Risk Retention

Updated on February 23, 2024
Article byAswathi Jayachandran
Edited byShreya Bansal
Reviewed byDheeraj Vaidya, CFA, FRM

Risk Retention Meaning

Risk Retention in risk management is a person or organization’s choice to assume accountability for a specific risk rather than passing that risk to an insurance provider through the purchase of insurance. It is done through retention rather than transfer by means of deductibles, noninsurance, and plans that are loss-sensitive.

Risk Retention

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It is a strategy used by organizations when the cost of insurance is high, the risk probability is low, or the organization believes it can manage the risk. In addition to potentially lowering insurance costs, preserving flexibility, and optimizing internal risk management options, it permits control of risk exposure and respective financial consequences. It also aligns risk appetite and management.

Key Takeaways

  • Risk retention definition reflects the intentional acceptance of losses and covering them out of pocket instead of transferring the financial responsibility to a third party through insurance.
  • Methods of risk retention include self-insurance, high deductibles, captive insurance companies, risk retention groups (RRGs), and financial reserves.
  • Retaining risks requires careful evaluation of potential outcomes, probability of risk occurrences, financial stability, and the availability and cost of risk transfer.
  • It allows organizations to align risk appetite with risk management strategies, save on insurance costs, make timely adjustments to operations, and gain a competitive advantage.

Risk Retention Strategy Explained

Risk retention is the intentional acceptance of losses. It secures all types of risks that are insignificant, such as unforeseen and foreseen risks. It indicates that instead of getting insurance to shift or transfer the financial responsibility of a loss to a third party, the person or organization has opted to cover any losses out of pocket.

It can be achieved through various methods, such as self-insurance, high deductibles, captive insurance companies, risk retention groups (RRGs), and financial reserves. Self-insurance allows larger companies to set aside funds to cover potential losses, potentially leading to cost savings. High deductibles allow companies to pay out-of-pocket for more minor claims and rely on insurance for more significant events. Captives allow for additional control over insurance costs and offer tax benefits.

RRGs are liability insurance firms created by owner-customers who share a joint industry and want to provide specialized insurance coverage for shared risks. Lastly, companies also set up cash reserves to handle known or anticipated hazards.

Retaining risks is an essential component of risk management, necessitating a careful examination of the possible outcomes, probability of risk occurrences, financial stability to withstand losses, and availability and cost of risk transfer. It is often contrasted with risk transfer, in which risk is transferred to a different party by means of contracts or insurance. Many firms base their risk management methods on this fundamental balance between the two.

Examples

Let us look at a few examples to understand the concept better:

Example #1

Suppose Daisy, the CEO of a clothing company, decides to implement this strategy for certain operational risks, specifically machine breakdowns and transportation issues. She believes that the company can manage these risks internally, thanks to its robust maintenance protocols and strong relationships with multiple transport providers.

By not purchasing additional insurance for these risks, the Company can save on premiums while maintaining agility in its operations. This decision is part of a more significant risk management strategy that balances risk retention with other approaches, ensuring that the company is well-prepared yet financially prudent in handling potential operational disruptions.

Example #2

An article investigating the decision-making processes of medium and large Polish companies regarding risk retention versus insurance purchase in property insurance was recently published. The study employed an econometric model to analyze a range of factors influencing these decisions, including financial data, existing insurance policies, and client satisfaction with insurance services. Key findings revealed that companies with higher satisfaction in claim settlements and overall insurance service quality tended to prefer insurance over risk retention.

The research highlighted that industry type significantly affects risk retention levels, with sectors like real estate, agriculture, mining, and energy showing higher tendencies towards retaining risk. These insights are crucial for understanding the dynamics of insurance demand and risk management strategies in various industries. The study’s outcomes not only contribute to the academic understanding of risk management but also have implications for policy formulation in areas such as environmental liability and cyber risk management.

Importance

Organizations need to retain risk to match their risk appetite with their risk management strategies. It is also to make sure that the amount of risk they take on aligns with their goals and overall business plans. It maintains consistency and coherence in decision-making. In addition, it can save money on insurance premiums and expenses by lowering reliance on outside insurance coverage or risk transfer methods.

Furthermore, risk retention enables firms to make timely modifications to pricing policies, resource allocation, and operations. It gives them the ability to seize new opportunities or counteract possible risks, giving them a competitive advantage.

Risk Retention vs Risk Transfer

Differences between both concepts are as follows:

Risk RetentionRisk Transfer
The Company controls and retains its risks, taking on the possible losses that come with them.The business assigns the risks to a different entity, like an insurance provider, which takes on the liability for any losses in return for a payment.
It entails putting money aside in reserves and developing plans to handle unforeseen losses.The organization transfers the risk to a third party, such as an insurance provider, In return for paying a premium.
By retaining risk, the business can have more control over the financial impact of hazards as well as the risk management procedure.By taking on the financial risk of any losses, the third party offers the organization coverage and protection.

Frequently Asked Questions (FAQs)

1. What is not a goal of risk retention?

The objective of risk retention is not to eliminate or altogether avoid risks but rather to effectively manage and control risks at an acceptable level, aligning risk exposure with the organization’s risk appetite and business objectives.

2. What are the factors that decide about risk retention?

Various factors influence the decision, including the organization’s risk tolerance, financial strength, availability and cost of external insurance coverage, the nature and severity of risks, and regulatory requirements.

3. What is the difference between risk retention and risk avoidance?

It involves accepting and managing potential risks within a project or business, often through strategies like self-insurance. On the other hand, risk avoidance aims to eliminate or steer clear of certain risks altogether, typically by refraining from engaging in activities that pose those risks. While risk retention deals with mitigating and handling risks, risk avoidance focuses on sidestepping them entirely.

This has been a guide to Risk Retention and its meaning. Here, we explain the concept with its examples, importance, and comparison with risk transfer. You can learn more about financing from the following articles –

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