Risk retention
Bearing the financial consequences of a risk oneself, instead of paying an insurer to take it on — the alternative to risk transfer, and the default position for anyone without insurance.
In plain language
Insurance is not the only way to deal with risk. A person can simply absorb the loss themselves if the risk turns into a real event. The workbook calls this risk retention.
The alternative is risk transfer — paying someone else, usually an insurer, to take the consequences on instead. Buying an insurance policy is the clearest example of risk transfer. Not buying one, by default, is risk retention.
How it works
The workbook frames this as the starting point for why insurance exists at all. An asset — a ship, a building, a person's ability to earn an income — can lose its value through an unforeseen event. The event itself usually cannot be prevented altogether, only reduced through precautions.
Once the event happens, the financial consequence has to land somewhere. It either stays with the person who would have enjoyed the benefit (risk retention), or it moves to an insurer, in exchange for a periodic premium (risk transfer). Insurance is simply a way of turning an uncertain, possibly large loss into a certain, small, regular payment.
A worked example
Illustrative figures. Mr Naik owns a small shop. A minor equipment breakdown, costing around Rs 15,000 to fix, could plausibly happen most years. A major fire that destroys the shop, costing Rs 20,00,000 to rebuild, is rare but catastrophic.
He chooses risk retention for the equipment breakdown. He keeps Rs 15,000 aside and pays for repairs himself, since insuring such a small, frequent risk would cost more in premium than it saves.
He chooses risk transfer for the fire risk. He buys a property policy for an annual premium of Rs 8,000, because a Rs 20,00,000 loss would be too much for him to absorb on his own, however unlikely it is in any single year.
Why NISM asks about it
Chapter 1 (Basics of Insurance), section 1.2, "Need for Insurance," introduces risk retention and risk transfer as the two ways the financial consequence of a loss can be handled, right before explaining how insurance works as a risk-transfer mechanism. Expect a conceptual question distinguishing the two, or asking which one a described scenario illustrates.
Common exam traps
- Not buying insurance is not "doing nothing." It is a deliberate or default choice to retain the risk.
- Risk retention is not always the wrong choice. For small, manageable, frequent losses, retaining the risk can be cheaper than paying a premium loaded with the insurer's own costs and margin.
- The event itself usually cannot be fully prevented, only reduced by precautions. Insurance addresses the financial consequence of the event, not the event.
Check yourself
1.The workbook classifies insurance needs into three broad categories. Under which category does it place health insurance and motor insurance?
- a)Income replacement needs, because they replace the earning ability of an asset
- b)Asset protection needs, because they protect assets from theft or destruction
- c)Income protection needs, because they take over large, unplanned expenses and so protect the available income from an unexpected charge
- d)Risk retention needs, because the insured bears a deductible on every claim
Show the answer
Answer: (c) Income protection needs, because they take over large, unplanned expenses and so protect the available income from an unexpected charge
The workbook: "Income protection needs protect the available income from an unexpected charge. Health insurance and motor insurance are examples of insurance products that will take over such expenses if they occur, and thereby protect the income from a large and unplanned outflow."
Option A is wrong — income replacement needs arise "in the event of risk to the earning ability of an asset, which includes the life of an individual as well as his earning ability". The workbook's examples are "Life insurance, critical illness and accidental disability insurance ... and annuities".
Option B is wrong — although a car is an asset, the workbook places motor insurance under income protection. Asset protection needs "include the need to protect assets created from theft or destruction. Household insurance is one such product."
Option D is wrong — risk retention is not a category of insurance need at all. It is the alternative to insurance: the consequences of a loss "can either be borne by the person to whom the benefits accrue (risk retention) or they can be transferred to another (risk transfer)."
Why this matters: "The type of insurance required depends upon the age and stage in the life of the individual. Insurance implies a cost and buying insurance that is not required is a wasteful use of income."
Where this is taught
Free preparation for NISM Series X-BRelated terms
- DeductibleThe portion of a claim the insured bears before the insurer pays anything — a fixed rupee threshold that lowers the premium and keeps small claims out of the system.
- InsuranceThe risk-management approach that pays an explicit upfront premium to remove the downside while keeping the upside — which in derivatives means buying an option rather than selling a future.
- Pure riskA risk that carries only the chance of loss or no loss, never a chance of gain — the requirement that separates an insurable risk from a speculative bet such as a stock market investment.
- ReinsuranceThe practice of an insurer transferring part of its own risk to another insurer or reinsurance firm, so that no single insurer is left exposed to the whole of a large claim.
- Risk transferThe economic function by which commodity price risk moves off the hedger, who does not want it, onto the speculator, who is willing to carry it for a return.
- Large number of exposure unitsThe first requirement of an insurable risk: large groups of similar though not identical units must face the same peril, so that only a few of a large pool suffer loss in any one year.
- SubrogationThe insurer's right to step into the shoes of the insured after paying a claim, and to pursue and recover the loss from whoever was actually at fault.