Final answer:
Loss retention is effective when potential losses can be accommodated financially, the cost of transferring risk is justifiable, and when a company incentivizes risk reduction measures. It is also necessary to acknowledge different risk groups and maintain actuarial fairness. Additionally, premiums must cover claims, costs, and profit margins, which align with the principles of insurance and loss retention.
Step-by-step explanation:
For loss retention to be an effective risk management technique, certain circumstances must be met. These include the ability to allocate funds to cover potential losses, understanding that some risks are insurable while others are not, and recognizing that insurance costs must be justifiable. Specifically, to be effective, loss retention requires assessing risks with low probability but high potential for damage — similar to the rationale behind purchasing insurance for catastrophic events.
The financial law of insurance dictates that an insured person's premiums over time need to collectively offset the cost of claims, operational costs of the insurance company, and allow for profit. This encapsulates the necessity for adequate reserves and investment income, as well as the mitigation of moral hazard and insurance fraud. Furthermore, insurance companies may incentivize behaviors that reduce risks, such as installing advanced security and fire sprinkler systems, which can also align with a strategy of loss retention.
Risk assessment and actuarial fairness are crucial components in determining insurance premiums and loss retention validity, as individuals or businesses in different risk groups will have varied levels of exposure to adverse events. It is also implied that loss retention should only be adopted when the entity can bear the financial implications of the potential loss and when it can contribute to the overall sustainability of the risk management program.