Plain version: once you spot a loss exposure, you have four basic choices. Stay away from it, make it smaller, keep it yourself, or hand it to someone else.
The four techniques:
Avoidance: give up the activity so the exposure no longer exists, as when a park closes a dangerous ride.
Reduction (loss control): keep the activity but make losses less likely or less severe, such as installing sprinklers or smoke alarms.
Retention: keep the loss yourself, such as paying small losses from savings or choosing a deductible.
Transfer: shift the financial burden to another party, most commonly by buying insurance.
Matching the technique to the exposure:
- Low frequency, high severity (a house fire): transfer. Insurance works best for losses that are rare but too large to absorb.
- Small, predictable losses: retention.
- Reduction is worthwhile alongside the others, but a smoke alarm does not pay to rebuild a house.
Techniques are often combined. A manufacturer that installs sprinklers (reduction) and takes a deductible (retention) transfers the rest of each loss to its insurer.
The deductible is the part of a loss the insured bears first. It is a form of retention. It eliminates small claims that cost more to process than they are worth, which lowers premiums, and it gives the insured a reason to prevent losses. It is not the policy limit: the limit is the most the insurer will pay.