Retentions, deductibles & excesses explained
Many even within the insurance industry consider a “Retention”, “Deductible” and “Excess” interchangeable. These concepts are not the same. In this article we explain the important differences between each of them and how they may affect you when a claim is made under your policy.
A “retention” specifies what proportion of loss (subject of the indemnity under the policy) the insured will need pay before the insurer’s liability under the policy is triggered. In other words, the insured is required to pay the amount of the retention towards any loss or damage before the insurer’s liability under the policy is enlivened.
If the insured cannot pay the amount of the retention, then the insurer will not be obliged to pay anything towards the loss. Another way of thinking of a “Retention” is that the insured “retains” or “self—insures” some of the risk.
For example, if a policy limit is $20 million and the retention is $1 million, the insured will pay for all costs associated with a loss that is up to $1 million. $20 million will then be available to cover any loss the insured suffers up to that amount.
There are several reasons why a retention may be beneficial to both insured and insurer. First, a retention hedge’s the insurer’s exposure to “moral hazards” i.e. the phenomenon that an insured will take more risks than it otherwise would have done because it knows that the insurer will cover the loss if the risk eventuates.
Secondly, a retention enables an insured to obtain insurance at a cheaper premium than it otherwise would be able to. As the amount of the retention goes up, the level of risk to the insurer goes down and consequently the premium is also reduced.
Thirdly, it sets a threshold minimum amount for the insurer and insured before a potentially expensive claims process is initiated. Low value claims are effectively dealt with by the insured; and the insured incurs defence costs and damages resultant of same under the retention.
A “deductible”, whilst similar to a retention operates differently. Both impose a threshold layer of risk that is to be met by the insured, but the similarity ends there.
Where there is a “deductible” and an insured event occurs, the insurer will step in to handle the claim and pay for the loss and then seek to recover the amount of the deductible from the insured.
As the name suggests, the amount of the deductible is deducted from the amount the insurer must pay at the end of the claim. For this reason, if the deductible is a large amount, an insurer may require an insured to provide collateral security for the amount of the deductible.
Under this type of policy, the amount of deductible forms part of the total insured policy limit, so that if the insured has a policy limit of $20M and a $1 million deductible, $19 million will be available to pay any claim.
Further, if a deductible is negotiated it is necessary to determine whether the insured or the insurer will pay any defence costs (in circumstances the relevant policy is one of liability). Where the deductible is for a small sum, defence costs are usually covered by the insurer, but where the deductible is for a larger sum (say over $100,000) which party pays for defence costs is a matter of negotiation between policyholder and insurer.
Where expressed by the insurer that the deductible is “costs inclusive” this will result in the insured becoming liable to pay defence costs once the insurer steps in to defend or settle a claim. The deductible is eroded by the aggregate amount of damages and defence costs.
A “costs exclusive” deductible means that the insurer pays defence costs in addition to the total insured amount under the policy and the amount of the deductible will be paid by the insured only if the insured is liable for the loss or damage. A costs exclusive deductible provides the insured with a greater level of cover for what can be very significant legal costs, but that comes at the cost of a higher premium.
An excess operates in a very similar way to a deductible. However, where there is an insurance policy with an excess, the policy limit is exclusive of the excess. Unlike a deductible, an excess does not erode the aggregate policy limit. In practice a deductible and an excess may have the same result, but this is not necessarily the case.
By way of example, if an insured has a policy limit of $20 million and an excess of $1 million and the insured incurs a loss of $10 million, the insured will pay $1 million towards the claim and the insurer will pay the remaining $9 million.
In this scenario an excess and deductible have the same effect. However, if the insured incurs or is liable for a loss of $25 million, being an amount in excess of the policy limit, the insurer will pay $20 million and the insured will pay the remaining $5 million. The “excess” is not “deducted” from the total amount paid out by the insurer, but in effect the insured will pay that amount as they remain liable for the amount of the loss that is in excess of the policy limit.
Like a deductible, an excess may be “inclusive of costs” or “exclusive of costs”, with the same effect as a deductible that is inclusive or exclusive of defence costs.
Which is better for my business?
Every business is different and the choice between a policy that includes a retention clause, a deductible clause or an excess is a matter of balancing affordability and levels of risk.
Your Bellrock Advisor will advise you on your obligations in the event of a claim, but more relevantly assist you with selecting the most appropriate retention, deductible or excess structure in consideration of your risk transfer objectives.
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