Risk Financing Options and Retention

Flashcards covering key concepts related to risk financing options, particularly retention.

Retention

Retention is a risk financing approach where a firm accepts financial responsibility for its own losses, thus 'retaining' the financial consequences from a loss.

Active Retention

When a firm knowingly engages in retention and plans for it in advance.

Passive Retention

When a firm engages in retention but is not aware of it.

Funded Retention

A form of retention where the firm sets aside funds periodically to cover potential losses.

Unfunded Retention

A form of retention where the firm does not set aside funds in advance for potential losses.

Advantages of Retention

In the long run, retention can be more cost-effective than risk transfer (insurance) and allows for investment of saved premiums.

Disadvantages of Retention

Risks include exposure to high severity losses that could jeopardize firm survival and the necessity of performing administrative activities typically handled by insurance companies.

Expected Value (Loss)

The theoretical amount a firm is paying for a risk based on anticipated losses.

Loading Charges

Additional costs built into insurance premiums to account for uncertainty and administrative expenses.

Risk Modification Programs

Programs aimed at decreasing the frequency and severity of potential losses.

Risk Financing

Strategy that determines who is responsible for paying when a loss actually happens, typically the company unless insurance or risk transfer mechanisms are utilized.

What causes PASSIVE Retention?

PASSIVE Retention results from failing to adequately identify a risk (Step #1 of the Risk Management Process) or underestimating the frequency or severity of that risk (Step #2 of the Risk Management Process).

Active and funded retention are good for:

Risks that are high frequency and low severity

Passive and unfunded retention are good for:

Risks that are low frequency and low severity

Solution to managerial activities behind active and funded risk retention

Administrative Services Only (ASO) contract.

Possibility of a Catastrophic Loss

A very low frequency event > that has very high severity. Worst Case scenario. Could be so severe that it puts the survival of the company in jeopardy.