Risk Transfer: Definition, Types & Examples | [Your Company Name]

Risk transfer refers to a risk managementRisk ManagementRisk management encompasses the identification, analysis, and response to risk factors that form part of the life of a business. It is usually done with technique in which risk is transferred to a third party. In other words, risk transfer involves one 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 loss from 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 from a traffic incident to an insurance companyProperty and Casualty InsurersProperty and casualty (P&C) insurers are companies that provide coverage on assets (e.g., house, car, etc.) and also liability insurance for accidents, injuries, and damage to other people or their belongings.. 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 premiumInsurance ExpenseInsurance expense is the amount that a company pays to get an insurance contract and any additional premium payments. – 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 indemnificationIndemnificationIndemnification is a legal agreement by one party to hold another party blameless – not liable – for potential losses or damages. 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. This is done through an insurance policy with reinsurance companies. Reinsurance companiesReinsurance CompaniesReinsurance companies, also known as reinsurers, are companies that provide insurance to insurance companies. In other words, reinsurance companies are companies that receive insurance liabilities from insurance 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 charge 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.

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to help anyone become a world-class financial analyst. To keep learning and advancing your career, the additional CFI resources below will be useful:

• ActuaryActuaryAn actuary essentially acts as the backbone of financial security for insurance and reinsurance companies, multinational corporations, and financial planners. The primary job of an actuary is to analyze risk and the costs associated with risks and uncertainty.
• Commercial Insurance BrokerCommercial Insurance BrokerA commercial insurance broker is an individual tasked with acting as an intermediary between insurance providers and customers.
• Safe HarborSafe HarborA safe harbor is a provision in law or regulation that affords protection from liability or penalty or reduces liability if certain conditions are met.
• SubrogationSubrogationSubrogation refers to the practice of substituting one party for another in a legal setting. Essentially, subrogation provides a legal right to a third