Many insurance policies feature a contractual clause called an application of retention. The clause’s objective is to state how much of any potential damages the policyholder will be responsible for. The insurance coverage would then pay any damages in excess of this withheld percentage.
What is insurance policy retention?
Have you ever had the feeling that reading your policy raises more questions than it answers? You’re not the only one who feels this way. Jargon abounds in the insurance industry. While there’s a valid reason for your insurance policy to be a 100+ page behemoth replete with a bewildering labyrinth of definitions and exclusions, most consumers are only interested in knowing what’s covered. We’d like to assist!
What’s a retention?
The term “retention” in the insurance industry refers to how a corporation manages its business risk. When you’retain’ a risk, you’re usually not insuring it. The most popular solution is to pay an annual payment to an insurance provider to take that risk off your hands.
When we look at the declarations page of your insurance, though, we get a little more explicit. You’ve probably seen it, followed by a cash number, if you have a directors & officers, errors & omissions, or cyber liability coverage (among many others). A self-insured retention is what the carrier is particularly referring to (SIR).
This is the amount of money you must pay each claim before the insurance company will begin to compensate you.
The carrier is requesting that you “retain” a portion of the risk in the form of self-insurance. The amount you must retain is determined by who you are and the type of insurance you are purchasing. Because a startup’s fiduciary liability policy is considered low-risk, each claim may only be subject to a $1,000 (or even $0) retention. Because a hedge fund’s professional liability coverage is considered high-risk, the retention might be as much as $250,000. D&O plans with self-insured retentions of $1,000,000 or more are common among large public businesses.
Why do I have to pay a retention?
It’s partly about how much risk is at stake, as we mentioned earlier. However, there are other less obvious reasons why you must pay a retention fee. You could have a cause to be glad about it…well, not quite happy, but bear with us.
So…what’s the difference between a deductible and a self insured retention?
For all of the reasons stated above, deductibles and self-insured retentions are interchangeable terms. However, there are significant differences between a deductible and a self-insured retention that become increasingly essential as the size of the deductible grows.
The difference between a deductible and a self-insured retention is that deductibles diminish the amount of insurance available, whereas a self-insured retention is applied and the limit of insurance available above that amount is fully available.
A policy with a $1,000,000 limit and a $100,000 deductible, for example, gives just $900,000 in coverage. A policy with a $1,000,000 limit and a $100,000 self-insured retention, on the other hand, gives complete coverage after a claim reaches $100,000.
Another significant distinction is that insurance companies typically handle claims from the start when a deductible is applicable, whereas self-insured retention is often only exceeded once a claim surpasses the self-insured retention.
What is the difference between retention and deductible insurance?
Losses that do not penetrate the attachment point of a SIR are usually not covered by the excess insurer. A deductible, on the other hand, requires the insurer to pay every loss (up to the maximum level of responsibility) and then refund the insured up to the deductible amount.
Is retention the same as excess?
Retention is the maximum amount of risk that an insurer will take on each life. The insurer then transfers the surplus risk to a reinsurer. The retention limit is the point at which the insurer cedes the risk to the reinsurer.
What is a retention amount?
A significant modification to the Construction Contracts Act 2002 (CCA) takes effect on Friday, March 31, 2017. This amendment creates a new retention plan to protect retention money in the event of the holding party’s insolvency.
The program will apply to any commercial construction contract signed after March 31, 2017, whether it is new or renewed. While the protection is helpful, people who retain retentions and their funders will face additional fees and problems.
Amount held aside from a payment made under a building contract is known as retention money. It is usually calculated as a percentage of the total amount due for each payment. It is usually held to ensure that a contractor fulfills all of the contract’s duties before being released, either at practical completion or after the expiration of a defects notice period. Retentions are not required to be retained on trust at the moment.
Retentions can be retained at many levels, such as between the principle and the head contractor, or between the head contractor and the subcontractors. Even if they all eventually belong to one building contract, each retention must be held individually by the responsible payer at each step.
