What is Risk Transfer?
Risk transfer can be defined as a mechanism of risk management that involves the transfer of future risks from one person to another, and one of the most common examples of risk management is purchasing insurance where the risk of an individual or a company is transferred to a third party (insurance company).
Risk transfer, in its true essence, is the transfer of the implications of risks from one party (individual or an organization) to another (third party or an insurance company). Such risks may or may not necessarily take place in the future. Transfer of wagers can be executed through buying an insurance policy, contractual agreements, etc.
How does Risk Transfer Work?
- One of the most common areas where risk transfer takes place is in the case of insurance. An insurance policy can be defined as a voluntary arrangement between the individual or an organization (policyholder) and an insurance company. A policyholder gets insured against potential financial risksFinancial RisksFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy. by purchasing an insurance policy from the insurance company.
- The policyholder will need to make regular and periodic payments to the insurance company for ensuring that his or her insurance policy is not getting lapsed on account of the failure of making timely payments, i.e., premiums. A policyholder might choose from a variety of insurance policies offered by various companies.
Risk Transfer Example
A buys car insurance for $5,000, which is valid only for the physical damage of the same, and this insurance is right up to 31st December 2019. A had a car accident on 20th November 2019. His car suffers from severe physical damage, and the cost of repair of the same accounts to $5,050. A can claim a maximum of $5,000 from his insurance provider, and the rest cost will be solely borne by him.
#1 – Insurance
- In an insurance mechanism, an individual or a company can purchase an insurance policy from the preferred insurance company and accordingly safeguard itself from the implications of financial risks underlying in the future.
- The policyholder will need to make timely payments or premiums to ensure that the undertaken insurance policy remains valid and does not fail on account of failure to make timely payments.
#2 – Derivatives
It can be defined as a financial product which attains its value from a financial assetFinancial AssetFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash. or an interest rate. DerivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. are mostly bought by firms to protect against financial risks like the currency exchange rate, etc.
#3 – Contracts with an Indemnification Clause
Contracts with indemnification clauses are also used by an individual or an organization for risk transfers. Contracts with such a clause ensure the transfer of financial risks from the indemnitee to the Indemnitor. In such an arrangement, the future economic losses shall be borne by the Indemnitor.
#4 – Outsourcing
Outsourcing is a type of risk transfer where a process or a project is outsourced for transferring various kinds of risks from one party to another.
- This can be defined as a strategy for ensuring that a financial asset is safeguarded against future contingencies. It helps in the allocation of risk equitably, i.e., it places the responsibilities for financial risks on the third party (insurance company in the case of an insurance and indemnitor in the case of a contract) who has taken the in-charge to safeguard the policyholder or indemnitee against future contingencies.
- This means that in the occurrence of an unfortunate event, the policyholder or indemnitee can be assured that the losses arising from the consequences of such an event will be duly taken care of by the insurance company or the Indemnitor.
Different Ways to Transfer Risk
#1 – Certificate of Insurance
- A certificate of insurance is used to minimize the financial liabilityFinancial LiabilityFinancial Liabilities for business are like credit cards for an individual. In simple terms, a financial liability is a contractual obligation that needs to be settled in cash or any other financial asset and are very useful in the sense that the company can employ “others’ money” in order to finance its own business-related activities for some time period which lasts only when the liability becomes due. The liabilities could be of two types, short term and long term. of an individual or an organization. A certificate of insuranceCertificate Of InsuranceCertificate of insurance refers to the document containing all the crucial details regarding an insurance policy in a comprehensive and standardized format as proof of the policy’s current status, coverage details, risk exposure and protection against third-party liability. is made between the policyholder and an insurance company or insurance provider.
- This certificate must reflect the necessary information like the date of issue of the certificate, name of the insurance provider, policy name, policy numbers, date of commencement as well as the expiry of the insurance policy, name, address, and such other details of the insurance agent, amount of eligible coverage for each type of financial risk, etc.
#2 – Hold-Harmless Clause
It is also known as a save-harmless clause. These are contracts with indemnity clauses that take place between an Indemnitor and an indemnitee. This agreement must reflect the critical information such as the responsibility of the Indemnitor against any loss, damage, or future contingencies towards the indemnitee, etc.
- Safeguard Against Future Contingencies – It shields an individual or an organization against unforeseen financial risks that could be in the form of damage, theft, losses, etc. A policyholder or an indemnitee can always be assured that the contingencies lying ahead in the future will be borne by the insurance provider or the Indemnitor as a result of the transfer of risk through an insurance policy or hold-harmless agreement.
- Expensive – One of the most common drawbacks could be the level of expenses that an individual or an organization is supposed to bear for purchasing and maintaining insurance, derivatives, or an indemnity clause.
- Time-Consuming – Time-consuming is another drawback. Purchasing an insurance policy might take a lot of time, and so does the claiming of the insurance. This could be tiresome and one of the discouraging factors of availing risk transfer.
This has been a guide to What is Risk transfer & its Definition. Here we discuss the types of risk transfer and how does it work along with importance, for example, advantages and disadvantages. You can learn more about from the following articles –