A risk management technique involving the transfer of risk to another party
Risk transfer is a risk management technique that involves transferring the financial consequences to another party (also known as the counterparty). The counterparty willin negative circumstances in exchange for regular payments.
The most common example of risk transfer is when Individuals and companies transfer risk to insurance companies by purchasing insurance policies. The insurance companies collect regular payments that compensate them for the risk they have taken on. For example, in the case of fire insurance, the insurance company will compensate the policy buyer for the number of goods destroyed by the fire.
What Is Risk in Business?
Risk relates to all the unpredictable events affecting a company or an individual.
Companies employ specialists in risk management, such as financial risk managers (FRM), to help them identify and mitigate the adverse effects of risks.
There are generally three broad categories of risk:
- Business risk - This relates to the company's activities. For example, business risk can arise from a marketing campaign or launching a new product line or a service.
- Non-business risk - Non-business risk concerns geopolitical circumstances or economic conditions.
- Financial risk - If a company is likely to incur losses because of negative events, these losses are related to financial risk. Financial risk can be categorized as market, credit, , legal, and operational risk.
These different types of risk can be minimized and accounted for by purchasing an insurance policy or structured financial product.
Risk Transfer: How Does It Work?
As a risk management tool, risk transfer involves shifting responsibility for the adverse effects of a risk to another party, such as an insurance company.
An individual will usually buy a flood or a travel insurance policy. If the person experiences financial losses due to flooding or lost luggage, the insurance company will cover those losses. The terms and the amount, which will be paid, are specified in the contract between the individual and the insurance company.
In a business setting, a company buys insurance to protect itself from financial losses if, for various situations such as:
- An employee gets injured during service,
- The business property gets damaged
- A service provided by the company negatively impacts a customer.
Insurance companies can also transfer risk. They transfer risk to reinsurance companies, which are insurance companies for insurance companies. Insurance companies will pay a fee to the reinsurance companies to transfer liabilities.
Whether it is insurance for a business or an individual, they have to make regular payments to the insurance company, known as insurance premiums. The insurance premium is paid monthly, semi-annually, or annually. The payment period depends on various factors, such as age or health condition of the individual or the size and location of the company.
Types of Risk Transfer
There are different types of risk transfer, and the most common are insurance policies and indemnification clauses in contracts. Other types of risk transfer include outsourcing and derivative products; the latter provides an investment hedge.
Personal Insurance Policies
People buy personal insurance cover to protect themselves in adverse conditions. The most popular individual insurance covers are:
- Homeowners insurance
- Renters insurance
- Life insurance
- Automobile insurance
- Flood and earthquake insurance
- Disability insurance
- Umbrella insurance
Business Insurance Policies
Depending on the state and the country in which a company operates, it is required to have different types of insurance that may or may not be specific to the industry they operate in.
Typically, this includes workers' compensation insurance and disability insurance. Business owners alsoinsurance. Although not mandatory, the public liability insurance will pay for legal costs if the business owner gets sued. Other common business insurance policies are:
- General liability insurance (GLI)
- Commercial property insurance
- Income protection insurance
- Professional liability insurance
- Workers' compensation insurance
- Data breach insurance
- Commercial vehicle insurance
- Commercial umbrella insurance
- Directors and Officers (D&O) liability insurance
Usually, as part of a commercial contract, the indemnity clause states that the indemnifying party will compensate the indemnified party in circumstances when the latter incurs the covered losses. Indemnity clauses are often used in intellectual property (IP) agreements, data licensing agreements, or photography licenses.
For example, a person uses an image supplied by a provider who isn't the true owner of the image. If the real owner finds out and brings claims against the person, the person can receive indemnities from the provider under the indemnity clause. The indemnity clause simply ensures that one party will compensate the other party in the event of wrongdoing resulting from the contract.
Risk Transference vs. Risk Shifting vs. Risk Sharing
Risk transfer or transference, as outlined above, defines the movement of risk to a third party in return for periodic payments. The purchasing of insurance policies is the most common type of risk transfer.
Risk shifting is a type of risk transfer. Risk shifting is often seen in the form of outsourcing - a company outsources some of its services to another entity, which is more competent in providing them, for example, customer service call center or cleaning and maintenance services. In this case, the company changes the distribution of risky outcomes. Another method of risk shifting is the.
Risk sharing is also known as risk distribution or risk pooling. In an insurance plan, policyholders share the risk within the group of policyholders as their premiums and losses are calculated according to a specified formula.