Transfer of risk

Transfer of risk is a contract between the entity that assumes the risk and the entity that transfers the risk. The content of the contract is an obligation to cover the loss that may occur to the transferor as a result of the materialisation of the risk in question.

Unacceptable risk refers to those disturbances whose likelihood and effects cannot be approved as acceptable by the company. Most often this means that the probability of an adverse event occurring is too high and the amount of potential losses associated with it is too significant for the organization. Transfer is a common method of dealing with risks that cannot be fully accepted by the company.

Transfer of risk is a risk management technique that takes the certain risks from the company to other partner, usually insurance institution. In such a case, against payment of an appropriate premium, the insurer is obliged to bear financial liability for any damage that may occur in the future with the policyholder. If someone buys car insurance, he/she transfers part of risk of car crash to insurance company. It is important to remember that not all the risks can be transferred. As in example - lost health can never be recovered .

Basic forms of risk transfer

The basic principle of transfer is to make it to an entity that is able to manage risk better than an entity that wants to "get rid of" risk. There are many techniques or forms of externalisation of risk, some of them rely on:

• the outsourcing of those business functions that carry a disproportionately high risk compared to the value added by those functions,
• leaving functions (areas, processes, assets) in the company, and taking the risk outside the company itself, it is often done by the participation of an external partner in the risk; an example of this can be financial participation of e. g. security companies in theft damage, the obligation to control (prevention and reduction as above) and to finance the risk of failure of the production line by its manufacturer or service technician, etc.,
• risk insurance.

Reinsurance

Also insurance companies transfer risks, as they use reinsurance services. In this day and age it's almost impossible for insurance company to operate without reinsurance. Extensive problems of several large customers of such company could lead to the bankruptcy. Reinsurance helps to transfer risk and survive difficult period. In order to be able to protect the company against the occurrence of an unfavourable random event, entities may, and sometimes are even obliged by law to do so, purchase appropriate insurance cover from an insurance company. For the price of the relevant premium, the insurance company, also called the insurer, decides to provide the required insurance cover. At the same time, he himself, also as a market participant, can insure himself, that's mean insure insurance the insurance granted to his customers. This insurance is called reinsurance .

Forms of reinsurance

• due to the form of risk acceptance - reinsurance underwritten, consisting of accepting all or part of the risk, and passive reinsurance consisting of the transfer of all or part of the risk (fronting),
• due to the form of commitment of the parties, we distinguish obligatory and optional reinsurance and, although much less frequently, optional and obligatory reinsurance;
• due to the methods of risk sharing we have to do with proportional reinsurance (amount and excedent), as well as with reinsurance of disproportionate excess loss and loss of claims.

Transfer of risk — recommended articles

Risk transfer — Termination clause — Litigation risk — Phoenix company — Imperfect information — Runoff Insurance — Hostile takeover — Operational risk — Currency risk

References

• Clifford, D. B., Yousry, T. A., & Major, E. O. (2017). A decade of natalizumab and PML: Has there been a tacit transfer of risk acceptance?. Multiple Sclerosis Journal, 23(7), 934-936.
• Lam J., (2014) Enterprise Risk Management: From Incentives to Controls Wiley
• Banks E., (2004) Alternative Risk Transfer: Integrated Risk Management through Insurance, Reinsurance and the Capital Markets John Wiley &Sons
• Culp C.L., (2002) The ART of Risk Management: Alternative Risk Transfer, Capital Structure And the Convergence of Insurance and Capital Markets John Wiley &Sons.

Footnotes

Author: Natalia Windys