What Does It Mean for a Company to Self-Insure?

Self-insuring is a risk management strategy where a company sets aside funds to cover unexpected losses instead of purchasing insurance policies. Rather than paying premiums to an insurance provider, the company retains the risk and pays for losses out of pocket. Self-insuring can save money over time but requires financial discipline to build up adequate reserves. Below is an in-depth look at what self-insuring entails and when it could be the right choice for a business.

What Is Self-Insurance?

Self-insurance is when a company chooses to pay for its losses directly rather than buy insurance to transfer the risk to an insurer. With self-insurance, the company takes on the financial responsibility for covering claims and losses.

Rather than paying an insurance company’s premiums, fees, and deductibles, the company deposits funds into a designated account or reserve fund. If an event occurs that would typically be covered by insurance, the company pays the costs out of its self-insurance fund.

Self-insurance is feasible for losses that are relatively small and predictable. Large and catastrophic losses are harder to self-insure because the required reserves would be enormous. That’s why most companies purchase commercial insurance policies to cover major perils like fires, floods, lawsuits, and injuries. Self-insurance is more common for smaller, routine expenses like workers’ compensation claims, auto repairs, or equipment maintenance.

How Self-Insurance Works

Implementing a self-insurance program includes these key steps:

Risk assessment – Evaluate potential losses and the likelihood they will occur. Actuaries often estimate future claim frequencies and severities.
Determine coverage – Decide which risks to self-insure versus which to buy commercial policies for. Self-insure more predictable, affordable losses.
Calculate required reserves – Estimate the amount needed to cover retained risks based on expected claims. This is the minimum to keep in the self-insurance fund.
Build reserves – Gradually build up the reserves through regular contributions. Aim to meet the target within 1-3 years.
Manage claims – Handle claims administration in-house or contract with a third party claims administrator (TPA).
Monitor and adjust – Review losses periodically and adjust reserves and contributions as needed.

The company retains liability for all risks it self-insures. It cannot file claims with an insurance company or ask another entity to pay. The company alone is responsible for investigating, adjusting, and paying claims from its self-insurance fund.

Examples of Self-Insurance

Some common examples of self-insurance include:

Health plans – Rather than buying a group health policy, a company sets aside money to reimburse employees’ eligible medical expenses.
Workers’ compensation – The company pays for any workplace injuries out of a designated fund rather than purchasing workers’ comp insurance.
Auto coverage – For fleet vehicles, the company self-insures physical damage and liability losses up to a certain amount, such as $50,000 per occurrence. For major losses exceeding the retention, the company buys excess policies to cover the higher amounts.
Equipment breakdown – Minor repairs and maintenance issues are covered through a self-insurance fund instead of equipment breakdown insurance.
General liability – Slip-and-fall injuries, small property losses, and other routine claims are self-insured up to a set limit per occurrence.

In these examples, the company retains the small to mid-sized losses that occur frequently but are predictable. Catastrophic claims would be covered through traditional insurance.

Pros and Cons of Self-Insurance

Benefits

Lower costs – In the long run, self-insuring predictable losses often costs less than buying insurance. Insurance includes overhead, fees, and profit margins for the insurer. With self-insurance, the company can retain those savings.
More control – The company maintains control over claims handling rather than relying on an insurer. It can customize claims management to its risk philosophy and needs.
Cash flow benefits – Rather than large intermittent premiums, self-insurance allows smaller incremental contributions to reserves. This can improve cash flow for some companies.
Investment income – Money in the reserves can be invested and earn interest. This helps offset expenses and reduces net costs.

Potential Drawbacks

Reduced risk transfer – The company retains more risk exposure rather than transferring it to insurers. This increases volatility in losses.
Inadequate reserves – Reserves might be insufficient if claims are higher than expected. It takes discipline to fund reserves adequately and avoid shortfalls.
Cash flow strain – Major claims can strain the business’s cash flow if reserves are inadequate.
Administrative costs – The company takes on the administrative duties and costs of handling claims in-house.
Reinsurance need – Separate reinsurance policies may be needed to protect against catastrophic losses. These add to costs.

Overall, self-insurance makes the most sense for high-frequency, low-severity losses that are relatively stable and predictable year-to-year.

Is Self-Insurance Right for Your Company?

Assessing whether self-insurance is a smart choice involves evaluating your risks, funding capabilities, and administrative bandwidth. The feasibility often comes down to your answer to these key questions:

Predictable losses? Are the risks you’re considering self-insuring relatively predictable based on stable historical loss patterns? The more variability, the less suited for self-insurance.
Large loss scenarios – What’s the worst-case scenario for losses? Could you withstand a worst-case year financially? Self-insure only losses your balance sheet can handle.
Adequate funding? Do you have enough capital or cash flow to build sufficient reserves in a 1-3 year timeframe?
Reserves expertise? Does your finance team have the expertise to accurately project required reserves and investment returns? Under-reserved programs lead to problems.
Administrative bandwidth? Do you have the systems, staff, and time to take on claims management duties? Can you handle the additional administrative workload?

If you answered yes to each of these questions, your company may be a good candidate for self-insuring certain risks. Be sure to revisit your analysis each year and discontinue self-insuring if the conditions are no longer optimal.

How Much to Put in Reserves

Determining adequate reserve levels is key for successful self-insurance. Actuaries often estimate reserves based on:

Average claims – Historical average claim amounts per loss
Claim frequency – Number of claims per year
Trend factors – Projected increases in medical costs, inflation, etc.
Confidence level – Statistical certainty target (e.g. 75% confidence reserves will be sufficient)
Investment income – Projected investment returns on reserves
Expenses – Administrative costs and taxes
Risk buffer – Extra cushion for unexpected fluctuations

Companies should have an actuary or risk management professional conduct in-depth analyses to quantify appropriate reserve levels. They should pad estimates with buffers and periodically review reserve adequacy as claims emerge.

Regulatory Considerations

State regulations often set rules and restrictions around self-insurance:

Workers’ compensation – Most states require companies to show adequate financial means to cover workers’ comp obligations. Some specify minimum reserve amounts.
Group health plans – Self-insured health plans are regulated under federal ERISA laws. Stop-loss insurance is often required for excess claims.
Auto coverage – Financial responsibility laws mandate that companies have enough resources to pay for auto liability losses.

Be sure to consult applicable insurance regulations when structuring self-insurance programs. Partnering with experienced actuaries and attorneys is recommended to ensure compliance.

The Bottom Line

Self-insuring can be a viable risk management strategy for companies willing and able to take on more risk exposure. It may lower costs compared to buying insurance. But self-insurance requires rigorous financial planning, discipline, and administration. Companies must objectively weigh the advantages and disadvantages relative to their situation. When implemented strategically, self-insurance can be an effective component of an enterprise risk management program.

Self-Insurance Explained

FAQ

Why would a company be self-insured?

A self-insured plan can offer the exact same insurance for lower administrative costs and no profit. It is simply less expensive to offer the exact same insurance through a self-insured plan than through an insurance company.

Is it better to be self-insured?

When you self-insure, you keep more money in your pocket because you don’t have to pay insurance premiums. Once you build up that nest egg, you can maintain it as long as you don’t experience losses, such as auto accidents. The downside of self-insuring is the risk and uncertainty of a potential loss.

How do I know if my company is self-insured?

Look at your paperwork and see if any reference to the insurer says “administered by” or a similar variation. This is a good indicator that your employer is self-insured.