Transfer of Risk Definition and Meaning in Insurance

What Is Transfer of Risk?

A transfer of risk is a business agreement in which one party pays another to take responsibility for mitigating specific losses. This is the underlying tenet of the insurance industry.

Risks may be transferred between individuals, from individuals to insurance companies, or from insurers to reinsurers. When homeowners purchase property insurance, they are paying an insurance company to assume specific risks associated with homeownership.

Understanding Transfer of Risk

When purchasing insurance, the insurer agrees to compensate the policyholder up to a certain amount for specified losses in exchange for payment.

Key Takeaways

• A transfer of risk shifts responsibility for losses from one party to another for payment.
• The basic business model of the insurance industry is the acceptance and management of risk.
• This system works because some risks are beyond the resources of most individuals and businesses.

Insurance companies collect premiums from customers every year, providing a pool of cash to cover costs of damage or destruction to their customers’ properties. Premiums also cover administrative and operating expenses and provide the company’s profits.

Life insurance works similarly. Insurers rely on actuarial statistics and other information to project the number of death claims it can expect to pay out per year. Because this number is relatively small, the company sets premiums to exceed death benefits.

Reinsurance companies accept transfers of risk from insurance companies.

The insurance industry exists because few individuals or companies have the financial resources necessary to bear the risks of loss on their own. They transfer the risks.

Risk Transfer to Reinsurance Companies

Some risks are too big for insurance companies to bear alone. That’s where reinsurance comes in.

When insurance companies don’t want to assume too much risk, they transfer the excess risk to reinsurance companies. For example, an insurance company may write policies that limit its maximum liability to $10 million but take on policies requiring higher maximum amounts and then transfer the excess risk to a reinsurer. This subcontract comes into play only if a major loss occurs.

Property Insurance Risk Transfer

Purchasing a home is the most significant expense most individuals make. To protect their investment, most homeowners buy homeowners insurance. With homeowners insurance, some of the risks associated with homeownership are transferred from the homeowner to the insurer.

Insurance companies assess their business risks to determine whether a customer is acceptable and at what premium. Underwriting insurance for a customer with a poor 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 of the higher risk being transferred to the insurer.