Risk Retention
What Does Risk Retention Mean?
Risk retention occurs when an individual or organization chooses to take financial responsibility for a specific risk instead of transferring it to an insurer. This means they cover any potential losses out of pocket rather than relying on insurance. Companies retain risks when the cost of doing so is lower than buying insurance or when a risk is uninsurable.
Insuranceopedia Explains Risk Retention
Understanding Risk Retention
Risk retention is a fundamental concept in risk management. It is often used as a strategic decision by businesses and individuals to manage costs and minimize expenses associated with insurance premiums. When a company retains risk, it acknowledges potential losses and plans for them financially instead of transferring the burden to an insurance provider.
This approach is common in industries where certain risks are either too costly to insure or occur frequently enough that purchasing coverage is impractical.
Why Do Companies Retain Risk?
There are several reasons why businesses choose to retain risks rather than transfer them:
- Cost Savings: Insurance premiums can be expensive, and if the potential loss is manageable, retaining the risk can be more cost-effective.
- Predictable Losses: Some risks, such as minor equipment damage or theft, happen frequently and are predictable, making them easier to budget for rather than insure.
- High Deductibles: If an insurance policy has a high deductible, a business may choose to handle smaller claims internally instead of filing a claim.
- Uninsurable Risks: Some risks, such as reputational damage, regulatory changes, or certain natural disasters, may not be covered by insurance policies.
- Self-Insurance Strategies: Large organizations may create reserve funds or self-insurance programs to cover potential losses instead of paying premiums to an external insurer.
Types of Risk Retention
There are two main types of risk retention:
1. Voluntary Risk Retention
This occurs when a company makes a strategic decision to retain risk because it is financially beneficial. Organizations with strong financial stability may choose this approach to avoid unnecessary insurance costs.
Example: A large retail chain may not insure against minor shoplifting losses, as the cost of insurance may exceed the expected losses.
2. Forced Risk Retention
In this scenario, a company has no choice but to retain the risk. This happens when:
- The risk is uninsurable.
- It falls below the deductible of an insurance policy.
- The company cannot find an insurance provider willing to cover the risk.
Example: A startup company might be unable to obtain cyber liability insurance due to its high-risk profile, forcing it to retain the financial impact of any cyber incidents.
How Companies Manage Retained Risks
Since risk retention involves accepting financial responsibility, companies must implement strategies to manage it effectively. Some common methods include:
- Risk Reserves: Setting aside funds to cover potential losses.
- Loss Control Measures: Implementing policies and procedures to reduce the likelihood or severity of a loss.
- Budgeting for Losses: Incorporating potential losses into financial planning.
- Self-Insurance Programs: Larger companies may establish internal insurance funds to cover retained risks.
Conclusion
Risk retention is a crucial risk management strategy that allows businesses and individuals to take control of their financial exposure. By carefully analyzing potential losses, companies can determine whether retaining a risk is more cost-effective than transferring it through insurance. Whether voluntary or forced, risk retention requires proper financial planning to ensure that any losses can be absorbed without negatively impacting business operations.
