What is 'Transfer Of Risk'

Transfer of risk is the underlying tenet behind insurance transactions. The purpose of this action is to take a specific risk, which is detailed in the insurance contract, and pass it from one party who does not wish to have this risk, the insured, to a party who is willing to take on the risk for a fee, or premium, the insurer. For example, whenever a person purchases home insurance, he is essentially paying an insurance company to take the risk involved with owning a home.

BREAKING DOWN 'Transfer Of Risk'

Risk may be transferred from individuals to insurance companies or from insurers to reinsurers.

Risk Transfer to Insurance Companies

When purchasing insurance, an insurer agrees to indemnify a policyholder up to a certain amount for a specified loss in exchange for a monthly, semi-annual or annual premium. For example, a woman buys a $1 million life insurance policy so her husband and children may maintain their standard of living and the children may attend college if she dies prematurely.

Risk pooling is the basis of risk transfer for insurance companies. A typical company collects millions of dollars in premium payments annually. The insurer uses the money for meeting its expenses and paying death benefits. Because death claims may be substantial and cost the company large amounts of money, insurers rely on actuarial statistics and other information when projecting the number of people who may die in a given year. Because the number of expected deaths is relatively small, the company expects its total premium payments to exceed the amounts paid in death benefits. For this reason, an insurer’s chances of sustaining financial loss after a policyholder’s death is minimal compared to a family’s odds of suffering financial loss when an income-earning member dies.

Risk Transfer to Reinsurance Companies

Because insurance companies often take on more risk than the capital they possess for paying death claims, insurers often pass on some of their risk to reinsurance companies. For example, an insurance company without reinsurance may write $10 million in limits on any given policy. With reinsurance, however, the company may cede part of the limit exceeding $10 million to the reinsurer and insure policies for greater amounts. If the insurance company pays a claim in excess of $10 million, the reinsurer pays the insurer part of the excess as stated in the contract.

Example of Risk Transfer

Because buying a home may lead to a large financial downfall, most homeowners purchase home insurance. Premiums are calculated based on where the home is located; the age, size and construction type of the home; the home’s replacement value and other factors. Shopping around for an affordable home insurance company with financial stability, adequate home values, rapid claims, discounts for upgrades and other benefits is recommended.

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