What is Risk Transfer?
Risk transfer refers to a risk management technique in which risk is transferred to a third party. In other words, risk transfer involves a party assuming the liabilities of another party. Purchasing insurance is a common example of transferring risk from an individual or entity to an insurance company.
How It Works
Risk transfer is a common risk management technique where the potential of an adverse outcome faced by an individual or entity is shifted to a third party. To compensate the third party for bearing the risk, the individual or entity will generally provide the third party with periodic payments.
The most common example of risk transfer is insurance. When an individual or entity purchases insurance, they are insuring against financial risks. For example, an individual who purchases car insurance is acquiring financial protection against physical damage or bodily harm that can result from traffic incidents.
As such, the individual is shifting the risk of having to incur significant financial losses in a traffic incident to an insurance company. In exchange for bearing such risks, the insurance company will typically require periodic payments from the individual.
Methods of Risk Transfer
There are two common methods of transferring risk:
1. Insurance policy
As outlined above, purchasing insurance is a common method of transferring risk. When an individual or entity is purchasing insurance, they are shifting financial risks to the insurance company. Insurance companies typically charge a fee – an insurance premium – for accepting such risks.
2. Indemnification clause in contracts
Contracts can also be used to help an individual or entity transfer risk. Contracts can include an indemnification clause – a clause that ensures potential losses will be compensated by the opposing party. In simplest terms, an indemnification clause is a clause in which the parties involved in the contract commit to compensating each other for any harm, liability, or loss arising out of the contract.
For example, consider a client that signs a contract with an indemnification clause. The indemnification clause states that the contract writer will indemnify the client against copyright claims. As such, if the client receives a copyright claim, the contract writer would (1) be obliged to cover the costs related to defending against the copyright claim, and (2) be responsible for copyright claim damages if the client is found liable for copyright infringement.
Risk Transfer by Insurance Companies
Although risk is commonly transferred from individuals and entities to insurance companies, the insurers are also able to transfer risk. It is done through an insurance policy with reinsurance companies. Reinsurance companies are companies that provide insurance to insurance firms. Similar to how individuals or entities purchase insurance from insurance companies, insurance companies can shift risk by purchasing insurance from reinsurance companies. In exchange for taking on this risk, reinsurance companies charges the insurance companies an insurance premium.
Risk Transfer vs. Risk Shifting
Risk transfer is commonly confused with risk shifting. To reiterate, risk transfer is passing on (“transferring”) risk to a third party. On the other hand, risk shifting involves changing (“shifting”) the distribution of risky outcomes rather than passing on the risk to a third party.
For example, an insurance policy is a method of risk transfer. Purchasing derivative contracts is a method of risk shifting.
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