Risk Retention versus Risk Reduction

1
Risk Retention versus Risk Reduction

• Retention is the decision to bear financial risk
  (thus increasing uncertainty and variability).
• If you retain risk, you can do so by using
• current cash
• other current assets
• reserve funds and
• borrowed funds.
• Retention can be part of an insurance plan, or
  may be used alone.

2
Benefits of Retention

• Eliminate premium loadings
• No insurance market cycles
• Reduced moral hazard
• No insurer uncertainty (due to asymmetrical
  information)
• No insurance price regulation

3
Benefits of Retention (Contd)

• Hold onto cash longer than with insurance thus
  potentially greater investment gains.
• Only pay if losses happen.
• Over the long term on average, usually costs less
  than insurance.

4
Disadvantages of Retention

• You bear the risk, which can be high if retained
  amount is high.
• You do not enjoy the predictive benefits of the
  Law of Large Numbers.
• If you cannot afford to live through to the long
  term financially, the fact that retention tends
  to cost less than insurance over time wont
  matter.

5
Retention Decision Rules of Thumb

• Retain risk where
• Frequency and severity are both expected to be
  low by your definition of low.
• You can transfer excess amounts of risk - those
  amounts above your low limit.
• If you do not tend to invest well (or do not have
  high levels of investment gains)
• you may be better off financially to retain.
  Since retention requires reserving by investing
  in safe assets, your investment opportunity
  cost is not as high as it would be for a firm
  that typically expects relatively high rates of
  return from its investments.

6
Specific Retention Plans

• Current Funds
• Reserves
• Tax favored
• Non-tax favored
• Captive Insurers
• Risk Retention Groups
• Self Insurance Pools

7
Cash Flow Impacts of Alternative Retention
Strategies

• Using Current Funds
• No cost until loss is incurred
• Can create extreme cash volatility
• May necessitate borrowing (and potentially at
  relatively high rates)
• Can deduct payments as ordinary expenses, but may
  lose tax advantages in years with accounting
  losses

8
Cash Flow Impacts of Alternative Retention
Strategies (Contd)

• Using Reserves
• Must apply and be approved for tax-favored
  treatment of such funds set aside
• Funds cannot be invested at high rates of return,
  resulting in opportunity cost of investment
• Catastrophic loss may necessitate borrowing

9
Cash Flow Impacts of Alternative Retention
Strategies (Contd)

• Captive Insurers (creating/acquiring insurer to
  funnel firms risks losses through)
• Tax favored treatment is questionable
• Can keep premiums in house
• Requires in-house actuarial insurance expertise
• Expensive to meet state insurance regulatory
  requirements
• Reinsurance still is necessary

10
Cash Flow Impacts of Alternative Retention
Strategies (Contd)

• Risk Retention Groups Self Insurance Pools
• Tax-favored treatment if set up correctly
• Adverse selection can be a significant issue
• Provides a less expensive alternative in states
  or industries where insurance is relatively
  expensive
• Not allowed in all states
• Reinsurance still is necessary