Insurance is a great tool to reduce your risk of loss, but it isn’t always the best method. This article will answer questions such as 'when should insurance be used?', 'when should risk be retained?', 'what's the difference between claim frequency and severity?', and 'when should loss control be used?'.
Many people become dissatisfied when they find out that their insurance doesn’t cover every peril. However, insurance is only one method of reducing risk. There are three other methods of risk reduction, and their use will depend on the frequency and severity of risk.
To clarify, frequency is the probability of a loss occurring, and severity is how much the damages will be during the loss. With these two facets of risk in mind, let’s look at the Risk Matrix:
Retain: These are losses that many typically don’t plan for, mainly because they are minor annoyances or gradual losses. It could be a uniform getting ripped or stained, office supplies being misplaced, or the wear and tear (depreciation) of equipment. No precautions need to be taken, because it would cost more to create regulations than to just absorb the losses. However, figuring in a retained-loss fund is a good idea to manage the accounting disturbances.
Loss Control: These types of risks are very likely to occur, but are often of small significance, such as the prevalence of petty theft in a convenience store, or small acts of vandalism such as table-etchings by teenagers in a restaurant. They are insurable losses, but it is often not cost-effective to do so. The best way to handle these is by creating rules and placing safeguards to mitigate these types of losses. Examples would be surveillance systems or requiring all minors to be accompanied by an adult.
Avoid: These are very risky situations, as it is probable that a loss will happen and the loss will be very large. What quantifies as too risky and too expensive depends on the size of your firm. Examples of risks that fall into this category could be expanding operations into a highly regulated area, expanding operations into an area with unstable government, or building new office space in a flood zone. These situations need to be carefully analyzed, as it may not be economical to operate in them and/or to insure against these types of risk.
Insure: These are your regular risks that are statistically unlikely (but calculable), and would create a burden if they were to happen. These risks include fires, slips and falls, claims of negligence, etc. By combining many similar operations into a large pool of insureds, these types of risk are economically insured by most insurance policies.
While insurance is a great risk management tool, it is not always the most economical method of risk reduction. Make sure to check on alternatives before you get insurance—make sure you're getting the best value for your money!