion of an insurer's exposure, with little or no control of claim handling because the reinsurer is obliged to "follow the fortunes" of the reinsured so long as it acts in good faith. When this model is used, the metaphor of "self-insurance" is extended, with the "self-insured" exposure "reinsured."

The nature of the relationship used as the "model" to be modified to create the hybrid insured/self-insured relationship is usually instructive in addressing issues arising under the modified terms. These analogies are especially important, because the case law dealing with self-insurance functions of insurance policies is sparse. Moreover, the cases do not always make clear the precise nature of the relationship adjudicated, so the full implications of even the cases which do exist are not always clear.

Issues arising from the hybrid nature of the policy areise at every stage of claim handling. A useful way of addressing those issues is to consider those stages in the order they would arise as to a typical claim covered by traditional insurance.

Interactions between insurance and self-insurance also arise when several different risk mechanisms apply to the same loss. An entity may be self-insured (or have a policy of insurance with self-insurance features) for losses generally but receive coverage as an additional insured under policies purchased by vendors, subcontractors or employees. Different levels of a corporate hierarchy may have different but overlapping insurance programs or corporate acquisitions may make multiple programs applicable to the same loss.

Problems of this sort will be addressed after considering the issues that arise in application of a single insurance/self-insurance program.

NOTICE

If the policy contemplates that the insurer will administer the claim process, it presumably will have requirements of prompt notice of all claims, similar to the requirements of a conventional primary policy. There seems no reason why those requirements ought to be interpreted differently or that violation ought to have any different impact on the insurer's duty to indemnify than if the same language appeared in a conventional primary policy.

If the policy leaves to the insured administration of claims within its retention, then some standard must be applied to identify potential excess claims that must be reported to the insurer. If the...