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Risk managers create value through a host of prevention, reduction, enablement and enhancement projects. Yet despite their best efforts, undesired losses and inadequate return on investments do occur. Even when the desired speculative outcomes result, the projects must be funded. So financing these outcomes is a realistic component of a comprehensive risk management portfolio containing both risk control and risk financing components.
One of the most common risk financing techniques is retention, or the self-funding of losses. Risk retention is the preferred risk financing method when the loss values are relatively low. An important advantage of using retention is that it encourages the organization to adopt loss prevention projects, thus reducing the total cost of risk. There are five common categories of retention:
Current expensing. This is appropriate when the probability of loss and the expected loss value is relatively low. Relatively small speculative project costs are also expensed on the current income statement. That is, these small costs are not material to the organization's liquidity. Many firms have a special fund set aside to pay these little investments or claims (current expense funds). The expense of these losses is taken as a taxdeductible expense on the income statement.
Borrowing. When slightly larger projects...