What is Risk Retention and is it a good Risk Management Policy?

FinanceBanking & FinanceTrading

Risk Retention is the process where an individual or a company accepts the financial risks and does not act on them before they actually occur. These risks may be too small for which paying attention before could be too early. Some other risks are so big that taking any action on them is impossible due to the costs. These all fall under the risk retention philosophy.

Risk-retention helps companies avoid negligible risks while paying more interest to operations. It is a valuable strategy applicable to budgeting and prioritization. Risk acceptance is a part of a risk management policy in which small and insignificant risks are considered bearable.

Explanation

A business is always surrounded by many risks and managers are interested in mitigating them. However, in some cases, the risks are avoidable because they will have a very low impact on the business. If the cost of managing risk is bearable, managers choose to let them remain as it is rather than acting on them instantly.

Risks may arise from a variety of reasons, such as overly aggressive competition, natural disasters, unexpected market conditions and variability of prices, and credit risk, etc. These are risks that cannot be controlled by businesses even if they choose to minimize them. Therefore, these risks are retained rather than acting on them.

It is natural that managers would be interested in mitigating the various risks that may arise with insurance. However, the cost of insurance may be too high in some instances so that they are better retained rather than insuring them altogether. These risks are also considered to be acceptable risks.

Limitations of risk retention come with the company's ability to meet the demands of the risk financially. It may lead to the risk managers and strategists take special considerations regarding risk retention.

Risk Management Policies

There are numerous other approaches to risk management than risk retention.

  • Avoid − Avoiding refers to changes in business and management policies to avoid the risks altogether. This is a good policy to contain the bigger risks.

  • Transfer − Transfer is the process of passing the risks to another party, such as in the case of insurance.

  • Mitigation − The impact of a risk is minimized in the case of mitigation. The risks are dealt with as and when they arise with various policies in mitigation.

  • Exploitation − Good risks that are good signs of business are retained and exploited. For example, the growth of the business may require more staff which can be exploited by hiring more employees.

Upsides of Risk Retention

Risk-retention strategies do not depend on insurance. The reason for this is that the long-term costs of insurance is more than the cost of the risks when it occurs. Therefore, the companies save substantially from risk retention.

In case insurance is put in place, the premiums outweigh the actual costs of risks. This is so because the risk profile considered for an individual company is different from the individual average values used while calculating the premiums.

Downsides of Risk Retention

Risk retentions are fully dependent on the manager's decision rather than on the market perspective. Therefore, there is a chance of increased losses in case of risk retention rather than any other way of mitigating it.

Apart from the risks considered and insured any other financial losses are also considered to be accepting risks. This increases the portfolio of risks that are unforeseen.

Points to Note

  • Risk Retention means accepting the risks rather than acting on them.

  • Businesses retain both bigger and smaller risks.

  • There are various ways of mitigating the risks businesses face.

raja
Published on 27-Jul-2021 10:55:18
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