The most important decision that a corporation makes in regard to any insurable risk it faces is determining the risk financing structure, including the trade-off between retained risk and transferred risk. Deciding the optimal amount of retained risk is often more art than science. Why don't companies always put themselves in the optimal position from a risk retention standpoint? Because there is risk—the uncertainty of what losses will be—which is perceived as difficult to quantify. Rules of thumb and anecdotal evidence often win out in decision making.
The traditional insurance language has been and is "cost of risk" (or sometimes just "expense"). This metric doesn't tell the whole story about risk. By incorporating the element of risk into retention analysis—calculating a distribution of loss incomes, as well as considering the effects of the firmness of the insurance market and taking a financial view of risk, the retention analysis can be made as a capital resource decision, incorporating the cost of capital embedded in an insurance purchase. This article compares a "cost of capital" approach with a more traditional cost of risk approach.
This op-ed appeared in the March 2014 issue of Captive Review.
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