Retained risk

What Is Retained Risk?

Retained risk, a core concept in risk management, refers to the portion of potential loss that an individual or organization chooses to bear directly rather than transferring it to another party, such as an insurer. This strategy falls under the broader financial category of risk management and is a deliberate decision to accept the financial consequences of a specific risk event. Organizations often choose to retain risks that are deemed minor, frequent, or too costly to insure, or when they believe they can manage the risk more efficiently in-house than through third-party insurance providers. Retained risk can manifest in various forms, from simply accepting a deductible on an insurance policy to fully embracing self-insurance for certain exposures.

History and Origin

The concept of retaining risk has always been inherent in human endeavors, as individuals and groups have historically borne direct consequences for unforeseen events. However, its formalization as a deliberate financial strategy, particularly in a corporate context, gained prominence with the evolution of modern risk management. A significant historical development in the United States was the passage of the Product Liability Risk Retention Act of 1981, followed by the Liability Risk Retention Act of 1986. These acts allowed businesses with similar liability exposure to form "risk retention groups" (RRGs) to collectively self-insure their liability risks, providing an alternative to traditional commercial insurance markets that were experiencing high premiums and limited availability for certain coverages.⁹ This legislation empowered businesses to actively manage and retain specific liabilities rather than solely relying on external insurers, marking a pivotal moment in the systematic adoption of retained risk.

Key Takeaways

• Retained risk is the intentional acceptance of potential financial losses by an individual or organization.
• It is a strategic decision often made for risks that are low in severity, high in frequency, or excessively expensive to transfer.
• Common methods of retaining risk include high deductibles, self-insurance, and establishing dedicated financial reserves.
• Choosing to retain risk allows for greater control over funds and the claims process, potentially leading to cost savings.
• Effective management of retained risk requires robust risk assessment and a clear understanding of financial capacity.

Formula and Calculation

Retained risk itself is not typically calculated by a single universal formula, as it represents a qualitative decision to bear a risk. However, the financial implications of retained risk involve calculating the potential maximum loss and the required reserves to cover such losses. This often involves actuarial methods to estimate the probability and severity of potential events.

For a self-insured entity, the calculation might involve estimating the expected annual losses based on historical data and projected claim frequency and severity.

For example, in a self-insured retention (SIR) program, the retained risk is a predefined monetary amount up to which the insured is responsible for losses before the insurance policy kicks in. The formula would simply be the stated SIR limit.

Expected Retained Losses = $\text{Frequency of Loss Events} \times \text{Average Severity per Event}$

This is an estimate used for budgeting and reserve setting, not a direct calculation of "retained risk" as a single value. The true "formula" for retained risk is the conscious decision not to transfer a particular risk. The financial impact of this decision is then managed through various methods, requiring sound financial planning and sufficient capital.

Interpreting the Retained Risk

Interpreting retained risk involves assessing an entity's willingness and ability to bear potential losses. A high level of retained risk suggests an organization has a significant risk tolerance and confidence in its internal controls and financial stability to manage adverse events. Conversely, a low level might indicate a more conservative approach or limited financial resources.

For businesses, the interpretation hinges on a cost-benefit analysis: Is the cost of transferring the risk (e.g., insurance premiums) greater than the expected value of the potential loss plus the administrative costs of managing that loss internally? If so, retaining the risk can be a financially sound decision. This also means having sufficient reserves or a contingency plan in place to cover the retained liabilities without jeopardizing financial solvency.

Hypothetical Example

Consider "Tech Solutions Inc.," a company with a fleet of 50 delivery vans. The company has historically experienced minor dents and scratches on its vans, costing, on average, $500 per incident, with about 20 incidents per year. A comprehensive collision insurance policy would cost $2,000 per van annually, with a $1,000 deductible per incident.

Tech Solutions Inc. decides to implement a retained risk strategy for these minor damages. Instead of paying the full insurance premium of $100,000 ($2,000 x 50 vans), they opt for a high-deductible policy where they pay the first $1,500 of any claim. For incidents below this threshold (like the typical $500 dents), they retain the risk entirely.

Walk-through:

1. Cost of Full Insurance: $100,000 per year.
2. Cost of High-Deductible Insurance: Let's assume a reduced premium of $800 per van annually, totaling $40,000 ($800 x 50 vans).
3. Expected Retained Loss: 20 incidents/year * $500/incident = $10,000.
4. Total Annual Cost with Retained Risk: $40,000 (premiums) + $10,000 (retained losses) = $50,000.

