Risk transfer

Risk transfer is a contract between an entity that takes over a given risk with the entity that transfers it. The content of the contract is an obligation to cover the loss that may occur in the transferring entity as a result materialization of a given risk.

Consequently:

• The risk transfer scope defines the content of the above undertaking
• The transfer is effective as long as the commitment is effective
• Risk transfer is actually replacing one risk with another

Characteristics

The scope in which the risk can be considered as transferred:

• when it was found that the insurance or non-insurance cover was fully met for certain risks selected from the risk map as not subject to retention
• the goal should not be only to minimize the level of the insurance premium, but to minimize the level of the total risk cost, as well as to eliminate the need for unplanned financing of risks from own resources
• there are no gaps in the scope or subject of risk subject to transfer
• there is no risk that the cover has been arranged in a way that does not guarantee its continuity
• has been introduced as part of risk management, risk control, which allows for monitoring them, introducing corrections and additions in covering their transferred part
• means have been provided to cover the retained part of the risk (retention).

Among the consequences that may occur as a result of the implementation of random events, it is possible to distinguish consequences related to :

• loss or damage to property, e.g. fire
• seize, destroy or damage property, e.g. theft
• civil liability for business operations
• liability for the manufactured product
• loss of profit as a result of a business interruption

Accomplishment of risk transfer

Insurance: Risk transfer is usually carried out through an insurance policy. It is an agreement between two entities: an insurance company and the policyholder, but this only occurs when the insurance company accepts defined financial risk from the policyholder. This means that if an employee bears any injuries, the insurance company bears the costs. If the building is destroyed by natural factors, the insurance company will bear the costs associated with bringing this building to its original state. Each insurance company charges a fee for taking over such a risk. What is more, there are many factors that change the financial risk, e.g. reserves, other financial contracts, deductions, reinsurance.

Contracts: There is a possibility of transferring risk not only through insurance contracts but also through agreements containing specific provisions that concern the compensation. Such a provision may be an indemnity clause, which is a contractual provision containing the consent of one entity for liability for damage suffered by the other entity. Such indemnification agreements are independent of the protection provided by the insurance company.

Examples of Risk transfer

• Insurance: Insurance is a form of risk transfer in which an insurance company agrees to cover the losses experienced by an individual or company in exchange for regular payments. For example, a homeowner may purchase an insurance policy to protect against the risk of fire or theft.
• Hedging: Hedging is a type of risk transfer in which an investor seeks to offset the potential losses associated with a particular investment by taking an opposite position in the market. For example, a trader may buy a futures contract to hedge against a decline in the price of a stock they own.
• Derivatives: Derivatives are a type of financial instrument used to transfer risk between two parties. For example, a company may enter into a derivatives contract to hedge against the risk of currency fluctuations.
• Reinsurance: Reinsurance is a type of risk transfer in which an insurance company transfers part of the risk they have assumed to another insurer. For example, an insurer may purchase a reinsurance contract to cover the risk of a large number of claims coming in at once.

Advantages of Risk transfer

Risk transfer offers numerous advantages to entities looking to manage their risk. These include:

• Reduced costs associated with managing risk, as the transferor no longer needs to pay for resources to monitor and manage the risk.
• Increased flexibility, as the transferor can choose the type of risk they want to transfer and the level of risk they are willing to accept.
• Access to a larger pool of resources, as the transferor can access the expertise of the transferee in managing the risk.
• Reduced liability, as the transferor no longer has to pay for any losses associated with the risk.
• Improved risk management, as the transferor can take advantage of the transferee’s risk management strategies.
• Improved all-around risk management, as the transferor can take advantage of the transferee’s knowledge of the marketplace and industry.

Limitations of Risk transfer

Risk transfer has its limitations:

• Risk transfer is not always possible. In some cases, the risk might be too complex to transfer or the potential losses too uncertain to be quantified.
• It is also difficult to transfer risks which are caused by human behavior or decisions, as they are difficult to predict.
• Risk transfer can be expensive, as it may require payment of a premium to the entity taking on the risk.
• Risk transfer may also not be effective if the transferring entity is not aware of the risks it is transferring or does not have the resources to adequately monitor the risk.
• Risk transfer does not always provide a complete solution, as it does not always address the underlying causes of the risks. It may also impose new risks.
• The transfer of risk may also be affected by legal restrictions, such as insurance regulations.

Other approaches related to Risk transfer

One of the other approaches to risk transfer is through insurance. Insurance is a type of risk transfer where a policyholder pays a premium to an insurer, who then agrees to pay for the policyholder's losses if the risk materializes. Other approaches to risk transfer include hedging, whereby the transferring entity enters into a financial contract to offset their risk exposure; diversification, where an entity spreads out their risk across different investments, and risk avoidance, where an entity takes steps to prevent risk from occurring. Ultimately, risk transfer is a way of managing risk, and can be used in various ways depending on the specific needs of the entity transferring the risk.

Footnotes

Risk transfer — recommended articles

Runoff Insurance — Pure risk — Net line — Insurance risk — Self insured retention — Dual insurance — Transfer of risk — Mudaraba — Concentration risk

References

• Cruz M. G. and others, (2015), Fundamental Aspects of Operational Risk and Insurance Analytics: A Handbook of Operational Risk, John Wiley & Sons, p. 685-688
• Frenkel M. and others, (2004), Risk Management: Challenge and Opportunity, Springer Science & Business Media, p. 439-441
• Hohl R., (2018), Agricultural Risk Transfer: From Insurance to Reinsurance to Capital Markets, John Wiley & Sons, p. 369-371
• Pompella M. and others, (2017), The Palgrave Handbook of Unconventional Risk Transfer, Springer, p. 2-4.

Author: Kristina Tyshchenko