DEFINITION of Mutualization Of Risk
Mutualization of risk is 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 risk.
BREAKING DOWN 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.
- 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.
- 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.
- An 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 risk. 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 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 want 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.