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Underlying Retention

Definition

Underlying retention, in financial terms, refers to the amount of risk a company retains before it begins to share losses with its reinsurer under a reinsurance arrangement. Essentially, it’s the company’s financial exposure or the amount they are willing to lose before claiming from reinsurance. It is often designed to match the company’s risk tolerance and financial capacity.

Phonetic

The phonetic transcription of “Underlying Retention” is:Underlying: /ˌʌndərˈlaɪɪŋ/Retention: /rɪˈtɛnʃən/

Key Takeaways

  • Underlying Retention refers to the amount of risk a company keeps for itself from the total risk it insures. It represents the maximum loss that a company agrees to absorb from a single event or multiple events.
  • It’s crucial for a company to balance its underlying retention well. If the underlying retention is set too low, it might increase reinsurance costs unnecessarily. Whereas, if set too high, it could expose the company to substantial loss from a single event or multiple events.
  • Finally, Underlying Retention is not static but should be reviewed regularly depending on a company’s risk tolerance, risk management capability, financial strength, reinsurance market conditions, and operational changes. This aids in ensuring the company remains financially stable and profitable in the long-term.

Importance

Underlying Retention is a significant term in business and finance, particularly in the field of insurance, as it directly impacts a company’s risk management and financial strategy. In essence, it refers to the portion of risk or liability that a company chooses to retain before it transfers the excess to a reinsurer. The significant reasoning behind this lies in the fact that it allows the company to self-insure up to a certain limit, thereby potentially saving on insurance premiums. However, it requires the company to have sufficient financial reserves to cover potential losses. Ultimately, the level of underlying retention is pivotal in finding the right balance between risk retention and risk transfer for a firm, thus shaping its overall risk management strategy.

Explanation

The purpose of underlying retention lies mainly within insurance and reinsurance sectors, particularly relating to risk management strategies. More specifically, it is used as a measure to understand and evaluate the level of risk that an insurer or reinsurer is willing to hold without transferring it further. It essentially indicates the amount of potential loss that an insurance company decides it will absorb for any particular incident. It helps businesses determine the threshold for risk coverage before external reinsurers are required to cover the remaining cost. Underlying retention is frequently utilized to maintain financial stability and manage potential losses.

It plays an important role in determining an insurer’s or reinsurer’s capital plans and strategy. By identifying and setting a specific underlying retention, these entities can optimize their risk profiles and protect themselves from extreme losses. This helps in creating a balance between the amount of risk undertaken and the premiums paid by insured parties. Lower underlying retention rates can mean more instances where the reinsurer is called upon for coverage, and higher rates could indicate that the insurer is taking on a considerable part of the risk instead of passing it on to a reinsurer.

Examples

1. Insurance Industry: The concept of Underlying Retention is broadly used in the insurance sector, specifically in reinsurance transactions. An insurance company might set an underlying retention limit – the amount of risk they are willing to take on – for a certain type of insurance policy, such as home or auto insurance. For example, the company might be willing to cover all claims up to $1 million. Any risk above that amount, they “ceded” to a reinsurer.

2. Corporation Financing: If a company wants to issue bonds to finance its projects or investments, it might only want to assume a certain level of risk (underlying retention). For example, the company would keep the risk of default up to a certain level (the amount it can afford to pay out in case of default), and sell the remaining risk to other investors in the form of higher-yielding, riskier bonds.

3. Retail Business: Suppose a retail company offers return policies on its products. If a customer returns an item, the retailer absorbs the cost. This is a form of risk that the retailer retains, known as the underlying retention. If the cost related to the returns crosses a certain threshold, the retailer might purchase an insurance policy that would cover any costs beyond this self-retained risk.

Frequently Asked Questions(FAQ)

What is Underlying Retention in finance and business?

Underlying Retention is a risk management strategy where a company decides to take on a certain amount of loss exposure internally, rather than transferring it to an insurance company. The part or amount of the risk retained is known as the underlying retention.

How is Underlying Retention typically determined?

The level of Underlying Retention is often determined by the firm’s financial capacity to absorb losses, it’s risk appetite and its access to reinsurance markets.

What is the benefit of having Underlying Retention?

The main benefit of Underlying Retention is saving on insurance premiums. By deciding to self-insure a portion of their risk, companies can avoid paying premiums on that portion to the insurance company.

What are the potential downsides of Underlying Retention?

The main risk with Underlying Retention lies in incorrectly assessing the firm’s risk exposure. If a firm underestimates its risk and retains more than it can afford to lose, it could result in significant financial stress or even bankruptcy.

How is Underlying Retention different from a deductible?

While both involve a company taking on a certain amount of risk, a deductible refers to the amount the insurance policyholder must pay before the insurance company begins to contribute. Underlying Retention, on the other hand, is the total amount of risk a company is willing to absorb internally.

Can Underlying Retention be used in all types of insurance policies?

No, Underlying Retention is typically used in Liability Insurance policies and Property Insurance policies where high levels of risk are involved, and not all businesses may need or be able to take on such risks.

Related Finance Terms

  • Retention Ratio: This refers to the portion of net income that a corporation retains for the purpose of reinvestment as opposed to distributing it to shareholders as dividends.
  • Risk Management : This process involves identifying, assessing, and controlling threats to an organization’s capital and earnings. It is typically associated with uncertainties in financial markets.
  • Reinsurance: This is a practice among insurance companies to protect themselves from major claims events. Underlying retention is often used in the context of reinsurance where the primary insurer retains some risk.
  • Profit Margin: This term refers to the amount by which revenue from sales exceeds costs in a business, often illustrated as a percentage. A higher underlying retention may lead to a higher profit margin.
  • Claim Settlement: This is the payment that an insurer makes to a policyholder following a loss. Underlying retention could affect the amount paid out in a claim settlement.

Sources for More Information

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