According to the CCA, the retention plan will apply to all commercial construction contracts after March 31, 2017. Because the concept of a residential (non-commercial) contract is narrow, care must be taken when determining whether or not a building contract is commercial in character.
The CCA contains a provision that would allow rules to set a minimum contract amount for the scheme, removing the need for lesser contracts to comply. It was expected that legislation would be in place to give the kind of advice that is usual in other countries. However, because no regulations have been suggested, the retention scheme will apply to all commercial construction contracts that include retention clauses, regardless of their value. Compliance is not a factor if no retentions are held.
The Regulatory Systems (Commercial Matters) Amendment Bill (Amendment Bill), which is currently before Parliament, will amend the CCA so that the retention scheme will only apply to contracts entered into or renewed after 31 March 2017, rather than all contracts in existence on that date, easing the pressure of immediate compliance. Even if the head contract was signed before that date, it will apply to subcontracts signed after that date.
When one party to a construction contract (party A) withholds retention money from the other party to the construction contract (party B), the retention money must be held on trust for the benefit of party B, according to the CCA’s retention scheme. The retention money might be kept in cash or in a bank account “other liquid assets that can be converted to cash quickly.”
The Amendment Bill also adds an alternative option, allowing party A to secure a financial instrument, such as insurance or a payment bond, to protect the retention money from third parties.
It is straightforward to keep the retention money in cash. Party A simply keeps the appropriate percentage of the payment and deposits it in a bank account. However, this may necessitate a considerable cash reserve on the part of the payment.
The money held on trust for retention does not have to be kept in a separate account; if Party A has many construction contracts, the money held on trust for each contract might be mixed. However, mixing funds might make it difficult to provide records indicating that monies are kept on trust, as well as demonstrating that trust requirements have been met.
Rather from keeping huge cash reserves, retention money might be kept in a bank account “other liquid assets that can be converted to cash quickly.” The CCA lacks a definition of liquid assets, hence the precise scope of this provision is unknown. In the lack of regulatory guidance, this is likely to be a component of the plan that will have to be clarified through litigation.
Based on materials alluded to when the retention system was first proposed, the current understanding is that liquid assets will comprise assets that:
Assets such as term deposits, bonds, and possibly party A’s accounts receivable will be included (to the extent that these funds can be realised within three months). Anyone planning to use their accounts receivable as part or all of their retention money should examine whether the accounts receivable will be achieved within three months, and account for the fraction of the accounts receivable that is likely to go underpaid, either due to a dispute or a bad debt.
The Amendment Bill will allow party A to depend on a financial instrument, such as insurance, a bond, or a guarantee, as an alternative to holding retention money on trust. The instrument must be issued by a licensed insurer or a registered bank, and it must meet the following requirements:
- compel the issuer to pay party B the retention money if party A fails to pay on the due date; and
The financial instrument may be the best alternative from the standpoint of party B. It ensures that the money set aside for retention will be available and will not be used to repay other creditors. However, there will be a cost to setting up the instrument for party A. The CCA forbids Party A from passing this cost on to Party B. Financial instruments may be prohibitively expensive or impossible to use for medium and small construction enterprises or solo entrepreneurs.
- after the retention money is payable under the building contract, to pay party B the amount owed;
- to resolve any issues with party B’s non-compliance with the construction contract’s duties; or
The CCA allows for the penalty interest rate for non-payment of retentions to be set by regulation, however this has yet to happen. As a result, it is up to the parties to ensure that their commercial agreements include this provision.
No, according to the CCA, if a construction contract includes a provision with the goal, or one of the purposes, of avoiding the retention scheme’s application, that provision is null and void.
As a result, the parties are not allowed to contract out of the retention plan. The parties may, however, agree to change some of the terms, such as requiring the retention money to be retained as a cash deposit in a separate bank account.
The retention scheme’s goal is great, but it has numerous ramifications for diverse industries.
Owners and head contractors will be expected to keep adequate liquid funds to pay all retentions that have been withheld unless they rely on financial instruments. This could easily result in millions of dollars being kept on deposit for large construction businesses with several projects.
