Self Insurance
Self-insurance, also known as self-funding, refers to a risk management approach in which an entity or individual sets aside funds to cover potential losses rather than purchasing an insurance policy from a third-party insurance company. Essentially, the entity or individual acts as its own insurer. This approach is often used by businesses, governmental entities, and some large organizations to manage risks and save on insurance premiums.
Key Points About Self-Insurance:
- Risk Retention: The entity retains the risk of loss and is responsible for claims up to a defined limit. Beyond this limit, they might purchase a form of stop-loss insurance to cover catastrophic events.
- Financial Reserve: Entities that choose to self-insure set aside a reserve of funds, often in a separate account, to cover anticipated claims. This reserve is built based on past claims data and actuarial calculations.
- Regulation: Depending on the jurisdiction and the type of risk being self-insured (e.g., workers’ compensation, health benefits), there might be regulations and requirements that entities must meet to be allowed to self-insure.
- Administration: Some self-insured entities handle claims in-house, while others may contract with third-party administrators to process claims and manage the self-insurance program.
- Potential Savings: One of the primary reasons entities opt for self-insurance is potential cost savings. By avoiding premium markups and overhead costs from traditional insurance providers, and by directly benefiting from years with low claims, they may save money in the long run.
- Flexibility: Self-insurance allows entities to customize their benefits and claim handling processes more flexibly than traditional insurance, tailoring coverage to specific needs.
- Risk: The primary downside is the exposure to unexpected high claim years. If claims exceed the reserved funds, the entity is responsible for the shortfall, which can strain finances.
Example of Self Insurance
Let’s craft a scenario to illustrate how self-insurance might work for a fictional company.
Scenario: XYZ Manufacturing, a midsized company with 500 employees, decides to explore self-insurance for its employee health benefits.
Decision Making:
After several years of facing rising health insurance premiums from traditional insurers, the CFO of XYZ Manufacturing evaluates the past five years of health claims made by its employees. The average annual claim amount is around $1.5 million, with the highest year at $1.8 million and the lowest at $1.2 million.
Based on this, the company decides to set a budget of $2 million per year for self-insurance, aiming to cover typical years and have a buffer for worse-than-average years.
Implementation:
- Setting up a reserve: XYZ Manufacturing allocates $2 million to a dedicated reserve account at the beginning of the year. This fund will be used exclusively to pay for health claims.
- Third-Party Administrator (TPA): Instead of managing the claims in-house, the company hires a TPA to process health claims, manage paperwork, and ensure that the health services provided to employees are consistent with the self-insured plan’s provisions.
- Stop-Loss Insurance: To protect itself from catastrophic claims or an unusually bad year, XYZ Manufacturing also purchases a stop-loss insurance policy. This policy would cover annual claims that exceed, say, $2.5 million.
Outcome:
At the end of the year:
- Total health claims amount to $1.6 million.
- Since XYZ Manufacturing had set aside $2 million, they have $400,000 left over in their reserve.
- The company decides to roll over the surplus to the next year’s reserve, allowing them to potentially reduce the amount they need to allocate for the next year or to have an even larger buffer against unexpected claims.
In this scenario, by opting for self-insurance, XYZ Manufacturing saves money compared to what they might have spent on premiums to a traditional insurer. They also benefit from the unused portion of their allocated funds. However, they bear the responsibility for any claims, although the stop-loss insurance provides a safety net against extremely high claims.
This example showcases the potential benefits of self-insurance: direct control over funds, potential cost savings, and flexibility. However, the risks are clear too—had the claims been significantly higher, XYZ Manufacturing would be on the hook for those costs up to the stop-loss limit.
