Business success of any profit making organization depends largely on how it manages its risks. Business operations involve risk. Risk varies depending on the industry involved. Risk retention forms part of Risk Management. Risk Management is gaining importance now a days.
Risk retention can be defined as a form of self insurance. Organizations set aside a reserve fund to be able to offset unexpected claims. They have realized by experience that it is not always profitable to transfer all the risks to insurance companies due to increasing insurance costs. They are retaining some business risks.
It is a well know fact that insurance companies charge for taking over the risks. The charge depends on the type of coverage and the amount of premium involved. Claiming for small losses from the insurance companies involves cost and time. Time is money in modern day business. Such small risks are retained by the organization. Businesses are also compelled to retain the risk of flood, earth quake and war. Insurance companies do not cover these risks.
It requires financial expertise and experience to decide on the extent to which the organization should retain insurable risks. Cash flow requirements, local regulations, sales projections, revenue, loan covenants, profit estimates, etc are some of the factors which are considered before taking a decision regarding this. There are no precise common solutions available. Various guidelines like “Percent of Sales Method”, “Earnings Per Share Method”, “Net Working Capital Method” and “Earnings Surplus Method” are followed by finance professionals all over the world.