People normally face increased health risks as they become older. The act of detecting, assessing, and subjugating risks is known as pure risk management, and it is a defensive approach for anticipating the unexpected. Risk management’s core principles—avoidance, retention, sharing, transferring, and loss prevention and reduction—may be applied to all aspects of a person’s life and can pay off in the long term.
What is Risk Transfer in Insurance?
Risk transfer is a risk management method that involves transferring risk to a third party. To put it another way, risk transfer entails one party taking on the responsibilities of another. Purchasing insurance is a typical way for an individual or business to shift risk to an insurance company.
How does Risk Transfer in Insurance works?
Risk transfer is a popular risk management method in which an individual or entity’s potential loss from an undesirable result is moved to a third party. To compensate the third party for taking on the risk, the individual or business will usually make monthly payments to the third party.
Insurance is the most frequent kind of risk transfer. When a person or a company buys insurance, they are protecting themselves against financial risks. A person who buys vehicle insurance, for example, is purchasing financial protection against physical damage or bodily harm that might occur as a consequence of traffic accidents.
As a result, the individual transfers the risk of serious financial loss from a traffic accident to an insurance provider. The insurance provider would usually need monthly payments from the individual in return for taking on such risks.
What Are the Methods of Risk Transfer?
There are two methods of transferring risk:
1. Insurance policy
Purchasing insurance, as previously said, is a common way of risk transfer. When a person or an organization buys insurance, they are transferring financial risks to the insurance provider. For taking on such risks, insurance firms generally charge a fee – an insurance premium.
2. Indemnification clause in contracts
Contracts can also be used to assist a person or organization in transferring risk. Contracts can include an indemnity clause, which assures that the opposite party will cover any possible damages. In its most basic form, an indemnity clause is a clause in which the contracting parties agree to compensate each other for any injury, responsibility, or loss incurred as a result of the contract.
Consider a client who signs a contract that has an indemnification clause. The indemnification clause says that the contract writer is responsible for any copyright claims made against the customer. As a result, if the client gets a copyright claim, the contract writer would be responsible for (1) covering the expenses of fighting against the copyright claim and (2) copyright claim damages if the client is held culpable for copyright infringement.
Risk Transfer by Insurance Companies
Although the risk is usually transferred from persons and businesses to insurance firms, insurers can also transfer risk to others. This is accomplished through the use of a reinsurance policy. Companies that provide reinsurance to insurance businesses are known as reinsurance companies. Insurance businesses can shift risk by acquiring insurance from reinsurance firms, similar to how people or entities acquire insurance from insurance companies. Reinsurance firms charge insurance companies an insurance premium in exchange for getting on this risk.
Risk Transfer vs. Risk Shifting
The terms risk transfer and risk-shifting are frequently used interchangeably. To summarise, risk transfer refers to the act of shifting risk to a third party. Risk shifting, on the other hand, is altering (or “shifting”) the distribution of dangerous outcomes rather than passing the risk on to a third party.
An insurance policy, for example, is a risk transfer technique. Risk shifting is accomplished by purchasing derivative contracts.
What is Risk Response in Insurance?
The process of managing identified risks is known as risk response. It’s the first stage in any Risk Management strategy. Risk response is a planning and decision-making process in which stakeholders determine how to respond to various risks. The fundamental types of risk responses are as follows.
8 types of Risk Response
- Avoidance refers to avoid engaging in activities that may be harmful to your health; smoking is an excellent example.
- Retention recognizes the inevitability of some risks, and in the case of health care, it may imply choosing a less costly health insurance plan with a larger deductible rate.
- The concept of risk sharing may be applied to how employer-provided benefits are frequently less expensive than purchasing individual health insurance.
- In healthcare, risk transfer refers to the transfer of the cost of care from the individual to the insurer, in addition to the cost of premiums and a deductible.
Avoidance is a risk-reduction strategy that involves avoiding engaging in activities that might result in damage, illness, or death. One such behavior is smoking cigarettes, which can have both health and financial consequences if avoided.
According to the American Lung Association, smoking is the biggest avoidable cause of death in the United States, claiming over 480,000 lives each year. Furthermore, according to the US Centers for Disease Control and Prevention, smoking is the leading cause of lung cancer, with the risk increasing as people smoke for longer periods of time.
