Umbrellas and Alternative Risk Financing

Excess Liability and Umbrella Liability Fundamentals

Primary liability policies provide the first layer of financial protection when an insured faces legal liability. However, serious claims can exceed primary policy limits. An excess liability policy provides additional limits of insurance over one or more underlying primary liability policies. Excess coverage comes in several structures. A pure excess liability policy provides higher limits but does not broaden the scope of coverage provided by the underlying policies. A follow-form excess policy generally follows the underlying policy's coverage terms, but its own terms, exclusions, conditions, or endorsements may differ. It generally does not cover a loss excluded by the underlying policy, unless the excess policy's own terms provide otherwise. In contrast, a stand-alone excess liability policy has its own coverage terms, exclusions, and conditions, which may differ from those of the underlying policies. Under a stand-alone excess policy, a loss covered by the underlying insurance might be excluded by the excess policy layer.

An umbrella liability policy provides higher limits of liability and can provide broader coverage than underlying primary policies. Umbrella policies commonly offer liability limits of $1 million or more, with available limits varying by insurer. Commercial umbrella policies typically sit over Commercial General Liability, Commercial Auto Liability, and Employers Liability policies. Personal umbrella policies typically sit over Personal Auto Policy liability, homeowners personal liability, and watercraft liability.

Both commercial and personal umbrellas contain standard exclusions. Commercial umbrella policies generally exclude coverage for workers compensation statutory disability and medical benefits. They also generally exclude professional services liability unless the policy or an endorsement specifically provides coverage. Personal umbrella policies generally exclude business-related liability, subject to policy-specific exceptions or endorsements.

Underlying Insurance Requirements and Policy Maintenance

An umbrella policy requires the insured to maintain agreed minimum underlying liability limits as scheduled in the policy declarations. These underlying policies act as the required buffer between routine claims and the umbrella policy's higher limits.

If an insured fails to maintain the required underlying insurance limits, the umbrella policy pays only as if those underlying limits were in effect. Similarly, if required underlying insurance lapses or is canceled, the umbrella generally responds as though that insurance remained in force, leaving the insured responsible for amounts the underlying policy would have paid.

For example, suppose an insured is required to maintain a $300,000 personal auto liability limit under a personal umbrella declarations schedule. If the insured reduces the auto liability limit to $100,000 without insurer agreement, or allows the policy to lapse entirely, the umbrella insurer still calculates claim payments assuming a $300,000 underlying layer exists. If a covered claim exceeds the required $300,000 underlying limit, the insured is responsible for the missing underlying layer: up to $200,000 if the auto limit was reduced to $100,000, or up to $300,000 if the auto policy lapsed.

Drop-Down Coverage, Self-Insured Retentions, and Defense Obligations

When an underlying liability limit is exhausted by payment of covered claims, an umbrella may pay additional covered amounts, subject to its attachment requirements, terms, and limits. For instance, if covered claims exhaust a Commercial General Liability policy's aggregate limit, an umbrella may cover later claims that would otherwise have been covered by that policy, subject to the umbrella's terms and limits.

An umbrella policy can also drop down to provide primary coverage for certain losses that are excluded by underlying policies but covered by the umbrella. When an umbrella covers a loss that underlying insurance does not cover, the insured generally must satisfy any self-insured retention specified by the umbrella. A self-insured retention is the portion of a covered loss the insured must bear before the umbrella pays when no underlying or other insurance covers the loss. The self-insured retention is an amount agreed to by the insurer and insured and stated in the umbrella policy, functioning like a deductible for claims where the umbrella drops down to provide primary coverage. A self-insured retention does not apply when an umbrella policy pays excess over an underlying policy limit that was exhausted by a covered claim.

Underlying policies commonly provide defense costs in addition to the stated policy limit of liability. Under the standard ISO commercial umbrella form, covered defense expenses are generally paid in addition to the liability limit; other umbrella forms may treat defense expenses differently, so you must check the policy. If an underlying insurer is defending a claim, the umbrella insurer generally does not provide a separate defense but reserves the right to associate in the defense. However, when an umbrella covers a claim that underlying insurance does not cover, the umbrella insurer generally has a duty to defend the insured, subject to the umbrella's terms. Whether defense costs count toward a self-insured retention depends on the umbrella policy's terms.

Risk Retention Groups and Purchasing Groups

The federal Liability Risk Retention Act allows the creation of risk retention groups and purchasing groups. These groups offer specialized structures for commercial liability exposures.

A risk retention group is an insurance company owned entirely by its members to pool and insure their commercial liability exposures. All members of a risk retention group must be engaged in similar or related businesses, trades, or activities with similar liability risks. A risk retention group can write only commercial liability insurance for its member-owners; it is prohibited by federal law from writing personal lines insurance or workers compensation insurance.

A risk retention group must be licensed and chartered as an insurer in at least one state, known as its domiciliary state. Once chartered in one state, a risk retention group can operate in other states without obtaining a full insurer license in those other states. Federal law limits regulation of a risk retention group by states other than its domiciliary state, but permits specified requirements, including registration, taxes, and certain claims-practice rules. Crucially, policies issued by risk retention groups are not backed by state guaranty funds if the group becomes insolvent, and risk retention group policies must contain a prominent disclosure stating that insolvency coverage is not provided by a state guaranty fund.

A purchasing group consists of members with similar or related business liability exposures who join together to buy liability insurance; it is not a way to insure personal-risk liability. Unlike a risk retention group, a purchasing group does not issue insurance policies or retain liability risk. Instead, a purchasing group buys liability insurance for its members from a risk retention group or another insurer, subject to the federal Liability Risk Retention Act and applicable state requirements for admitted or surplus lines coverage. A purchasing group may obtain lower premiums or coverage tailored to its members' shared exposures, but neither benefit is guaranteed.

Alternative Risk Financing: Captives, Self-Insurance, and Retrospective Rating

Alternative risk financing refers to methods of funding losses other than purchasing traditional guaranteed-cost commercial insurance. These arrangements allow organizations to manage and finance their exposures with greater flexibility.

Self-insurance is an alternative risk financing method in which an entity retains responsibility for paying specified losses rather than transferring that risk to an insurer; it may set aside funds for those losses. A self-insured entity uses its own assets to pay retained losses, but it may also buy insurance for losses above a chosen amount and pay a premium for that coverage.

A captive insurer is an insurance company formed to insure risks of its owner or owners, often including affiliated businesses. A single-parent captive insurer primarily insures risks of its parent organization and affiliates; whether it can insure other risks depends on applicable law and its structure. A group captive insurer is owned by multiple unrelated companies to provide insurance coverage for its member owners. Captive insurers may offer cost savings and access to coverage for hard-to-insure risks; tax treatment depends on the arrangement and applicable law.

Another funding mechanism is a retrospective rating plan. A retrospective rating plan is an insurance pricing method that adjusts the premium under a predetermined formula using losses arising from the policy period, generally subject to minimum and maximum premiums. Unlike a guaranteed-cost policy, a retrospectively rated policy makes the final premium depend in part on losses arising from the policy period, subject to the plan's formula.