A corporation decides to pay for small repair losses out of operating cash but buys an insurance policy with a large deductible to cover major losses. This combination of techniques is best described as:
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
The corporation is combining two risk-management techniques. It retains the predictable, affordable small losses by paying them from operating cash, while transferring the large, potentially catastrophic losses to the insurer through the policy above the deductible. This layered approach is economically rational because small losses are frequent but cheap, whereas large losses are rare but financially dangerous. Retention and transfer are complements rather than substitutes, and the deductible is the boundary between what the firm keeps for itself and what it shifts to the insurer. This structure is sometimes called self-insurance combined with catastrophic coverage.
Why the other options are wrong
- B) Avoidance means not engaging in the risky activity at all; the corporation still operates and still faces losses, so nothing has been avoided.
- C) Sharing distributes risk among many participants in a pool, and no government program is involved in this arrangement.
- D) Insurance cannot reduce the probability of a loss to zero; it only transfers the financial consequences of losses that do occur.
Memory hook
Keep the small bites you can chew; transfer the ones that would swallow you whole.