What Is Mutualization of Risk?
The mutualization of risk is the process of dividing up exposure to potential financial losses among several insurance policyholders, investors, businesses, organizations, or people. Mutualizing risk lowers the overall potential for significant financial loss to any one entity. However, it also lowers the potential pay-off to the single entity since the rewards must be shared among other parties taking on some of the risks.
- The mutualization of risk is a reference to the sharing of the costs and financial risks that are often necessary for business between a group of investors or businesses.
- The process is designed to limit the scope of the financial loss that any one particular company might face, and therefore spread that risk to several parties.
- However, by taking on less risk, the parties in question are also primed for less reward, as any benefits must be shared with the group, as well.
Understanding the Mutualization of Risk
Mutualization of risk commonly refers to spreading insurance loss risk over hundreds or thousands of individual policyholders, but the term can be broadly applied in many other business situations.
Based on the concept of a joint venture, mutualization of risk is a tool often used in oil exploration, which is an expansive, lengthy process that may not result in profitable discovery. For example, an energy company's geological surveys suggest that a large natural gas deposit exists at a certain spot. It wants to drill but the financial risk is too high for it alone. The company, therefore, seeks a joint-venture partner to take on half the risk in return for half of the potential profits should their exploration be successful.
The mutualization of risk is derived from a joint venture business arrangement, in which two or more parties agree to work together and combine resources to accomplish a task or develop a new product or business.
Examples of Mutualization of Risk
Here are additional examples of the mutualization of risk, as applied to different industries.
A corporate bank has won the lead role to underwrite a term loan for a company. The loan is too large for the bank to place on its own books, so it forms a syndicate whereby several other banks agree to extend part of the total credit to the client. Each syndicate member now has some risk exposure to the term loan.
A property and casualty (P & C) insurance company is interested in underwriting a policy that would cover significant property losses from a natural disaster. It approaches a reinsurance company to share some of the risks. The reinsurer agrees to some risk transfer in return for premium payments from the primary insurer.
A venture capital investor is considering funding a start-up. However, due to the high failure rates of start-up companies, it does not want to invest too much on its own. It persuades other venture capital investors to go in on the deal to spread out the risk.
An investment bank wants to purchase a failing financial institution. It covets the target's assets but does not like the extent of its liabilities. The investment bank seeks mutualization of risk with the federal government for the liabilities. The government agrees to backstop potential losses to the bank.