Low Frequency, High Severity risks are typically transferred via which mechanism?

Low Frequency, High Severity risks are typically transferred via which mechanism?

• A. Retention
• B. Insurance
• C. Hedging
• D. Diversification

Answer: (B)

Low frequency, high severity risks are best transferred through insurance because insurance is specifically designed to shift the financial burden of rare, costly losses from the insured to a large pool of policyholders. By paying a premium, the insured gains protection against catastrophes (like major property damage, liability claims, or health crises) and the insurer pools funds from many customers to cover these big claims, often with reinsurance to handle extreme losses. This mechanism turns a potentially devastating single event into an affordable, predictable cost for the insured. Retention would keep the risk with the entity, not transfer it. Hedging focuses on mitigating specific financial exposures with instruments, which works well for market risks but isn’t a comprehensive solution for broad, catastrophic losses. Diversification spreads risk across many exposures but does not transfer a large single loss to another party and thus does not provide the same protection against a single high-severity event.

Low frequency, high severity risks are best transferred through insurance because insurance is specifically designed to shift the financial burden of rare, costly losses from the insured to a large pool of policyholders. By paying a premium, the insured gains protection against catastrophes (like major property damage, liability claims, or health crises) and the insurer pools funds from many customers to cover these big claims, often with reinsurance to handle extreme losses. This mechanism turns a potentially devastating single event into an affordable, predictable cost for the insured.

Retention would keep the risk with the entity, not transfer it. Hedging focuses on mitigating specific financial exposures with instruments, which works well for market risks but isn’t a comprehensive solution for broad, catastrophic losses. Diversification spreads risk across many exposures but does not transfer a large single loss to another party and thus does not provide the same protection against a single high-severity event.