Retention, in the context of risk management, insurance, and reinsurance, refers to the amount of risk that a ceding company, typically an insurance company, chooses to retain and manage on its own. The portion of risk that exceeds the retention limit is transferred to a reinsurer. This strategy is essential in mitigating potential losses while maintaining a balance between risk and financial stability.
Definition
Retention is defined as the specific portion of risk or liability that an insurance company (the ceding company) keeps on its own books before passing on the remaining risk to a reinsurer. It represents the threshold at which the ceding company starts to seek reinsurance coverage.
Types of Retention
Specific (Per Risk)
- Definition: When retention applies to individual risks or policies.
- Example: An insurance policy covering a single building, where the ceding company retains $500,000 of the risk and reinsures the remaining amount.
Aggregate
- Definition: When retention is calculated on a cumulative basis over multiple risks or policies within a specified period.
- Example: A ceding company retains up to $5 million in losses over the course of a year, beyond which reinsurance kicks in.
Special Considerations
Several factors influence how retention levels are determined:
- Financial Strength: Stronger financial profiles allow companies to retain more risk.
- Risk Appetite: Companies with higher risk tolerance might retain more.
- Market Conditions: Fluctuation in reinsurance premiums can affect retention decisions.
Historical Context
Retention has evolved as a fundamental concept in the insurance and reinsurance industries. Historically, as insurers managed larger and more diverse pools of policyholders, the need to balance risk and capital became crucial, giving rise to strategic retention practices.
Applicability
Insurance Companies
Insurance companies use retention to optimize their balance sheets, ensuring that they do not over-extend their capital.
Reinsurance Agreements
Reinsurers require ceding companies to retain a certain portion of risk to discourage moral hazard and ensure that the ceding company remains judicious in underwriting policies.
Comparisons
Retention vs. Deductibles
- Retention: Typically refers to how much risk an insurer keeps before reinsurance.
- Deductibles: Refers to the amount a policyholder must pay out-of-pocket before insurance coverage begins.
Retention vs. Co-insurance
- Retention: The insurer’s liability portion before seeking reinsurance.
- Co-insurance: Shared risk between the insurer and the insured on a specified ratio, usually after a deductible is met.
Related Terms
- Ceding Company: The insurer that transfers risk to a reinsurer.
- Reinsurance: A contract whereby one insurer transfers part of its risk portfolio to another insurer.
- Risk Management: The identification, assessment, and prioritization of risks.
FAQs
What is the purpose of retention in insurance?
How is retention level determined?
Can retention levels change?
References
- Rejda, George E., and Michael McNamara. “Principles of Risk Management and Insurance.” Pearson, 2017.
- Vaughan, Emmett J., and Therese Vaughan. “Fundamentals of Risk and Insurance.” Wiley, 2013.
Summary
Retention is a pivotal concept in the insurance and reinsurance industry that denotes the amount of risk an insurer retains before transferring the remainder to a reinsurer. It balances risk exposure and financial stability, influenced by a company’s financial health, risk appetite, and market conditions, and is intrinsic to strategic risk management practices.