Unfortunately, bonds will almost certainly be limited to the larger contractors, and insurance coverage covering retentions, while widespread in other countries, are still unusual in New Zealand.
If party A becomes bankrupt and an insolvency practitioner is involved, whether through receivership, liquidation, or voluntary administration, the insolvency practitioner must consider retention money right away.
Receivers will have no access to or control over the distribution of funds kept in trust.
It will be difficult to determine what, if any, monies are available for the running of the firm if the retention money is not kept in a separate account and is mixed in with other cash. This could make the process of realizing assets for secured creditors more unclear and costly.
The retention plan will give retention money a new priority above claims from a company’s secured and preferential creditors. When reviewing a business’s liquidity and considering whether or not to grant financing, building project lenders will need to consider these additional standards. They’ll need to know whether cash or accounts receivable are being held on trust for retentions in particular.
Because of the additional compliance requirements, the new CCA retention plan is projected to raise construction costs. To account for all of the retention money held on trust, construction companies will need to put in place solid mechanisms. If they choose to rely on this method for retentions, they must also guarantee that they are appropriately measuring the worth of their liquid assets.
Contact a member of our Construction and Projects team if you have any questions regarding how to comply with the retention program.
Disclaimer: The information in this update is not intended to replace specialized professional advice on any subject and should not be used as such.
What is the purpose of retention money?
The purpose of retention money is to provide security to the employer in the form of a source of funds against the contractor’s failure to complete any outstanding work when the works are taken over and to remedy any defects or damage, as well as any other liability the contractor may have to the employer. Retention money, in general, offers protection to the employer. The idea of retention money conveys the necessity of finishing the signed project according to its terms and plans. With such a retention in place, the contractor has responsibility for completing the construction project according to the design and quality specifications specified in the initial contract.
How do retentions work?
The term “retention” refers to money promised but held back by the client to protect themselves from contractor failure. Retention is usually set at 3 percent or 5% of the total work value. That money is deducted from contractor payments, which are subsequently deducted from payments to subcontractors.
How does a self-insured retention work?
What is Self-Insured Retention, and how does it work? In a liability insurance policy, the self-insured retention is a defined financial sum. The insured must pay this clearly stated amount before the insurance policy can cover any damage, defense, or loss.
Is insurance retention a deductible?
Every company or non-profit that buys liability insurance has come across the terms deductible and self-insured retention (SIR). Many people are aware of the differences between the two, yet many are unaware. Deductibles and SIRs are both designed to keep your premiums low, despite their differences. Because the insured takes some of the risk, insurers are prepared to lower premiums for policies with a deductible or SIR. But that’s where the parallels end.
The three main distinctions between self-insured retention and deductibles are as follows:
When there is a claim with a deductible, the insured tells the insurer. After the claim is closed, the insurer offers rapid defense, pays for any losses incurred, and then collects reimbursement from the policyholder up to the deductible amount. The insured must still notify the insurer of any claim under a SIR. Until the SIR is fulfilled, the insured will begin making payments on that claim right now. The insurance will take over at that point.
Deductibles reduce your insurance policy’s maximum, whereas SIR(s) do not. Assume your coverage has a regular $1 million cap and a $50,000 deductible. Because the insured is obligated to compensate the insurer for the full deductible amount, the insurer will be responsible for $950,000 in the case of a loss. The insured is responsible for the first $50,000 of any claim under the SIR, while the insurance company is responsible for the entire $1 million maximum.
Large deductibles may necessitate the provision of a letter of credit or other appropriate type of collateral by the insured to cover predicted losses that occur within the deductible.
The insurer is not responsible for paying losses until the SIR is depleted, hence there is no need for collateral with SIR(s).
What is a retained limit in insurance?
Umbrella liability is a type of excess third-party liability insurance that offers coverage above and beyond a schedule of underlying policy and a self-insured retention. The insurance will cover the eventual net loss in excess of the retained limit on behalf of the insured, which the insured will be legally compelled to pay as damages due to Personal Injury or Property Damage. For those situations where primary coverage is not required, the retained limit is the limit on secondary policies that the insured is required to carry, or the self-insured retention.