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.
Table of contents
- What is Risk Transfer?
- . Risk transfer is a risk management technique that involves transferring future risks from one person to another. Purchasing insurance is a well-known example of risk management since the risk of a person or entity is transferred to a third party (an insurance company).
- Risk transfer methods include insurance, derivatives, contracts with indemnity provisions, and Outsourcing. It facilitates the equitable allocation of risk, i.e., it places financial bets on the insurance company in the event of an insurance policy and the Indemnitor that safeguards the policyholder or indemnitee from future contingencies.
- Certificates of insurance and hold-harmless provisions are two ways to transfer risk.
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 to ensure that their insurance policy is not getting lapsed because of the failure to make timely payments, i.e., premiums. A policyholder might choose from various 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 repair cost of the same accounts for $5,050. A can claim a maximum of $5,000 from his insurance provider, and he will solely bear the rest cost.
#1 – Insurance
- In an insurance mechanism, an individual or company can purchase an insurance policy from the preferred insurance company and safeguard itself from the implications of financial risks 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 because of failure to make timely payments.
#2 – Derivatives
It can be defined as a financial product that 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. Firms mostly buy 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. to protect against financial risks like the currency exchange rate, etc.
#3 – Contracts with an Indemnification Clause
Individuals or organizations also use contracts with indemnification clauses 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 in which a process or project is outsourced to transfer various 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 allocate 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
These are contracts with indemnity clauses between an Indemnitor and an indemnitee. This agreement must reflect critical information such as the responsibility of the Indemnitor against any loss, damage, or future contingencies towards the indemnitee, etc. It is also known as a save-harmless clause.
- 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 insurance provider or the Indemnitor will bear the contingencies ahead in the future due to the transfer of risk through an insurance policy or hold-harmless agreement.
- Expensive – One of the most common drawbacks could be the expenses that an individual or an organization should 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.
Frequently Asked Questions (FAQs)
A pension risk transfer occurs when a defined-benefit pension provider wants to withdraw some or all of its commitment to offer plan participants guaranteed retirement income or post-retirement benefits.
Outsourcing can mitigate risk in the following ways: If a corporation wishes to focus on its core business, it can outsource its auxiliary activities to third-party providers. For example, if a corporation is primarily concerned with production, it can outsource its security concerns to other firms.
Significant risk transfer (SRT) transactions allow credit institutions to reduce the amount of regulatory capital they must hold by transferring credit risk concerning specific assets to third parties as part of either a traditional cash securitization or a synthetic securitization.
This has been a guide to what Risk Transfer is & its definition. Here we discuss the types of risk transfer, how they work, and their importance, such as advantages and disadvantages. You can learn more about it from the following articles –