What is this Balance About? Self-Insurance Insights from Our Actuaries

Many companies are self-insured and accordingly record a liability on their balance sheets for insurance-related risk exposure. Depending upon your background, this liability may appear to be based on pure speculation rather than facts. Since the liability is an estimate, a non-insurance company should accrue losses for the total cost for both asserted and unasserted claims in accordance with ASC 450, Contingencies. What is involved in supporting that total cost and the estimate for this liability on the balance sheet?

This article is the first in a three-part series designed to help interpret self-insurance liabilities and to challenge how well the estimation process is working. Read on to understand why companies self-insure and what this balance represents.

What is self-insurance?

Every business is exposed to risk of varying levels. As such, each must decide how to manage and mitigate those risks to avoid a going concern and help ensure profitability. To mitigate certain risks, companies commonly purchase insurance coverage which effectively transfers the risk exposure to third parties (insurance company). With first dollar coverage, the insured has no financial pressure in the form of deductibles or retentions; however, many businesses retain a portion of the financial risk of loss instead of purchasing first dollar insurance. Retained risks often include claims related to medical plans, medical professional liability, worker’s compensation, auto liability, and general liability exposure.

Depending upon a self-insured's risk appetite, entities might retain increasing levels of risks themselves before transferring their exposure by purchasing protection against large, random losses through excess of loss, stop-loss, or large-deductible policies. These policies apply when claims reach a certain level, either individually and/or in aggregate.

Although technically more narrowly defined, the term “self-insurance” is commonly used to capture a wide variety of retained risk mechanisms. To that point, the colloquial use of “self-insurance” is generally used throughout this article unless specifically stated.

Why do companies self-insure?

Primarily, a company retains exposure to otherwise insurable risk because it believes it can reduce its cost of insurance and/or obtain cash flow advantages. Insurance companies load many expenses into premium rates that a self-insured could initially recognize as a reduction in cost by not purchasing first dollar coverage. Examples include premium taxes, assessments for residual market losses which are proportional to premium volume, and administrative costs.

More established companies are generally better positioned financially to absorb income statement fluctuations from the inherent volatility due to direct exposure to the underlying claims being self-insured. Further, larger entities with a greater volume of claims typically have a more predictable level of claim costs.

Additionally, self-insurance provides cash flow advantages when payments are made over the life of the claim instead of paying premium costs up front. The company can invest the difference in the growth of the business or in its investment portfolio. This timing difference is often substantial as many claims take years before reaching a settlement. Another often unrealized benefit ― self-insurance can make businesses more aware of risks and increase incentives for stronger risk control when it directly affects profit.

Finally, there is a subsection of entities that is forced to retain risk because coverage is not available in the traditional insurance market for a variety of reasons including capital restraints or poor historical performance.

Claims administration

Self-insured companies may administer claims internally, or contract with an insurance company or a third-party administrator (TPA). The TPA, in addition to a claims administration, may also take responsibility for complying with administrative, legal, and regulatory requirements related to the self-insurance plan.

The balance sheet

Specific requirements vary depending upon which accounting guidance applies (net/gross of insurance, discounting, margin, etc.), but generally an accrual is required for the total unpaid claims related to incidents occurring prior to the financial reporting date, whether known or not, to the extent estimable. While not necessarily segregated in the financial statements, or even in derivation, the estimates typically include multiple components:

• Case Reserves: The claims administrator’s estimate for all known claims on a claim-by-claim basis.
• Incurred but not Reported Reserves (IBNR): A bulk provision for additional unpaid claim costs. Use of the term “IBNR” most commonly refers to its broad definition, which includes the following components:
  • Pure IBNR: A provision for unasserted claims due to lags between incident occurrence and report date. Since not yet reported, the claims administrator does not include an estimate in case reserves.
  • Incurred but not Enough Reported (IBNER): Case reserves are based on the information known at the time and adjusted as more information becomes available. IBNER is an aggregate estimate of the future development on known claims.

Given the specialized knowledge required, companies often engage a third-party actuary to estimate this accrual.

Actuaries can help with the following tasks:

1. Review key assumptions used in the derivation of an estimate including loss development factors, expected loss rates, frequency/severity, and weighting of methods. Do they reflect the retention and characteristics of the risk?
2. Access the accuracy and application of loss data used.
3. Evaluate the technical accuracy of a company’s calculation.
4. Provide actuarially sound estimates which could potentially lead to lower earnings volatility.
5. Explain sources of volatility and performance of the self-insured estimate.

Summary

Self-insurance can be a powerful tool for reducing insurance costs and increasing cashflow, but it comes with risks that should be carefully evaluated. A company would generally be best served producing a robust estimate when recording self-insured liabilities on the balance sheet. In part 2 of our series, we will expand on accounting for self-insured balances and related pitfalls.