Updated July 17, 2023
Introduction of Risk Transfer
Risk Transfer is a term used in the industry to define the concept of risk management, which means the transfer of risk, precisely future risk, from a person, being individual or corporate, to another person such that in case the event may happen/occur in the future. In a few words, it means transferring the risk of a future event, may or may not happening, to another party.
Explanation
It is a risk management mechanism to shift the responsibility of a potential unfavorable outcome against any financial risks. The risk transfer is basically for future events, which involves a contractual arrangement between two parties, wherein one party pays a premium to another party, to mitigate any financial losses on account of any loss or damage to the product for which such risk management is being undertaken.
How Does It Work?
Let us understand how does this concept of risk transfer work in real life. A classic case of risk transfer will be in the case of insurance. Any type of insurance is the best example for risk transfer.
In the case of insurance, an insurance policy is an agreement or arrangement entered into by an individual or company, referred to as a policyholder, with an insurance company. By entering into such an agreement, the policyholder gets an insurance cover for against any potential financial loss or damage, for which the insurance is taken, from the insurance company. In order to buy insurance, the policyholder has to pay an insurance premium amount, either one time or annually, as the case may be, in order to keep his insurance policy active.
Real Life Examples of Risk Transfer
In practical scenarios, it is very easy to relate with insurance taken for a motor vehicle. Say, Mr. Peter, has taken insurance cover for his motorbike for $1000 cover. This insurance will be covering any physical damage to the vehicle, roadside assistance and will be valid for a year from the date of purchase, say 31 December 2021.
Now, suppose his motorbike had some physical damage and Mr. Peter incurred an amount of $500 for the cost of repairing his motorbike. In such a case, he will be able to claim $500 from the insurance company, as his total cover for the vehicle is $1000.
Types of Risk Transfer
Risk transfer can be of mainly three types, namely, Insurance, Derivatives, and Outsourcing.
- Insurance: In the case of Insurance, there is an insurance policy issued by the company, the risk bearer, to the policyholder, to compensate for the specified risks to the insured asset of the policyholder. Insurance can be taken for insuring against an asset, property, health, and life.
- Derivatives: Derivatives means a financial asset that derives its values from the value of its underlying asset. The underlying asset can be anything, such as a financial product, interest rate, commodity etc. Any change in the value of the underlying asset will bring in a change to the value of the derivative. Most commonly derivative products are used for hedging against certain financial risks.
- Outsourcing: Outsourcing means transferring an assignment or work or project to another party for a specified set of conditions set as per the contract between both parties. It enables the transfer to risk associated with such outsourced assignment.
Reasons for Transferring Risk
The main reason for risk transferring is shifting or transferring to another party, to take the responsibility of mitigating any financial risk on account of any loss or damage, which may occur in the future.
Yes, it is possible that any untoward incident may not occur in the future and in such cases the premium paid to mitigate such risks shall get lapsed.
Risk Transfer Agreement
A risk transfer agreement is an agreement between two parties involved, detailing the terms and conditions of the contractual agreement and the same shall be binding on both the parties.
Such agreements are in written, rather than oral and specify all the conditions under which the insurer shall bear the financial loss and to the extent to which it shall bear.
It also gives out the details regarding the periodic payments to be made, also referred as premium amount, to be paid by the policyholder, the cover, the situations or conditions under which the policyholder shall be eligible to receive financial compensation against any damage to the asset insured. Further, it evens details the procedure for claiming such reimbursement of financial loss, which the policyholder has borne, against the damage to the asset.
Benefits of Risk Transfer
Risk transfer has its shares of benefits. Certain benefits are listed below:
- The individual or company is safeguarded against any unforeseen future risks
- It helps in covering the financial losses at least to the extent of policy coverage
- It saves the person from unexpected and huge financial burdens by paying a small amount
- The clauses are mostly standard and thus does not bring in ambiguity in claims
- The terms are fixed and are not subject to any changes in market conditions
Disadvantages
Though risk transfer has its own advantages, it does come with its shares of disadvantages.
Some common disadvantages are mentioned below:
- It creates an additional expense for the asset holder
- It comes with limited coverage
- The additional cover requires additional expense
- The company, to which risk is being transferred, needs to be solvent
- The company takes time to settle the claims
- In certain cases, it is mandatory to follow a risk transfer mechanism
Conclusion
Briefly, we have discussed about what the term risk transfer refers to, its types, and the benefits and disadvantages it carries with it. To sum up the whole discussion, it would be right to say that, risk transfer is a way to transfer risk from one party to another party in exchange of a price, commonly referred to as premium, whereby the insurer bears the risk to do good against any financial loss of the policyholder in connection to the asset insured.
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