Financing of Risk: Retention, Transfer, and Alternative Risk Transfer
Who bears the loss
Every exposure is ultimately retained or transferred; the questions are how much, by whom, and whether the retained portion is funded. Retention can be passive (unrecognized deductibles, coverage gaps) or active and planned (deductibles, self-insured retentions, captives, pools). Funded retention sets money aside - a captive, loss fund, or reserve; unfunded retention absorbs losses as they occur. Transfer includes insurance and contractual transfer.
Alternative risk transfer (ART) includes captives, finite risk programs, parametric covers, catastrophe bonds, industry loss warranties, sidecars, weather derivatives, and contingent capital.
Insurance mechanics
Deductibles and self-insured retentions shift the first dollars to the insured; coinsurance shares losses; limits cap recovery; aggregates and reinstatements restore cover. Choose retentions by comparing the premium credit against expected retained losses plus the cost of volatility - the cheapest retention on average may be the most volatile.
Traps
A self-insured retention sits below the policy and the insured typically handles the claim, whereas a deductible is usually subtracted from the insurer's payment. Captives are primarily retention vehicles even though risk is transferred within the group. Parametric covers pay on a trigger rather than actual loss, creating basis risk. Catastrophe bonds transfer risk to capital markets. Self-insurance is a misnomer - it is retention.
Rule of thumb: retain what is frequent and predictable; transfer what is severe and rare.
Worked example: Option A - $100,000 deductible, premium $400,000. Option B - $25,000 deductible, premium $520,000. The extra $120,000 of premium buys $75,000 of expected retained-loss transfer, attractive only if retained losses would exceed that plus the volatility the organization cannot bear.