A client aged 52 owns a coastal holiday house with a replacement cost of 900,000 dollars and no mortgage. Local records show a storm surge severe enough to destroy a house on that street happens roughly once every 40 years, and the client has no other liquid assets beyond an emergency fund of 60,000 dollars. Applying the frequency and severity framework of the risk management process, which treatment should the planner recommend for the storm surge exposure?
- ARetain the exposure and fund it from the emergency reserve, because a once in 40 years event is an infrequent loss
- BAvoid the exposure by selling the holiday house and renting comparable accommodation each season
- CTransfer the exposure to an insurer through a policy covering storm surge damage to the dwelling Correct
- DReduce the exposure by fitting storm shutters and raising the foundations, with no insurance purchased
Why A is wrong: Retention is tempting because the frequency really is low, but retention is appropriate only when the severity is also low enough that the client can absorb the loss; a 900,000 dollar loss against a 60,000 dollar reserve would be financially ruinous.
Why B is wrong: Avoidance does eliminate the exposure completely, but it also destroys the client's stated objective of owning the property, and avoidance is reserved for exposures that cannot be economically insured or reduced.
Why C is correct: Low frequency combined with high severity is the classic quadrant for risk transfer, because the premium is small relative to a loss the client could not absorb, and the insurer can pool the exposure across many similar properties.
Why D is wrong: Loss reduction is a sensible supplement and may earn a premium credit, but on its own it lowers the size of a loss rather than removing the catastrophic tail, so the client is still exposed to a loss far beyond the reserve.