Faith Morrow
Risk transfer is a risk management technique where potential losses are shifted to a third party, usually an insurance company. This is a common strategy in the finance industry, where an organisation transfers the responsibility of risk to another party for a fee. The most common example of risk transfer is insurance, where an individual or entity purchases financial protection against physical damage or bodily harm. For instance, car insurance provides financial protection in the event of a traffic incident. Similarly, life insurance ensures that an individual's loved ones are cared for in the event of their death. Risk can also be transferred from insurance companies to reinsurance companies, which provide insurance to insurance firms. This is known as risk pooling.
| Characteristics | Values |
|---|---|
| Definition | A risk management technique involving the transfer of risk to a third party |
| Risk Transfer vs. Risk Shifting | Risk transfer is passing on (“transferring”) risk to a third party; risk shifting involves changing (“shifting”) the distribution of risky outcomes rather than passing on the risk to a third party |
| Common Examples | Insurance, indemnification clause in contracts |
| Risk Transfer by Insurance Companies | Insurance companies can transfer risk to reinsurance companies |
| Risk Shifting | Outsourcing, derivatives |
What You'll Learn
Insurance policies
When purchasing insurance, the insurer agrees to indemnify, or compensate, the policyholder for a specified loss or losses in exchange for payment. This is a legally binding contract, where the insured agrees to pay an insurance premium for the insurer's protection. The insurance company agrees to take on the risk for a fee.
For example, if an individual purchases car insurance, they are acquiring financial protection against physical damage or bodily harm that can result from traffic incidents. The individual is shifting the risk of having to incur significant financial losses from a traffic incident to an insurance company. In exchange, the insurance company will typically require periodic payments from the individual.
Insurance companies collect premiums from thousands or millions of customers every year. This provides a pool of cash that is available to cover the costs of damage or destruction to the properties of a small percentage of its customers. The premiums also cover administrative and operating expenses and provide the company's profits.
Insurance companies can also transfer risk to reinsurers. This is known as "risk pooling". Reinsurance companies provide insurance to insurance firms, and they help manage the risk of large-scale events that would cause insurers to issue many payments at once, such as a natural disaster.
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Outsourcing
Risk Transfer to Third-Party Providers
Access to Specialized Professionals
Cost Savings and Scalability
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Indemnification clauses in contracts
Indemnification clauses are a common feature of commercial contracts and are an essential tool for allocating risk between the parties. They are also heavily negotiated. This type of clause is an agreement by one party (the indemnifying party) to compensate the other (the indemnified party) for costs and expenses, usually arising from third-party claims.
Indemnification clauses allow a contracting party to customise the amount of risk it is willing to take on. They also protect the contracting party from damages and lawsuits that are more efficiently borne by the counterparty. For example, in an agreement for the sale of goods, the risk that a product injures a third party is more efficiently borne by the seller than the buyer, as the seller has more control over the goods. The seller is therefore in a better position to mitigate losses and liabilities related to the goods.
A typical indemnification clause consists of two obligations: the obligation to indemnify and the obligation to defend. The obligation to indemnify requires the indemnifying party to reimburse the indemnified party for its costs and expenses, referred to as losses. The obligation to defend requires the indemnifying party to reimburse the indemnified party for defence costs and expenses, and also gives the indemnifying party the right to assume and control the defence of the third-party suit. The obligation to defend is broader than the obligation to indemnify, as it applies regardless of the merits of the third-party suit.
Most indemnification provisions also require the indemnifying party to "indemnify and hold harmless" the indemnified party for specified liabilities. The phrase "hold harmless" may require the indemnifying party to advance payment for covered unpaid costs and expenses, even when the defined recoverable damages are limited to losses. If the "hold harmless" obligation is omitted, the indemnifying party does not become responsible for losses until the indemnified party makes payment.
There are several common exceptions to indemnification. These include circumstances where the indemnified party's own actions cause or contribute to the harm that triggers indemnification. For example, an indemnification provision may exclude indemnification for claims or losses that result from the indemnified party's negligence or improper use of the products.
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Reinsurance
There are two basic categories of reinsurance: treaty and facultative. Treaties are agreements that cover broad groups of policies, while facultative covers specific individuals or generally high-value or hazardous risks that wouldn't be acceptable under a treaty.
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Derivatives
There are two major types of derivative contracts: forward commitments (e.g. futures) and contingent claims (e.g. options). The value of a derivative is indirectly dependent on the price fluctuations of the asset that underpins the contract. Derivatives are commonly used to hedge established positions, reduce exposure to the risk of price fluctuations, and for pure speculation.
Some common types of derivatives include:
- Futures contracts: a forward commitment contract between a buyer and seller to exchange a specific, standardised asset at a precise time in the future for a particular price.
- Forward contracts: similar to futures, but traded OTC and not on an exchange.
- Options: a contingent claim contract that grants the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on a specific date.
- Swaps: derivatives where counterparties exchange cash flows or other variables associated with different investments.
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Frequently asked questions
Risk transfer is a risk management technique where the potential loss from an adverse outcome is shifted to a third party. This is usually done in exchange for periodic payments to the third party.
Purchasing insurance is a common example of risk transfer. When an individual buys insurance, they are protecting themselves financially from physical damage or bodily harm. For example, car insurance provides financial protection in the event of a traffic incident.
An insurance contract passes the responsibility for the insured risk to another party. The insurance company agrees to take on the risk for a fee, usually an insurance premium. In the event of a loss, the insurance company will indemnify the policyholder up to a certain amount.
Yes, insurance companies can transfer risk to reinsurance companies. Reinsurance companies provide insurance to insurance firms, helping to protect them against loss from catastrophic events.
Outsourcing is a form of risk transfer. By outsourcing a project to another party, a business can shift the risks involved to a more competent entity. This allows the business to focus on areas where it is more competent.
