What is Transfer of Risk?
A transfer of risk, considered the underlying tenet of insurance transactions, is a risk management technique where risk shifts from one party to another. Risks may transfer between individuals, from individuals to insurance companies, or from insurers to reinsurers. For example, when a person purchases home insurance, they are paying an insurance company to assume the risks associated with homeownership.
BREAKING DOWN Transfer of Risk
When purchasing insurance, the insurer agrees to indemnify a policyholder up to a certain amount for a specified loss in exchange for payment. In general, most insurance companies collect millions of dollars in premiums annually. The premiums compensate the insurance provider for administrative and operating expenses, death or other benefits they must pay out, and profits for the company.
Since claim payouts may be substantial, insurers rely on actuarial statistics and other information when projecting the number of deaths per year. Because this number is relatively small, the company anticipates total premiums received to exceed death benefits paid. Furthermore, an insurer’s probability of sustaining financial loss after a policyholder’s death is minimal compared to the likelihood of a family suffering financial loss when an income-earning member dies.
Risk Transfer to Reinsurance Companies
When insurance companies assume too much risk, they often transfer some of that risk to reinsurance companies. For example, an insurance company without reinsurance may write $10 million in limits on a policy. With reinsurance, the insurance company can underwrite policies for higher amounts as they cede part of the ceiling exceeding $10 million to the reinsurer. If the insurance company pays a claim exceeding $10 million, the reinsurer pays the insurer part of the excess as stated in the contract.
Property Insurance Risk Transfer
Purchasing a home is likely the most significant purchase an individual will make. To protect their investment, most homeowners will buy homeowners insurance. With homeowners insurance, associated risks transfer from the homeowner to the insurer.
Insurance companies assess risks to determine insurability and premiums. For example, underwriting insurance for a customer with a compromised credit profile and several dogs is riskier than insuring someone with a perfect credit profile and no pets. The policy for the first applicant will command a higher premium because the transfer of risk from the applicant to the insurer is higher.