Transfer of Risks: Definition & How It Works
Businesses rely on critical connections with customers, suppliers, vendors, and contractors. Agreements are reached and written contracts are negotiated in these situations.
Contracts where one party agrees to take over the obligations of another party are becoming more common. Business owners that are savvy understand the advantages of assigning potential liability to others and arranging contracts in their favor. What does this mean for a company’s bottom line, though?
This is where a transfer of risks comes into play.
But what exactly is a transfer of risks?
Read on as we take an in-depth look at everything you’ll need to know.
Table of Contents
- A transfer of risk moves responsibility for future potential losses from one individual to another.
- The insurance industry is built on the business model of accepting and managing potential risks.
- Transfer of risk works effectively since many risks can go beyond what most businesses and individuals can handle.
What Is Transfer of Risk?
A transfer of risk is a type of business agreement that’s put together. It works by having one party pay another party to take on the responsibility for potential financial risks and business risks. Basically, the party that is paid agrees to mitigate specific losses that may or may not occur.
In a lot of ways, the transfer of risk plays a big role in the insurance industry, especially when it comes to risk assessment. A variety of risks can be transferred from individuals to insurance companies, between two individuals, or even from an insurer to a reinsurer.
For example, when a homeowner purchases property insurance, they’re basically paying an insurance company to take on potential risks that can come with homeownership. This plays a big role in potential financial losses from an adverse outcome.
How the Transfer of Risk Works
If you were to go and purchase insurance, the insurer you purchase it from would agree to compensate you up to a certain amount. This is in the case of a specified loss, or even losses, and is in exchange for your payment.
The easiest way to think about how the transfer of risk works is with insurance companies. They undergo an assessment of risk and collect premiums that are paid on policies from millions of customers. By doing this, they generate a pool of cash that’s then available to cover potential costs of damage to property or destruction. And this can be for a business owner or an individual.
It works well because there is often only a small percentage of policyholders that need to have their insurance cover damage. As well, premiums that get paid also cover operating and administrative expenses, which in turn generate the company’s profits.
The insurance contract is a common method to ensure customers have insurance for accidents and it’s also common in the life insurance industry. Purchasing insurance premiums is based on statistics that can forecast the number of death claims that might have to get paid each year, or the burden of risk.
Since this number can be low, the insurance company establishes its premiums at a higher level to help exceed the death benefits.
Risk Transfer to Reinsurance Companies
Even though insurance companies regularly rake on risk, some risks are just too big to handle alone. This is where reinsurance comes into play.
If there comes a time when an insurance company doesn’t want to or isn’t able to assume a lot of risks, they then transfer the excess risk to a reinsurance company. The complexity of risk can vary and often it can depend on the current risk status.
For example, one insurance company might regularly have policies that limit its maximum liability to $5 million. However, if it takes on additional policies that have a need for higher maximum amounts, it can transfer the excess risk to a reinsurer. This can be important if a major loss ends up occurring from common risk.
Ways to Transfer Risk
There can be a few ways to undergo the process of transferring risk. One of the main ways is through an insurance policy, which is the most common method. When a policyholder takes out insurance from an insurance agent, they transfer financial risks to the insurer.
In exchange for doing this, the insurance companies often charge a fee, or the insurance premium.
Another way to transfer risk is through indemnification clauses in contracts. The contracts would include a clause that outlines assurances for potential losses. It will specify that any potential losses will be compensated.
It’s worth mentioning indemnification clauses are separate from insurance coverage. They can also get referred to as a save-harmless clause or a hold-harmless clause.
Benefits of Transferring Risk
By transferring risk, you can remove any liabilities from your business and have an insurance company look after them. This is done through insurance or a contract with an indemnification clause.
If you don’t have these in place then an injury or property damage caused by a third-party can lead to a claim situation. Undergoing risk transfer properly will help allocate risk equitability. Plus, it will designate certain risk responsibilities for certain parties.
Ultimately, the biggest benefit of transferring risk is to protect your business from financial liabilities.
Transfer of Risk Example
One of the most common examples of risk transfer happens with property owners. For example, a commercial property owner faces a wide range of potential risks and challenges with their tenants.
This is why most property owners include an indemnity clause or hold-harmless agreement. Having these in place releases you from general liabilities or any consequences that arise from the actions of a tenant.
Taking out an insurance policy and paying an insurance premium is meant to provide peace of mind. When you do this, you’re basically transferring risk from yourself to the insurance carrier. For example, by taking out homeowners insurance, insurance liabilities are then covered by the insurer if property damage or physical damage occurs.
It also works the same way in life insurance to help provide insurance for accidents should death benefits happen. If the risk becomes too great, there can be a management of risk from insurance companies to a reinsurer.
Frequently Asked Questions
What Are the Two Forms of Risk Transfer?
The first form included in risk transfer is the insurance policy. The second is the indemnification clause that’s included in the contracts. These contracts can be helpful to help an individual transfer risk.
Why Do You Transfer Risks?
Essentially, the main purpose of risk transfer is to pass the financial liability, such as legal expenses or damage costs, to an insurer that would be responsible should something happen. It’s common in the insurance industry.
What Is the Difference Between Risk Sharing and Risk Transfer?
Basically, transferring risk means putting the responsibility of handling the liabilities or damages that come with a potential risk to a third party. Risk sharing, on the other hand, involves the need to cooperate with another party to increase the probability of risk.
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