Write a short note on 'Risk Retention', as a risk management strategy. Should an insurance company opt for reinsurance or retention?

Risk retention is one of the methods of handling risk. An individual or a business firm may retain all or part of a given risk. Risk retention can be either active or passive. Active Risk Retention: Active risk retention means that an individual is consciously aware of the risk and deliberately plans to retain all or part of it. For example a motorist may wish to retain the risk of small collision loss by purchasing an own damage insurance policy with a ₹2000 voluntary excess. A homeowner may retain a small part of the risk of damage to the house by purchasing a Householders policy with substantial voluntary excess. A business firm may deliberately retain the risk of petty thefts by employees, shop lifting or the spoilage of perishable goods. In these cases, the individual or business firm makes a conscious decision to retain part or all of a given risk. There are benefits to active retention if the funds remain untouched and avoidable in the event the need for them arises. Passive Risk Retention: Risk can also be retained passively. Certain risks may be unknowingly retained because of ignorance, indifference or laziness. This is often dangerous if a risk that is retained has the potential for destroying a person financially. For example, many persons with earned incomes are not insured against the risk of long term disability under either an individual or group disability income plan. In summary risk retention can be extremely useful technique for handling risk especially in a modern corporate risk management program. Risk retention, however, is appropriate primarily for high frequency, low severity risks where potential losses are relatively small. Except under unusual circumstances, an individual should not use the technique of risk retention to retain low frequency, high severity risks such as the risk of catastrophic losses like earthquake and floods. Reinsurance is when an insurance company will guard themselves against the risk of loss. Reinsurance in simpler terms is the insurance that is taken out by an insurance company. Since insurance companies provide protection against the risk of loss, insurance is a very risky business, and it is important that an insurance company has its own protection in place to avoid bankruptcy. Through a reinsurance scheme, an insurance company is able to bring together or 'pool' its insurance policies and then divide up the risk among a number of insurance providers so that in the event that a large loss occurs this will be divided up throughout a number of firms, thereby saving the insurance company from large losses. The Insurance Company should prefer reinsurance over risk retention.