The Evolving Impact of Self-Insured Retentions and Deductibles

Michael A. Hamilton , Michael Murphy


October 1, 2010

As the global economic crisis continues to have an adverse impact on the economy, commercial insureds are increasingly looking for ways to tighten their corporate belts and cut costs. One risk management strategy related to such cost-saving efforts is to obtain commercial policies written with large self-insured retentions (SIRs) and higher deductibles. Insurance 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. 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 SIRs, in contrast, place responsibility for claims handling, settlement and payment of claims, in the hands of the insured. Under a policy with an SIR, the insured is typically required to pay defense 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 a growing numbers of insureds elect to control more of their insurance costs by increasing SIRs and deductibles, a body of case law is beginning to emerge that highlights some of the issues that often accompany this decision.

Taking a Chance on Claims Settlement

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 may 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 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 Assur. Cos. v. Safeway Stores, Inc. In that case, after a judgment against Safeway, its excess insurer brought an action against Safeway and the primary carrier based on their failure to settle the claim. In ruling against the excess insurer, the court noted that "[the] insured owes no duty to defend or indemnify the excess carrier; hence, the carrier can possess no reasonable expectation that the insured will accept a settlement offer as a means of 'protecting' the carrier from exposure. The protection of the insurer's pecuniary interests is simply not the object of the bargain." Courts from other jurisdictions have either expressly adopted the Safeway court's holding or have cited the decision with approval.   

Significantly, while an insured may not have a common law duty to its excess insurer to settle a claim within its self-insured retention, as even the Safeway court acknowledged, "equity requires fair dealing between the parties to an insurance contract" and a party's status as an insured "is not a license for the insured to engage in unconscionable acts which would subvert the legitimate rights and expectations of the excess insurance carrier." To the contrary, a policy's "cooperation" clause may require an insured to contribute its SIR to settle a third-party action.  

Furthermore, if an excess insurer wants to protect itself from the possibility that an insured may refuse to accept a reasonable settlement offer, one way to do so is in the language of the policy itself. Some policies contain clauses stating that [the insured] shall exercise the utmost good faith, diligence and prudence to settle all 'claims' and 'suits' within Self-Insured Retention." This may provide additional protection against the possibility that an insured will ignore reasonable offers to settle a claim before the excess insurer's coverage attaches.

Consent to Settle Claims

Another issue that arises is whether an insurer may agree to a settlement without the consent of the insured where the insured has a substantial deductible or SIR that must be applied to the settlement. The majority rule is that where the policy language gives the insurer the exclusive right to control and settle the claim, courts will enforce such language even where the insured has a direct financial stake in the settlement. As explained by the court in American Protection Ins. Co. v. Airborne, Inc., "an insured cannot complain that such a provision inevitably allows an insurer to commit an insured's funds -- the policy deductible -- without the insured's consent, because that is exactly the bargain that the insured struck under the policy that it bought and paid for."

The United States Court of Appeals for the Eighth Circuit recently held in Stan Koch & Sons Trucking, Inc. v. Great West Casualty Co. that the insurer could settle the claim over the insured's objection where the policy included a provision giving the insurer the right to "settle or defend, as we consider appropriate" any covered claim. In that case, an insured trucking company claimed that its excess insurer breached its fiduciary duty by settling a personal injury claim against the insured. The excess insurer settled the matter for $750,000 triggering the insured's obligation to contribute $500,000 towards the settlement pursuant to the policy's retention endorsement. The court concluded that the insurer had the unfettered right under the policy to settle claims despite the substantial retention in the policy. This right to settle under the policy was balanced by the insurer's duty of good faith in settling claims.

In contrast to the above decisions, a distinct minority of jurisdictions have adopted the view that where the insured has a financial stake in the settlement, including a significant deductible, the law requires the insurer to obtain the insured's consent before settling a claim  regardless of the terms of the insurance contract.   

Taken together, these cases stand for the proposition that where the language of the policy clearly provides that the insurer has the right to settle a claim or suit, it may generally do so without the insured's consent (and over its objection) even if the settlement triggers an obligation on the insured's part to pay a substantial SIR or a sizeable deductible. The right to control the settlement does not, of course, relieve the insurer of its obligation to act in good faith. On the other hand, to the extent that an insured has the ability to negotiate clear language in a policy reserving unto the insured the right to approve or consent to any settlement on its behalf, that language will also be enforced.

Excess Insurer's Obligations and Insolvent Insureds

As the number of commercial bankruptcies continues to skyrocket as a result of the global financial crisis, questions inevitably arise as to how the insurer's obligations are affected, if at all, when an insured is unable to pay its SIR. Most courts hold that insurers have an obligation to defend and indemnify their insolvent insureds under their policies to the extent that covered claims exceed the SIR, irrespective of whether the insured has actually paid the SIR. These decisions are based, in part, on the "bankruptcy clauses" contained in most liability policies, providing that "the bankruptcy or insolvency of the insured will not relieve the insurer of its obligations under the policy," which are mandated by statute in many states.

