The Disadvantages of Risk Retention

When a company buys insurance, it transfers risk to the insurer. But when a company doesn't obtain insurance -- either because insurance is not available or because it makes financial sense not to pay for insurance -- it’s known as risk retention. Risk retention is sometimes the wise choice, but a misstep can prove costly.

Risk analyses can provide insight into potential liabilities, but no assessment is entirely accurate. A company’s estimates could be far off the mark. For example, a company might decide to put aside money to cover its losses in the event of an earthquake. It might have financial predictions for how much damage an earthquake would do, but a record-breaking earthquake could cause damage that greatly exceeds those estimates. As a result of its underestimation, the company might not have the funds to cover the losses.

Risk can also be overestimated, resulting in steep opportunity costs. For instance, suppose the company puts aside large sums of money to cover losses due to an earthquake. If no earthquakes occur, or a quake causes much less damage than predicted, those reserved funds represent missed opportunities. Instead of reserving the money, the company could have invested it in research and development or in opening new locations to reach more customers. Overestimating risk can cause a company to overcompensate, thus losing money that could go into business opportunities.

Risk retention is often appropriate when the cost of insuring against a potential problem outweighs the financial burden the problem itself would impose. For example, it usually doesn’t make sense to buy insurance for a small risk. But that's another disadvantage of risk retention: It’s not always clear whether it’s better to buy insurance or retain risk. A company might lose money because it bought insurance, or it might lose money because it didn't buy insurance.

Insurance companies use advanced statistical analyses to guide their decisions, but small businesses don’t have their resources. As a result, sometimes retaining risk is just a guessing game. There’s just no simple recipe for deciding which risks you should transfer and which you should retain. If you’re not sure, the most effective approach is to ask experts in your industry to assess your risk profile and design a risk management plan.