Page 20 - RMAI BULLETIN Jan - Mar 2020

RMAI BULLETIN JANUARY TO MARCH 2020

likely to happen such as the loss that could likely to they occur. It includes the possibility to set aside a
result if lightning strikes an individual’s home or the contingency fund to pay for the larger losses. Please
firm’s building. The maximum possible loss is an mind that such retention of risk may be either a
estimate of the worst possible loss that might result deliberate decision or a result of a failure to recognize
fromthelightning. thatsuchriskwhenexisted.
An example to illustrate the difference may be in order. Factors determining risk financing
Say, in a flood a firm’s plant is destroyed. It is estimated
that the cost of debris removal, costs for restoration of decisions:
the plant, the cost of replacement etc., will total Rs.2 A number of factors are considered by individuals
Crores.ThemaximumpossiblelossisthusRs.2crore. It before making risk-financing decisions or choosing the
is also estimated that a flood causing more than Rs.1.5 category appropriate to them out of the three available
Croreofdamagetothefirm’splantisveryunlikely.Such options, risk retention, risk reduction and risk transfer.
a flood is unlikely to occur more than once in 40 years, Thefactorsinclude
aninfrequentoccurrence. • Expectedcost
• FinancialPosition
Thus,themaximumprobablelossisRs.1.5crore.Hence
in the process of risk management, it is necessary to • DegreeofRiskAversion
examine two facets of loss exposures; namely, possible • ExternalConstraints
severity of loss and the possible frequency or
The expected value and the variabilityof cost of various
probability of loss. It is the size and probability of the risk-financing options are prime considerations in
potential loss that influences what has to be done
regard to the choice people make. The financial
about a particular exposure. Measurement of
position of the individual making the choice also
potential severity is required for classifying risks influenceshis/herdecision.Thedegreeofriskaversion
whether a particular exposure to risk or loss is
of the individual will also be an influencing factor in the
critical/importantorunimportant.
choice of risk-financing decision. Finally, the choice of
RiskRetention: an individual of the type of risk financing he or she
makes may be constrained by external factors. e.g.
Meeting the loss costs by the individual or family by
Motor owners are constrained by legislation in many
internalizing them is called risk retention. The losses
that are internalized would be financed out of one’s countries to the purchase of motor vehicle insurance.
own income or wealth. While the decision to retain a Another example is the constraint that insurance be
purchased for the purpose of protecting the collateral.
lossexposureandfinanceitoutofone’sownfundsmay
When financial institutions extend credit or provide
be a conscious decision of the individual or family.
loans for home purchase or car purchase, they impose
Losses that do occur when prior planning for their
financing has been done are also retained. In many a condition that the debtors purchase property
cases, it may be a “default option” or an involuntary insurance.
option if the option of loss transfer is not available or is Risk transfer & insurance as the it’s best
not affordable or if the individual is unaware of the loss method:
exposure–allofthesemayboundtohappen.
While one end of the risk-financing continuum, as
The expected cost of risk financing through the method mentioned earlier, is risk retention, the other end of
of risk retention involves an uncertain amount for the continuum is risk transfer. In risk transfer, the
which the individual or family must be prepared. financial impact of loss is shifted to another party. Risk
Retention is resorted to when no other risk transfer involves agreement by the transferee to
management treatment is available like when assume the loss or risk that the transferor is desirous of
insurance coverage is not available or very expensive. escaping. The process of risk transfer involves a
Further, non-insurance transfer may be unavailable. payment by the transferor to the risk bearer or
Thus, retention may in fact be a residual method. transferee. It is normally done through insurance.
Retention can be effectively used when the potential Through the process of transfer, the degree of risk is
losses are highly predictable. It is also said that “the sometimes reduced as the transferee may be in a
more risk averse the less the retention”. It is the easiest position to predict loss by applying the law of large
& the cheapest way of dealing with relatively small numbers. Transfer of Risk can be through non-
losses to pay them out of one’s own resources when insuranceorinsuranceagreements.

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