Smokers’ rates are higher than nonsmokers’ premiums, therefore life insurance firms minimize this risk on their end. Health insurers can raise rates depending on age, region, family size, and smoking status under the Affordable Health Care Act, often known as Obamacare. The law provides for a premium fee of up to 50% for smokers.
In ERM terms, this implies taking actions to limit the possibility or effect of a loss. Reduce is a suitable technique for lowering the risk down to within acceptable bounds if the risk is only slightly beyond your appetite and tolerance level.
On a personal level, we all use risk reduction in our everyday lives in some way. When we get in our automobile to go someplace, we buckle up to decrease the risk of an accident.
However, keep in mind that this action does not lower the likelihood of an accident occurring; if that is your aim, you should just stay at home.
Spending too much to mitigate risk in the company can be a waste of time and money.
Related: What Are Insurance Return Checks
To give you an example, I’m going back to my first work as a grocery store cashier.
A cashier’s main job is to ensure that your drawer balances at the conclusion of each shift. We were given some leeway at my store, particularly an “over/under” of up to $3, which meant that if my drawer was missing $1.80, the business would simply write it off. It was reassuring to know I had this cushion, but if this happened on a regular basis, the business would be suspicious.
Let’s pretend there was simply a 2 cent over/under range…
Is it more economical to pay someone their hourly rate to track down 50 cents or a $1, or is it better to accept that you’ve lost a dollar?
Spending too much time on small issues may be unproductive, as you can see from this example, so keep that in mind while selecting this risk answer.
Unlike choices 1 and 2, this option delegated or transferred responsibility for the risk to a third party rather than eliminating or reducing the odds of it occurring. Purchasing storm insurance can not prevent or lessen storm damage, but it does provide a financial safety net in the event that damage does occur.
In addition to insurance, indemnity clauses in contractual agreements, which are often included in construction and service job contracts, rental contracts, purchase order agreements, leasing agreements, consultancy agreements, and more, are another typical way for transferring risk. Both of these and insurance policies are designed to make you whole if a covered hazard (or event) occurs.
One thing to keep in mind with this option: it only kicks in after the event, and intangible risks like reputation and skill cannot be transferred to a third party, as we’ve addressed in numerous articles since the original piece.
Finally, when it comes to managing business risks, the objective of risk transfer is to decrease the (primarily financial) effect if something goes wrong. As a result, the firm is ready to take a chance on the risk occurring.
There will very certainly be additional risks outside your tolerance range for which one of the other response choices will not be a suitable match because the chance and/or effect are so low that it makes no sense to spend resources avoiding, transferring, or reducing the risk.
In situations like this, you can just take the danger and do nothing…yes, you read it correctly…nothing! To put it another way, risk acceptance is a choice that needs no action on the part of the individual.
Emerging hazards, or those that might pose a concern in the not-too-distant future, are examples of this type of risk.
You’re still accepting the part inside your appetite if you decrease danger. When you shift risk to insurance, you still take a portion of the risk in the form of monthly premiums and deductibles/retentions. Only when a covered incident surpasses this amount will your insurance kick in to pay your losses.
By default, you’re employing a mix of the decrease (mitigate), transfer, and/or accept risk response strategies unless you’re completely avoiding the risk.
Employer-based benefits that allow the firm to pay a percentage of the employee’s insurance premiums are frequently used to share risk. In essence, the firm and all employees who participate in the insurance benefits share the risk. The idea is that as more people share the risks, premium costs would decrease proportionally. Individuals may find it advantageous to engage in risk sharing by selecting employer-sponsored health and life insurance policies wherever possible.
Getting prepared to deal with the danger if it arises. Backout processes, for example, can restore a system if a launch fails.
A response to a positive risk is enhancement. Finishing work early or under budget may be viewed as a positive risk by project management techniques. Enhancement is a step performed to enhance the likelihood of a danger occurring.
Another therapy for risks that are positive. Exploiting a risk entails taking advantage of resources that become accessible as a result of the risk. If a job is completed early, for example, you intend to shift the resource to other tasks.
A risk response may evolve over time, as we discussed in the introduction, and this is much more true now than it was when this article was initially published. Risk monitoring should be done on a regular basis to determine which response methods should be changed and when.
What criteria does your firm use to select risk response strategies? Do you adopt a conservative, risk-averse attitude, or do you take the opposite way?