A homeowner installs a fire alarm, self-funds minor repairs out of pocket, and purchases a homeowners policy for major losses. Which risk management technique does the purchase of insurance represent?

Why A is correct

Purchasing insurance is the risk management technique of transfer: the financial consequences of a loss are shifted from the individual to the insurer, which assumes the risk in exchange for a premium. In the scenario, installing a fire alarm is reduction, because it makes a loss less likely to occur; self-funding minor repairs is retention, because the homeowner keeps small losses on his own books; and buying the homeowners policy is transfer, because a major loss is shifted to the insurer. Avoidance would mean refusing to own the exposed property at all. Transfer is the technique that defines insurance itself and is used for losses too large to retain.

Why the other options are wrong

• B) Avoidance eliminates a risk by not engaging in the loss-exposing activity at all, such as selling the home or giving up the hobby; buying a policy keeps the risk in place and shifts its financial cost, so it is not avoidance.
• C) Retention means accepting a loss within one's own financial resources, as the homeowner does for minor repairs by paying them out of pocket; the policy shifts a major loss to the insurer, which is the opposite of retention.
• D) Reduction lowers the chance or size of a loss, as installing a fire alarm does by making fires less likely; the insurance policy instead shifts the financial burden of a major loss to the insurer, which is transfer.

Memory hook

Insurance hands the risk to someone else — that is transfer, not avoidance, retention, or reduction.