Risk retention

3 key takeaways

• Risk retention involves accepting the potential financial consequences of certain risks rather than transferring them through insurance or other means.
• This strategy is often used when the cost of transferring the risk outweighs the potential losses, or when risks are considered manageable internally.
• Effective risk retention requires a thorough understanding of the risks, sufficient financial reserves, and robust risk management practices.

What is risk retention?

Risk retention is a strategy used by organizations to manage potential risks by retaining them internally instead of transferring them to an external party, such as an insurance company.

This approach involves accepting the financial consequences of certain risks and managing them through internal resources and processes.

Organizations may choose risk retention for various reasons, such as when the cost of insurance premiums is too high relative to the potential losses, or when they have confidence in their ability to manage and mitigate the risks effectively.

Risk retention can be part of a broader risk management plan that includes a combination of risk retention, risk transfer, and other strategies.

How does risk retention work?

Risk retention involves several key steps to ensure that the organization is prepared to handle the potential financial impact of retained risks:

Identifying risks

The first step in risk retention is to identify and assess the risks that the organization faces. This involves analyzing the likelihood and potential impact of various risks, such as operational risks, financial risks, and strategic risks.

Evaluating costs and benefits

Next, the organization evaluates the costs and benefits of retaining each identified risk. This includes comparing the cost of potential losses with the cost of transferring the risk through insurance or other means.

If the cost of transferring the risk is higher than the potential losses, the organization may decide to retain the risk.

Establishing financial reserves

To manage retained risks, organizations need to establish sufficient financial reserves. These reserves act as a buffer to absorb potential losses and ensure that the organization can continue operating smoothly despite adverse events.

Implementing risk management practices

Effective risk retention requires robust risk management practices to minimize the likelihood and impact of potential losses. This includes implementing safety protocols, conducting regular risk assessments, and developing contingency plans.

Example scenario

Consider a manufacturing company that decides to retain the risk of minor equipment breakdowns. The company calculates that the cost of insurance premiums for covering these breakdowns is higher than the average cost of repairs.

By retaining this risk, the company saves on insurance premiums and uses its internal maintenance team and financial reserves to manage and cover the costs of repairs.

Importance of risk retention

Risk retention is an important aspect of risk management for several reasons:

Cost savings

By retaining certain risks, organizations can save on insurance premiums and other costs associated with transferring risks. This can be particularly beneficial for risks that are unlikely to occur or have relatively low potential impact.

Control over risk management

Retaining risks allows organizations to maintain greater control over their risk management processes. This can lead to more tailored and effective risk mitigation strategies that align with the organization’s specific needs and capabilities.

Flexibility

Risk retention provides organizations with flexibility in managing risks. Instead of relying on external parties, organizations can adjust their risk management practices based on changing circumstances and emerging risks.

Benefits and limitations of risk retention

Understanding the benefits and limitations of risk retention provides insight into its practical implications and effectiveness.

Benefits

• Cost savings: Retaining risks can reduce expenses associated with insurance premiums and other risk transfer mechanisms.
• Enhanced control: Organizations have greater control over their risk management practices, allowing for more tailored and effective strategies.
• Increased flexibility: Risk retention offers flexibility to adapt risk management practices as needed based on changing conditions and new information.

Limitations

• Financial burden: Retaining risks can place a significant financial burden on the organization, especially if multiple risks materialize simultaneously.
• Resource allocation: Effective risk retention requires sufficient financial reserves and resources, which may divert funds from other important areas.
• Potential for underestimation: Organizations may underestimate the potential impact of retained risks, leading to insufficient preparation and greater vulnerability.

Examples of risk retention in practice

To better understand risk retention, consider these practical examples that highlight its application in different contexts:

Example 1: Self-insurance

A large corporation decides to self-insure its fleet of company vehicles. Instead of purchasing commercial auto insurance, the company sets aside a reserve fund to cover the costs of accidents and repairs. This approach saves on insurance premiums and allows the company to manage its own claims process.

Example 2: Deductibles in insurance policies

Many organizations choose higher deductibles in their insurance policies to reduce premium costs. By accepting the responsibility for smaller claims up to the deductible amount, the organization retains that portion of the risk and lowers its overall insurance expenses.

Example 3: Employee health benefits

Some companies opt to self-fund their employee health benefits rather than purchasing traditional health insurance. They retain the risk of healthcare costs and establish a fund to pay for employees’ medical expenses, often using third-party administrators to manage the plan.

Risk retention is a valuable risk management strategy that allows organizations to control costs and tailor their risk management practices. If you’re interested in learning more about related topics, you might want to read about risk management strategies, self-insurance, and financial reserves.