Assumption of risk, also known as retention or self-insurance, is a risk management technique in which an individual or business firm consciously retains the responsibility for certain expected losses that are not catastrophic. The entity prepares to cover these anticipated losses through their resources while protecting against catastrophic losses by purchasing insurance.
Types of Assumption of Risk
Assumption of risk can be broadly categorized into three types:
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Voluntary Assumption:
- This occurs when individuals or organizations knowingly expose themselves to potential risks. For example, an athlete participates in a high-risk sport understanding the dangers involved.
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Involuntary Assumption:
- Here, the risk is not actively chosen but must be assumed due to external factors. For example, a company might have to retain certain operational risks due to the lack of insurable options.
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- A deliberate decision by a firm to bear certain predictable losses internally rather than purchasing insurance coverage. This is typically chosen for frequent, minor losses to avoid high premium costs.
Examples of Assumption of Risk
Consider a business firm dealing with employee absenteeism:
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Minor Illness:
- The firm assumes the risk of absenteeism due to minor illnesses such as colds or short-term injuries. This is managed internally without investing in additional insurance.
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Extended Illness:
- For more serious, long-term medical issues, the firm may purchase disability insurance to cover the financial impact, protecting against catastrophic consequences.
Historical Context
The concept of assumption of risk has its roots in the early doctrines of tort law, where it was recognized as a defense mechanism whereby plaintiffs were barred from recovering damages if they voluntarily exposed themselves to known risks. Over time, this concept evolved and became a structured part of modern risk management techniques.
Applicability in Modern Risk Management
Assumption of risk is crucial in today’s risk management strategies across various industries. Organizations execute it to:
- Reduce overall insurance premiums by only insuring catastrophic risks.
- Encourage proactive risk assessment and internal risk mitigation measures.
- Retain flexibility in handling minor, frequent losses.
Comparisons
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Assumption of Risk vs. Insurance:
- Assumes minor risks internally vs. transfers all or part of the risk to an insurer.
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Assumption of Risk vs. Risk Avoidance:
- Engagement in the risk with precaution vs. completely avoiding the risk.
Related Terms
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- Similar to assumption of risk, where an organization keeps some risk exposure.
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- The process by which an organization sets aside funds to cover potential losses instead of purchasing insurance.
FAQs
What is the primary benefit of assumption of risk?
Can assumption of risk lead to financial difficulty?
Is assumption of risk suitable for all types of businesses?
References
- “Principles of Risk Management and Insurance” by George E. Rejda, Michael McNamara.
- “Risk Management and Insurance” by Scott E. Harrington, Gregory R. Niehaus.
Summary
Assumption of risk, also known as retention or self-insurance, is a fundamental technique in risk management where an individual or company retains responsibility for expected, non-catastrophic losses while protecting against severe, catastrophic losses through insurance. This approach allows entities to save on premiums and maintain control over minor losses but requires careful planning and risk assessment to prevent financial strain.
