SIRs and deductibles - evolving policies and their impact on carrier duties.

• Author: Hamilton, Michael A.
• Position: Self-insured retentions

EVEN as the global economic crisis begins to show signs of recovery, commercial insureds continue to look for ways to tighten their corporate belts, cut costs and boost profits. One of the areas where insureds are increasingly taking a second look to determine whether it is possible to reduce costs is their corporate risk management programs, including the insurance products they purchase. As a direct result of such cost-saving efforts, more and more commercial policies are being written with large self-insured retentions ("SIRs") and higher deductibles. As noted by the Wisconsin Supreme Court in a recent decision, as a growing numbers of insureds elect to control their insurance costs by purchasing policies with substantial SIRs and deductibles, a body of case law is beginning to emerge highlighting some of the issues that often accompany an insured's decision to manage its costs, and its exposure, in this way.

This article addresses a number of issues that are implicated by an insured's decision to assume responsibility for a greater portion of its risk in the form of an insurance policy with a significant SIR or deductible, and the case law that impacts on these issues. First, this article examines the differences between SIRs and deductibles, including the advantages and disadvantages to a commercial insured of purchasing a policy with a significant SIR or deductible as part of its overall risk management and cost containment strategy. Second, this article addresses whether an insured with a large SIR has a duty to its excess insurer to settle claims within the SIR and whether it can be held liable if it fails to do so. Third, this article addresses whether an insurer has the right to settle a claim over the objection of an insured with a substantial SIR or deductible especially where the settlement would involve a substantial contribution by the insured with little or no contribution by the insurer. Fourth, this article addresses the obligations of an excess insurer when an insured is insolvent and is incapable of paying its SIR. Finally, this article addresses the coverage implications associated with the satisfaction of the SIR by insurers or other third parties to the insurance contract.

1. SIRs and Deductibles--What's the Difference?

   In the current economic climate, first-dollar coverage has become a luxury that many commercial insureds can no longer afford. Although policies with large self-insured retentions and deductibles have always been available, they were frequently overlooked in the past when bottom lines were healthier and insurance premium costs were subject to less scrutiny. As more insureds assume greater responsibility for managing the risk of smaller claims while relying on traditional insurance products for catastrophic protection, more policies are being issued with significant SIRs and deductibles.

   True "self-insurance" involves a pure risk retention approach under which a company elects to assume full responsibility for any losses that may arise and insures none of its potential liability with a third party. (2) As such, a corporation that truly self insures must pay all judgments and settlements for all claims asserted against it, as well as the related loss adjustment expenses including defense costs. All other forms of self-insurance, including the strategic use of deductibles and SIRs as part of an overall risk management strategy, represent a departure from true self-insurance.

   SIRs and deductibles are similar in that both require the insured to bear financial responsibility for a portion of a loss and, in this regard, represent an exposure that is not covered by insurance. However, there are important differences in the way they operate, and it is a mistake to use these terms interchangeably as inexperienced insureds occasionally do. In Allianz Ins. Co. v. Guidant Corp., the Indiana Court of Appeals explained the distinction between a deductible and an SIR was recently explained by one appellate court in this way: "[a] policy with a deductible obliges the insurer to respond to a claim from dollar one (i.e., immediately upon tender), subject to the insurer's right to later recoup the amount of the deductible from the insured. A policy subject to a SIR, in contrast, obliges the policyholder itself to absorb expenses up to the amount of the SIR, at which point the insurer's obligation is triggered." (3)

   Insurances policies written with deductibles provide that the insurer will pay the defense and indemnity costs in connection with a covered claim, and then charge or bill back the deductible amount to the insured. In other words, the "deductible" is a sum that is subtracted from the insurer's indemnity and/or defense obligation under the policy. Importantly, the responsibility for the defense and settlement of each claim rests solely with the insurer, and the insurer maintains control of the entire claim process.

   Policies written with large self-insured retentions, in contrast, may place responsibility for claims handling, including the investigation, settlement and payment of claims, in the hands of the insured. Under a policy with an SIR, the insured is typically required to pay the defense and other allocated expense costs as well as indemnity payments until the amount of the retention has been exhausted. Once the SIR has been exhausted, the insurer responds to the loss and assumes control of the claim.

   As the pressure to contain insurance costs by increasing the portion of the risk retained by the insured grows, larger SIRs and deductibles offer the commercial insured a series of advantages and disadvantages. On the positive side, SIRs allow the policyholder to control the defense and settlement of smaller claims and, depending on the reporting requirement in the specific policy at issue, may allow the insured to keep smaller claims out of its experience rating. On the negative side, administering claims within the SIR may involve more staff and resources than planned or may require the insured to hire a third-party administrator ("TPA") at its own expense to handle claims within the retention amount. Under deductible policies, not only does the insured avoid the indemnity obligations it would have under an SIR, it also avoids the loss adjustment expenses. In addition to lower premium costs, one of the major benefits identified by many commercial insureds whose policies have larger SIRs and deductibles is that they provide the company with an entirely new awareness of loss control which, in turn, can translate into improved loss experience in the long run.

2. Does an Insured Have A Duty of Good Faith to Settle Claims Within the SIR?

   In addition to enjoying the benefit of reduced policy premiums that come with an SIR, an insured who selects a policy with a substantial SIR also retains greater control over the handling of claims, including the decision as to whether to settle a given claim within the policy's SIR. Where a loss is likely to exceed the amount of the SIR, an issue arises as to whether the insured or its insurer should have control over decisions regarding settlement. Presented with a settlement demand at or near its SIR as the trial date approaches, the insured may be inclined to roll the dice and proceed to trial knowing that its indemnity obligation is capped in an amount equal to the SIR. In such a case, the insurer providing coverage in excess of the SIR would want to settle the case in order to avoid the risk of its own exposure. Under these circumstances, the issue is whether an insured has a duty to accept a settlement offer within the amount of the SIR to avoid exposing the excess insurer to liability.

   One of the first reported decisions to address the issue of whether an insured who retains a portion of the risk of loss has a duty to its excess insurer was the California Supreme Court's decision in Commercial Union Assurance Companies v. Safeway Stores, Inc. (4) In that case the insured, Safeway, maintained primary insurance through Travelers Insurance Company and Travelers Indemnity Company for the first $50,000 of liability for covered claims. For losses between $50,000 and $100,000, Safeway was self-insured. With respect to liabilities in excess of the self-insured amount, Safeway purchased an excess insurance policy for liability in excess of $100,000 and up to $20 million.

   A claimant initiated an action against Safeway and recovered a judgment in the amount of $125,000. In order to discharge its obligations under the policy, the excess insurer was required to pay $25,000 towards the total judgment. After paying its share of the judgment, the excess insurer brought an action against the insured and the primary carrier to recover the $25,000 it had expended based on their failure to settle the claim for less than the amount of the judgment.

   The excess insurer argued that the insured and its primary insurance carrier had an opportunity to settle the case for $60,000, or possibly, even $50,000. According to the excess insurer, the insured and the primary knew or should have known that the probable liability for the claim was in excess of $100,000 and, further, that the defendants had an obligation to settle the claim for less than $100,000 when they had an opportunity to do so. The causes of action asserted by the excess insurer against the insured and the primary were for negligence and breach of the duty of good faith and fair dealing.

   In ruling against the excess insurer and dismissing the claim against the insured, the court noted that the essence of the implied covenant of good faith in every insurance policy is that "neither party will do anything which injures the right of the other to receive the benefits of the agreement." (5) As explained by the court, one of the most important benefits of a maximum limit insurance policy is the assurance that the company will provide the insured with defense and indemnification for purposes of...