By retaining the risk for minor incidents, Tech Solutions Inc. potentially saves $50,000 per year ($100,000 - $50,000). They commit to covering these smaller, more predictable losses from their operational budget, while still having insurance for larger, catastrophic events that exceed their retained amount. This strategy allows for more efficient cash flow management.

Practical Applications

Retained risk is a common practice across various sectors, from personal finance to large-scale corporate operations.

• Personal Finance: Individuals retain risk when they choose higher deductible auto or home insurance policies to lower their premiums. They are accepting that they will pay more out-of-pocket for smaller claims in exchange for reduced ongoing costs. This also applies to individuals who forgo certain types of insurance, such as extended warranties on electronics, believing the cost of the warranty outweighs the likelihood and impact of a defect.
• Corporate Risk Management: Businesses frequently use retained risk strategies for predictable or high-frequency, low-severity losses. This often involves self-insurance programs, where a company sets aside its own funds to cover potential losses instead of paying premiums to external insurers.⁸ For example, a large retail chain might self-insure against minor slip-and-fall claims in its stores, setting aside a reserve fund to cover these frequent but generally low-cost incidents.⁷ This approach allows companies to save on profit margins and administrative costs that insurers would charge.⁶
• Healthcare Benefits: Many large employers self-fund their employee health benefits. Instead of paying fixed premiums to an insurance company, they pay for employee healthcare claims directly as they are incurred, often with stop-loss insurance to protect against unusually large claims.⁵ This strategy can offer greater control over benefit design and potential cost savings.⁴
• Financial Institutions and Regulation: Regulatory bodies also incorporate risk retention concepts. For instance, the Dodd-Frank Act introduced risk retention requirements for securitizers of asset-backed securities, obligating them to retain a portion of the credit risk of the assets they package and sell. This "skin in the game" aims to align the interests of securitizers with investors and promote more responsible lending and underwriting practices.³

Limitations and Criticisms

While retained risk offers potential benefits, it also carries significant limitations and criticisms. The primary drawback is the direct financial exposure to unexpected or catastrophic losses. If the retained losses exceed the budgeted or reserved amounts, an organization's financial stability could be severely impacted. For example, a business that chooses to absorb the potential loss for major property damage might face severe financial strain if a large, unexpected disaster occurs and their reserves are insufficient.

Other limitations include:

• Volatility of Losses: While some risks are predictable in aggregate, individual losses can be highly volatile. A self-insured entity, unlike a traditional insurer, does not benefit from the widespread diversification of risk across a vast portfolio of policyholders. This can lead to significant swings in annual costs.²
• Administrative Burden: Managing retained risks often requires internal expertise for claims administration, legal compliance, and ongoing risk assessment. This can be a substantial administrative burden, particularly for smaller organizations that may lack the dedicated resources.¹
• Opportunity Cost of Capital: Funds set aside as reserves for retained risk are often held in liquid, low-yield assets. This presents an opportunity cost, as these funds could potentially be invested in higher-returning assets if the risk were transferred.
• Misjudgment of Risk: Improperly assessing the probability or severity of a retained risk can lead to insufficient reserves, leaving the entity vulnerable to unexpected financial shocks.

For these reasons, the decision to retain risk should be based on a thorough analysis of all potential outcomes and a realistic assessment of an organization's financial capacity and risk tolerance.

Retained Risk vs. Transferred Risk

Retained risk and transferred risk represent two fundamental approaches within risk management, often applied in conjunction to form a comprehensive strategy. The core difference lies in who bears the financial consequences of a loss event.

Confusion often arises because elements of retained risk can exist within transfer mechanisms, such as a deductible on an insurance policy. In this scenario, the deductible is the portion of risk retained, while the coverage above the deductible is transferred. The choice between retaining and transferring risk is a strategic one, influenced by an entity's financial strength, appetite for risk, and the nature of the specific exposures.

FAQs

Q: Why would an organization choose to retain risk?
A: Organizations choose to retain risk primarily to save on costs, gain greater control over the claims process, and tailor their risk management strategies more precisely. If the expected losses for a particular risk are less than the cost of transferring that risk (e.g., through insurance premiums), retaining it can be more financially efficient.

Q: What are common methods of retaining risk?
A: Common methods include accepting a high deductible on an insurance policy, establishing internal financial reserves to cover potential losses, or implementing formal self-insurance programs, especially for large corporations or government entities.

Q: Is retained risk only for large companies?
A: While large companies with substantial financial capital often have the capacity for extensive self-insurance programs, the concept of retained risk applies to everyone. Individuals also retain risk when they choose a higher deductible for their car insurance or opt not to insure certain low-value items. The scale of the retained risk simply varies with the entity's financial capacity and risk tolerance.