What is Transfer of Risk?
Transfer of risk refers to a business agreement, where one party pays money to another party to mitigate specific losses that may or may not occur. This is the base of the insurance industry.
Risks can be transferred between individuals, from individuals to insurance companies, or from insurers to reinsurers. When an insurance policy is purchased, the insurance company agrees to compensate the policyholder for specific losses in exchange for the premium received.
Breaking Down Transfer of Risk
Many people pay premiums to insurance companies every year, and this gives the insurance companies cash to cover the costs of damage caused to the properties and humans of a small percentage of its customers. The premiums received is also used to pay wages to the staff as well as handle other administrative and operational expenses. It also makes the profit earned by the company.
When it comes to life insurance, insurance companies research on the number of death claims it can expect in a particular year. Since this number is usually small, the companies set the premiums such that it will exceed the death benefits.
Not all individuals or companies will have the financial resources required to bear the risk of loss on their own. Therefore, they transfer risk to insurance companies.
Transfering Risk to Reinsurance Companies
When a risk is too big for an insurance company to bear on their own, they split the excess risk with reinsurance companies. Say, an insurance company can handle a maximum risk worth Rs.1 crore. However, it may still accept policies with a higher maximum amount and internally transfer the risk excess of Rs.1 crore to a reinsurer.
Illustration
Many middle-class individuals consider purchasing a house as the greatest investment. To protect this, homeowners go for homeowner's insurance and transfer the risks associated with owning a house to the insurer. The policy for the first applicant comes with a high premium due to the high-risk transfer associated.
