Before discussing the question, firstly I want to explaining what are risk retention ，risk transfer and captive insurer. Then I will discuss how a firm decide between risk retention and risk transfer if a captive insurer is not to be employed. At last, I will discuss how a firm makes decision using a captive insurer.
Risk retention is a method to deal with risk. A company or an individual may retain part or all of the risk. Risk retention can be classified into two categories, one is active risk retention and the other is passive risk retention.
Active risk retention shows that an individual is consciously aware of the risk and deliberately plants to retain part or all of it. (George E, 1986)
There are two major reasons for why use the active risk retention:
Firstly, using risk retention is a way to save money. There is not necessary to purchase insurance or some may buy with a deductible because sometimes the cost of insurance is unreasonable.
Secondly, a company or an individual may retain the risk because the commercial insurance is either unavailable or can be obtained only by the payment of prohibitive premium.
1.2. Passive risk retention
Sometimes retain risk is passive. Because of the people's ignorance or indifference, some risk may be retained, which has a possibility to break a company or an individual financially.
To conclude, risk retention can be an important method to deal with risk. However, is appropriate mainly for dealing with high frequency, low severity type risks with small potential losses. An individual should not use risk retention method to retain low frequency, high severity risks.
2. Risk transfer
Risk transfer is another method to deal with risk, which is an indispensable element of insurance. Risk transfer means that the risk is transferred to the insurer from the insured. The insurer always is in a better financial situation to pay the loss than the insured. George E. Rejda pointed out that risk can be transferred by three methods as follows:
2.1 Transfer of risk by contracts
Risk can be transfer by contracts. The risk of growing in rent can be transferred to landlord by making a long term contracts.
2.2 Hedging price risks
George E. Rejda stated "the hedging price risks is a method for transferring the risk of unfavourable price fluctuation to a speculator by purchasing and selling future contracts on an organized commodity exchange."
The investors have sold stock index futures contracts to hedge against adverse price decrease in the stock market. This method is named portfolio insurance. It is a risk transfer method that provides protection against a decrease in stock prices.
2.3 Incorporation of a business firm
If a business is a sole proprietorship, the owner's personal assets can be attached by the owner's personal assets and the company's assets. If a enterprise incorporates, creditors for payment of the firm's debts cannot attach the personal assets of the stockholders. The liabilities are limited to stockholders and and do not have enough assets to pay corporate debt to the creditors of the company's risk transfer.
Captive insurer
Captive insurer is an insurance company established and owned by the parent company for the purpose of insuring the firm's loss exposures exist at the present time. It is a special form of risk retention.
How should a firm decide between risk retention and risk transfer
Having introduced risk retention and risk transfer above, the following will discuss how a firm should decide between risk retention and risk transfer, if a captive insurer is not to be employed or using a captive insurer.
The determination between risk retention and risk transfer is base on the frequency probability and severity of loss.
For the risk, which has high frequency probability and low severity of loss, it's better for companies to use risk retention. This is because the loss occurs within a long period of time, the total loss would be more stable, the use of risk retention as a method of risk management would cost low fees, which is better than purchasing insurance.
For the risk, which has low frequency probability and high severity of loss, it's better for companies to use risk transfer. This is because the high severity of loss will cost much, it's better to transfer the risk.
For the risk, which has high frequency probability and high severity of loss, risk retention is better, as the same for the risk, which has high frequency probability and high severity of loss.
A company have to take taxes into account when it wants to make a decision. A company cannot get tax relief, when record the loss as current expense, establish a fund or loan, but the Premium expenses can be tax-free. "When calculating its taxable income, a noninsurance company can only deduct losses that were paid during the year. In contrast, an insurer can deduct the discounted value of incurred losses, which equals losses paid during the year plus the change during the year in the discounted value of its liability for unpaid claims. This distinction essentially allows insurers to deduct losses earlier than noninsurance companies, which all else equal increases the present value of expected tax deductions if a loss exposure is insured. Although the tax break is granted to insurers, competition among insurers for business will cause most or even the entire tax break to be given to policyholders through lower premiums." (Harrington and Niehaus 1999)
As the business has grown, the increasing number of affiliates can share in its internal loss, the loss of good management experience, ability to increase funding, will gradually replace the use of risk retention to manage some of the insurance risk of loss. In choosing the form of risk retention, companies often choose to establish internal funds, since the establishment of internal funds can provide liquidity to cover loss, without bringing too much to the financial impact, and do not have to pay to the third parties, and also bring some additional investment income.
Captive insurer is a special form of risk retention. Many companies establish their captive insurance companies, which becomes an important method to deal with loss. Compared with internal funds, the establishment of captive insurance companies can save cost, make investment income, and underwrite some risk which insurance companies do not guarantee. In addition, it can enter the reinsurance market and have a more affordable and quality services, and get the tax concessions. When a company has a captive insurer, the company can reduce the risk losses by purchasing insurance from the captive insurer. Insurance has advantages in taxes than risk retention.
On the other hand, captive insurers usually belong to their parent, or formed from the joint of a small number of companies, so once catastrophe occurs, it would be a serious challenge of captive insurer.
In conclusion, the determination between risk retention and risk transfer is base on the frequency probability and severity of loss. Risk transfer should be use when the risk is low frequency and high severity，while risk retention should be use when the risk is high frequency and low severity. Captive insurer is a special form of risk retention, s also an important method.
