Risk Retention and Risk Reduction Decisions

Risk Financing
As stated earlier, risk financing refers to techniques that provide for the payment of losses after
they occur.

Major risk-financing techniques include the following:

■ Retention
■ Noninsurance transfers
■ Insurance

Retention is an important technique for managing risk. Retention means that an individual or a
business firm retains part of all of the losses that can result from a given risk. Risk retention can
be active or passive.

● Active risk retention means that an individual is consciously aware of the risk and deliberately
plans to retain all or part of it. For example, a motorist may wish to retain
the risk of a small collision loss by purchasing an auto insurance policy with a $500 or higher
deductible. A homeowner may retain a small part of the risk of damage to the home by
purchasing a homeowners policy with a substantial deductible. A business firm may deliberately
retain the risk of petty thefts by employees, shoplifting, or the spoilage of perishable goods by
purchasing a property insurance policy with a sizable deductible. In these cases, a conscious
decision is made to retain part or all of a given risk. Active risk retention is used for two major
reasons. First, it can save money. Insurance may not be purchased, or it may be purchased with a
deductible; either way, there is often substantial savings in the cost of insurance. Second, the risk
may be deliberately retained because commercial insurance is either unavailable or unaffordable.

● Passive Retention Risk can also be retained passively. Certain risks may be unknowingly
retained because of ignorance, indifference, laziness, or failure to identify an important risk.
Passive retention is very dangerous if the risk retained has the potential for financial ruin. For
example, many workers with earned incomes are not insured against the risk of total and
permanent disability. However, the adverse financial consequences of total and permanent
disability generally are more severe than the financial consequences of premature death.
Therefore, people who are not insured against this risk are using the technique of risk retention in
a most dangerous and inappropriate manner.

Self-Insurance Our discussion of retention would not be complete without a brief discussion of
self-insurance. Self-insurance is a special form of planned retention by which part or all of a
given loss exposure is retained by the firm. Another name for self-insurance is self-funding,
which expresses more clearly the idea that losses are funded and paid for by the firm. For
example, a large corporation may selfinsure or fund part or all of the group health insurance
benefits paid to employees. Self-insurance is widely used in corporate risk management
programs primarily to reduce both loss costs and expenses. There are other advantages as well.

In summary, risk retention is an important technique for managing risk, especially in modern
corporate risk management programs. Risk retention, however, is appropriate primarily for high-
frequency, low-severity risks where potential losses are relatively small. Except under unusual
circumstances, risk retention should not be used to retain low-frequency, high-severity risks,
such as the risk of catastrophic medical expenses, long-term disability, or legal liability.

Retention means that the firm retains part or all of the losses that can result from a given
loss. Retention can be either active or passive. Active risk retention means that the firm is aware
of the loss exposure and consciously decides to retain part or all of it, such as collision losses to a
fleet of company cars. Passive retention, however, is the failure to identify a loss exposure,
failure to act, or forgetting to act. For example, a risk manager may fail to identify all company
assets that could be damaged in an earthquake. Retention can be effectively used in a risk
management program under the following conditions:

■ No other method of treatment is available. Insurers may be unwilling to write a certain type of
coverage, or the coverage may be too expensive. Also, noninsurance transfers may not be
available. In addition, although loss prevention can reduce the frequency of loss, all losses
cannot be eliminated. In these cases, retention is a residual method. If the exposure cannot be
insured or transferred, then it must be retained.
■ Funded reserve. A funded reserve is the setting aside of liquid funds to pay losses. A self-
insurance program (discussed later) that is funded is an example of a funded reserve. However, if
not required to do so, many businesses do not establish funded reserves because the funds may
yield a higher return by being used elsewhere in the business. In addition, contributions to a
funded reserve are not income-tax deductible. Losses, however, are tax deductible when paid.

■ Credit line. A credit line can be established with a bank, and borrowed funds may be used to
pay losses as they occur. Interest must be paid on the loan, however, and loan repayments can
aggravate any cash-flow problems a firm may have.

Risk Retention Groups (RRGs) Federal legislation allows employers, trade groups,
governmental units, and other parties to form risk retention groups. A risk retention group is a
group captive that can write any type of liability coverage except employers’ liability, workers
compensation, and personal lines.

For example, a group of physicians may find medical malpractice liability insurance difficult to
obtain or too expensive to purchase. The physicians can form a risk retention group to insure
their medical malpractice loss exposures.

Risk retention groups are exempt from many state insurance laws that apply to other insurers.
Nevertheless, every risk retention group must be licensed as a liability insurer in at least one
state. Advantages and Disadvantages of Retention The risk retention technique has both
advantages and disadvantages in a risk management program.8 The major advantages are as
follows:

■ Save on loss costs. The firm can save money in the long run if its actual losses are less than the
loss component in a private insurer’s premium.

■ Save on expenses. The services provided by the insurer may be provided by the firm at a lower
cost. Some expenses may be reduced, including loss-adjustment expenses, general administrative
expenses, commissions and brokerage fees, risk-control expenses, taxes and fees, and the
insurer’s profit.

■ Encourage loss prevention. Because the exposure is retained, there may be a greater incentive
for loss prevention.

■ Increase cash flow. Cash flow may be increased because the firm can use some of the funds
that normally would be paid to the insurer at the beginning of the policy period.

The retention technique, however, has several disadvantages:

■ Possible higher losses. The losses retained by the firm may be greater than the loss allowance
in the insurance premium that is saved by not purchasing insurance. Also, in the short run, there
may be great volatility in the firm’s loss experience.

■ Possible higher expenses. Expenses may actually be higher. Outside experts such as safety
engineers may have to be hired. Insurers may be able to provide risk control and claim services
at a lower cost.

■ Possible higher taxes. Income taxes may also be higher. The premiums paid to an insurer are
immediately income-tax deductible. However, if retention is used, only the amounts paid out for
losses are deductible, and the deduction cannot be taken until the losses are actually paid.
Contributions to a funded reserve are not income-tax deductible.