For example, in Admiral Insurance Co. v. Grace Industries, Inc., the insurer argued that it had no obligation to defend any actions against its insured, a Chapter 11 debtor, until its insured had paid its $50,000 SIR. The insurer's choice was to defend the claims within the SIR before the costs reached $50,000, or wait until the smaller claims ultimately exceed the SIR because they were not defended or settled. Accordingly, the insurer argued that requiring it to defend would impose a new, extra-contractual obligation because if the insured had paid out claims within the SIR as it would have done but for its insolvency, the insurer would have no exposure on such a claim.

The district court disagreed, noting that the insurer was "only obligated to do what it contracted to do and that obligation was not relieved by [the insured's] bankruptcy." Section 365 of the Bankruptcy Code made it clear that the failure of a bankrupt insured to fund a SIR did not relieve the insurer of the obligation to pay claims. The district court also rejected the argument that the policy's SIR endorsement should supersede the policy's bankruptcy clause, ruling that the bankruptcy clause was required under New York law and must be given full force and effect. Accordingly, the court held that the insured was "neither required to fund nor exhaust the SIR before [the insurer's] obligations to pay claims-settled or litigated-in excess of $50,000 is triggered."

Based on this case, it appears clear that an insured's inability to pay its SIR neither expands nor contracts an insurer's obligation under the policy. Instead, courts seemingly strive to ensure that insurers do exactly what they contractually agreed to do under their policies. Accordingly, while they are not required to "drop down" and cover claims within the self-insured retention, neither are they relieved of their obligation to provide coverage for claims in excess of the SIR.

Protocols for Satisfying the SIR

As the number of commercial policies written with substantial SIRs continue to increase, issues as to the extent an insurer can dictate the manner in which an SIR may be satisfied are starting to emerge. These issues are particularly prevalent where an insured qualifies as such under more than one policy. In Forecast Homes, Inc. v. Steadfast Ins. Co., for example, housing developers were named as additional insureds under their subcontractors' liability policies. Five lawsuits alleging various construction defects were filed against the developers; however, no subcontractor was named as a defendant in any of the suits. After incurring defense costs and related expenses in excess of the SIRs in the subcontractors' policies, the developers tendered their defense to several of the insurers of the subcontractors.

An insurer who issued policies to several subcontractors denied the developers' tender, arguing that, according to the policy, only the "named insured" could satisfy the policies' SIR. In the developers' coverage suit, they argued that this was contradicted by other language in the policy that rendered it ambiguous. The developers also argued that the insurers' interpretation rendered coverage illusory and violated public policy. The California Court of Appeal disagreed, holding that the SIR endorsement defining "you" and "your" to mean the "named insured" clearly limited who could satisfy the SIR.

In Vons Companies, Inc. v. United States Fire Ins. Co., the court addressed the related issue as to whether an SIR could only be satisfied by an out-of-pocket payment by the insured or whether it could be satisfied by "other insurance." In that case, Vons was the named insured under a CGL policy with a $1 million limit that was subject to a $1 million SIR. Vons also qualified as an additional insured under a second policy that also had a policy limit of $1 million.

Vons was named a defendant along with several others in a tort action, and the case was settled for approximately $1.5 million. The settlement was funded by the insurer's $1 million payment under a policy where Vons qualified as an additional insured, together with approximately $500,000 of Vons' own funds. Thereafter, Vons sought reimbursement of its settlement contribution from its own insurer.

The insurer filed a declaratory judgment action, and took the position that that the SIR endorsement in its policy required Vons to pay $1 million of its own money, not money coming from other insurance, before the SIR was exhausted and its obligations were triggered. The trial court ruled that the insurer was required to reimburse Vons for the total amount it paid toward the settlement. The California Court of Appeals affirmed, ruling that the SIR endorsement permitted payment through other valid and collectible insurance because (1) the policy was "subject to" the policy's "other insurance" provision which made the policy excess if there was another policy covering the accident, and (2) the policy did not expressly state that the insured had to pay the SIR.

Common Law and the Insurance Contract

The duties and obligations of insurers and policyholders in relation to SIRs or deductibles have their genesis in two sources: the common law and the insurance contract. Principles of equity and good faith govern the relationship between the parties. However, as in most insurance coverage disputes, rights set forth in the insurance contract will control. Thus, courts will enforce clear policy language setting forth items such as an insured's duties concerning the handling claims within the SIR, who must satisfy the SIR before an insurer's obligations will be triggered, and an insurer's duties when an insured is insolvent. The interplay between common law rights and contractual undertakings will help shape courts' future decisions in this emerging area of insurance law.
Michael A. Hamilton is a partner with Nelson Levine de Luca & Horst, LLP and chairs the firm's National Insurance Coverage Group. He concentrates his practice in the areas of insurance coverage disputes, bad faith defense and commercial litigation.
Michael Murphy is an associate with Nelson Levine de Luca & Horst, LLP and concentrates his practice exclusively on advising and representing insurers in complex insurance coverage matters and bad faith claims.