Transfer of Risks

A transfer of risk is a business agreement in which one party pays another to take responsibility for mitigating specific losses that may or may not occur. This is the underlying tenet of the insurance industry.

Risks may be transferred between individuals, from individuals to insurance companies, or from insurers to reinsurers. When homeowners purchase property insurance, they are paying an insurance company to assume various specific risks associated with homeownership.

When purchasing insurance, the insurer agrees to indemnify, or compensate, the policyholder up to a certain amount for a specified loss or losses in exchange for payment.

Insurance companies collect premiums from thousands or millions of customers every year. That provides a pool of cash that is available to cover the costs of damage or destruction to the properties of some small percentage of its customers. The premiums also cover administrative and operating expenses, and provide the company’s profits.

Life insurance works the same way. Insurers rely on actuarial statistics and other information to project the number of death claims it can expect to pay out per year. Because this number is relatively small, the company sets its premiums at a level that will exceed those death benefits.

Working

Risk transfer is a common risk management technique where the potential of an adverse outcome faced by an individual or entity is shifted to a third party. To compensate the third party for bearing the risk, the individual or entity will generally provide the third party with periodic payments.

The most common example of risk transfer is insurance. When an individual or entity purchases insurance, they are insuring against financial risks. For example, an individual who purchases car insurance is acquiring financial protection against physical damage or bodily harm that can result from traffic incidents.

As such, the individual is shifting the risk of having to incur significant financial losses in a traffic incident to an insurance company. In exchange for bearing such risks, the insurance company will typically require periodic payments from the individual.

Reinsurance companies accept transfers of risk from insurance companies.

The insurance industry exists because few individuals or companies have the financial resources necessary to bear the risks of the loss on their own. So, they transfer the risks.

Risk Transfer to Reinsurance Companies

Some risks are too big for insurance companies to bear alone. That’s where reinsurance comes in.

When insurance companies don’t want to assume too much risk, they transfer the excess risk to reinsurance companies. For example, an insurance company may routinely write policies that limit its maximum liability to $10 million. But it may take on policies that require higher maximum amounts and then transfer the remainder of the risk in excess of $10 million to a reinsurer. This subcontract comes into play only if a major loss occurs.

Property Insurance Risk Transfer

Purchasing a home is the most significant expense most individuals make. To protect their investment, most homeowners buy homeowners insurance. With homeowners insurance, some of the risks associated with homeownership are transferred from the homeowner to the insurer.

Insurance companies typically assess their own business risks in order to determine whether a customer is acceptable, and at what premium. Underwriting insurance for a customer with a poor credit profile and several dogs is riskier than insuring someone with a perfect credit profile and no pets. The policy for the first applicant will command a higher premium because of the higher risk being transferred from the applicant to the insurer.

• A transfer of risk shifts responsibility for losses from one party to another in return for payment.
• The basic business model of the insurance industry is the acceptance and management of risk.
• This system works because some risks are beyond the resources of most individuals and businesses.

Methods of Risk Transfer

There are two common methods of transferring risk:

1. Insurance policy

As outlined above, purchasing insurance is a common method of transferring risk. When an individual or entity is purchasing insurance, they are shifting financial risks to the insurance company. Insurance companies typically charge a fee an insurance premium for accepting such risks.

2. Indemnification clause in contracts

Contracts can also be used to help an individual or entity transfer risk. Contracts can include an indemnification clause  a clause that ensures potential losses will be compensated by the opposing party. In simplest terms, an indemnification clause is a clause in which the parties involved in the contract commit to compensating each other for any harm, liability, or loss arising out of the contract.

For example, consider a client that signs a contract with an indemnification clause. The indemnification clause states that the contract writer will indemnify the client against copyright claims. As such, if the client receives a copyright claim, the contract writer would

• Be obliged to cover the costs related to defending against the copyright claim.
• Be responsible for copyright claim damages if the client is found liable for copyright infringement.