A technique used by some entities for risk control is to transfer the
property or liability that creates an exposure to another entity. Examples
of this include outsourcing business functions, leasing business property,
disclaimers, and formal legal strategies such as hold-harmless and indemnity
agreements. The success of these strategies is often a matter of a court’s
interpretation rather than the original intent of the user. Therefore, they
should be used carefully and with the advice of counsel.
Overall risk control includes all of the following areas where the tech-
niques mentioned previous ly are applied.
. personnel safety
. industrial hygiene
. compliance (e.g., with OSHA)
. security of people, pro perty, and data
. property conservation
. liability prevention and defense (e.g., product quality control)
There are fundamentally four choices for risk financing: non-insurance
transfers, retention, insurance, and financial derivatives. (Some persons view
financial derivatives as a hybrid device involving aspects of both risk control
and risk financ ing.) Beyond some limited use of non-insurance transfers, the
essential choice for virtually every pure risk exposure is whether to retain it
or to insure it. The core notion is that an entity either bears losses through
retention or shares losses through insurance.
In some instances, insurance may be required. Examples include required
insurance on real property covered by a mortgage, required insurance on
personal property financed by a loss payee, and state-mandated workers’
compensation insurance. Theoretically, every exposure that has been identi-
fied will be matched with a risk financing procedure.
Retention involves absorbing losses within the entity’s own financial re-
sources. This is a logical strategy for frequent, predictable losses. Active
Essentials of Risk Management 343
retention occurs when the entity makes a conscious choice after an analysis
of the potential severity of a known exposure. Passive retention occurs when
the entity is not aware of an exposure or when the potential severity has been
Possible funding sources for retention include current expensing of the
losses, a reserve (funded or unfunded), or a line of credit. Borrowing can be
an effective strategy for some kinds of losses. Larger entities with financial
stability may form captive insurance companies or participate in risk reten-
tion groups. These more-sophisticated risk financing strategies are used
when an entity realizes that it controls a critical number of exposure units
to make its losses predictable and further realizes that it is paying its own
losses in its insurance premiums. There is also an assumption that the entity
has a firm commitment to risk co ntrol.
A caution about retention is that it does not make losses go away. There is
sometimes a false belief that retention will allow savings of the entire
insurance premium. The losses will still occur, though, and there will be
costs associated with adjusting those losses. There is a tax shelter on retained
losses because of their deductibility. Most entities will consider formal
retention carefully and will use a service entity both for claim services and
the acquisition of stop-loss reinsurance. The stop-loss reinsurance puts a
limit on the entity’s annual loss payments.
Most entities will make the choice to acquire insurance and will limit their
retention to the deductibles in that insurance. This relates to a preference for
stability and peace of mind. Los ses are random, but insurance premiums are
(relatively) stable. The entrepreneur is a risk taker but recognizes that an
insurance company has a comparative advantage when dealing with pure risk.
Insurance involves sharing of losses within a group of entities that are
‘‘similarly situated.’’ That means that they represent the same degree of
risk to the insurance company (e.g., they are insuring the same kinds of
property for the same perils or they face the same liability expo sures). The
insurance premium is paid in exchange for the promise of indemnity in case
of loss. Indemnity is the promise to make the insur ed whole in the event of a
covered loss. With insurance the entity pays its fair share of losses, whereas
with retention the entity pays its exact share of losses.
The insurance premium is composed of the loss and loss adjustment costs,
the costs of services and admini stration, distribution costs, and state pre-
mium taxes. Some of the services provided (e.g., underwriting), are critical to
the interests of insured s. If you are aware that you are sharing losses with
others, then you have an interest in having a ‘‘gatekeeper’’ to determine what
344 Essentials of Risk Management

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