#risktransfer

Insurance companies do not transfer risks for numerous reasons. First, let’s talk about what transfer of risk is and how it works.

What Is Risk Transfer?

Business agreements that involve risk transfer are agreements whereby one party pays another to mitigate losses that may or may not occur. The insurance industry operates according to this tenet. Transfers of risk can occur between individuals, between individuals and insurers, or between reinsurers and insurers.

How It Works

A risk transfer is a risk management technique in which individual or corporate loss is shifted to a third party if there is an adverse outcome. Third parties have compensations for bearing risks by periodic payments from individuals or entities. Insurance is a typical example of risk transfer. A person or entity purchasing insurance is protecting itself against financial risks. Car insurance, for example, provides financial protection for individuals in case of traffic accidents that could result in bodily damage or injury. As a result, the person is shifting the risk of a traffic collision resulting in significant financial losses to the insurance company. Individuals will generally need to pay a periodic premium to the insurance company to cover these risks.

Methods Of Risk Transfer

In general, there are two methods of transferring risk:

Insurance Policy

Purchasing insurance is a standard method for transferring risk. In purchasing insurance, an individual or entity is shifting financial risk to the insurance company. Such risks typically incur a fee – an insurance premium – from insurance companies.

An Indemnification Clause In Contracts

Additionally, contracts are for transfer risk from one entity to another. An indemnification clause in an arrangement ensures that the opposing party will compensate for potential losses. By definition, an indemnification clause says that parties to the contract will pay each other if they suffer harm, liability, or loss.

Why Do We Not Transfer All Risks By Using Insurance?

Insurance companies can’t and won’t accept the transfer of all risks for many reasons. It is essential to know that there are two types of risks: pure risks and speculative risks. Insurance companies do not insure theoretical risks. An investment that could prove beneficial if it fails is investing in a business and insuring against it failing. Risks based on speculation are not covered by insurance since they are the upsides and downsides that every business owner faces. However, companies may bet on a fall in the currency to increase profits when money drops. However, that is not insurance as we understand it. A common term for this strategy is “hedging your bets.”

In years past, risk was financed and transferred strictly through guaranteed cost insurance. As insurance capacity crises grew during the 1970s and through the 1990s, alternative risk transfer (ART) techniques emerged as a different route to take for transferring and financing risk. Alternative risk transfers are a series of techniques that leverage both insurance and retention to manage risk.  Although these techniques may be complex, organizations of varying sizes can implement a certain form of it to serve as a benefit. In this article, we are going to go over some common alternative risk transfer techniques to think about practicing and including into your risk management strategy.

Self Insurance

One of the most common and well-known techniques is an organization handling its own losses by tracking and paying out of pocket for themselves. Self-insurance involves retaining the most risk out of the other techniques mentioned later, but allows an organization to benefit with their cash flow due to paying with its own rather than paying for coverage, which has a premium attached to it. This allows for the organization to save money rather than lose out on paying premiums to an insurance provider. Organizations can also mix and match what they self insure. Many organizations will self insure up to a certain threshold then purchase a policy that covers excess in the event of a very severe loss. Efficiency can be generated from self-insurance if organizations experience a large volume of losses due to avoiding the claims process with an insurer. Self-insurance allows for complete control of the claims process as well as avoidance of any policy conditions that could tack on extra fees.

Captives

Captives are another technique that has seen its popularity rise for transferring and financing risk. A captive is a subsidiary that is created to insure the parent company. Captives can be owned by a single parent company or a group of companies. Group captives are pools of like-minded companies that share exposures and financial costs together in the event of a loss from any of the included organizations. Single parent captives are used more as a formal retention plan and cover exposures of the parent company and any child companies. Captives are an alternative for organizations that may not be able to insure their exposures in the traditional insurance world due to high risk or current loss history. Same examples of industries that form captives are medical practices and real estate. Captives are not subject to any policy conditions or changes either, which can allow for a wider range of coverage. Captives can take advantage of different tax codes around the world to save money as well.

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