What it means
Every business faces events that could cost it money, such as fire, a lawsuit, a customer default or a swing in exchange rates. Transfer of risk is one of the four standard responses, alongside avoiding the risk, reducing it and accepting it.
Insurance is the clearest example. The business pays a premium and the insurer agrees to pay for specified losses, which turns an uncertain and possibly crippling cost into a known and manageable one.
Contracts do the same job in less obvious ways. A construction contract can make the subcontractor responsible for defects, a lease can make the tenant responsible for repairs, and an indemnity clause can oblige one side to cover the other's losses from a named event.
Financial instruments also move risk. A company that fixes the price of fuel with a forward contract, or buys an option to cap an interest rate, pays to pass price movement to a counterparty that is willing to bear it.
The nuance is that risk is rarely transferred in full. Policies have exclusions and limits, counterparties can fail to pay, and reputation damage cannot be handed over at all, so a sensible plan checks what is left behind after the transfer.
A good habit is to list each major risk and write beside it who ultimately pays if it happens. Cost matters as well.
The price of the transfer will usually exceed the average loss, because the other party needs to cover its own costs and earn a margin, and the business should only buy cover when the protection is worth that extra cost.
In practice
Real-world examples.
Example
A restaurant owner buys public liability insurance for $3,000 a year. If a customer is injured and sues, the insurer handles the claim, so a claim of $200,000 would not threaten the business. The owner also keeps a small deductible fund for minor incidents that the policy will not cover.
Example
A small exporter agrees a contract to sell in dollars rather than in the buyer's currency. The exchange-rate risk has been transferred to the buyer, who will bear any swing in the value of their own currency.
Example
A software company hires a specialist payment processor to hold customer card data. By outsourcing, it transfers much of the security and compliance risk, although it remains answerable to its customers. The contract with the processor spells out who pays if a breach occurs, and the company checks that the processor has enough capital or insurance to honour that promise.
Formula
Calculation
A simple way to judge the price of transferring a risk is to compare the premium with the expected loss:
Expected loss = Probability of loss x Size of loss
Loading = (Premium - Expected loss) / Expected loss
An illustrative warehouse is worth $1,000,000 and has a 2% chance of being destroyed in a year, so the expected loss is 0.02 x $1,000,000 = $20,000. An insurer quotes a premium of $26,000. The loading is ($26,000 - $20,000) / $20,000 = 30%, which is the margin the buyer pays for certainty. Whether this is worth paying depends on whether the business could survive a $1,000,000 loss without the cover.Case study
Seen in the real world.
Larkfield Bakeries is an illustrative, fictional chain of 12 bakeries that relied on a single flour mill. The owner realised that a fire or a flood at that mill could stop production for weeks, and that a stoppage would cost about $400,000 in lost sales.
Her finance manager priced three options. Business interruption insurance cost $14,000 a year, a second supplier would raise ingredient costs by about $30,000 a year, and holding extra stock of flour would tie up cash.
The owner chose insurance for the large, rare event and a modest buffer stock for small delays. In this illustrative story the cover was never used, but the lender cited it as a reason for offering better loan terms, so the premium paid for itself indirectly. The owner now reviews the policy limit every year against sales, because a limit that was adequate for 12 shops may fall short once the chain grows.
Watch out
Common mistakes.
- Believing that transferring a risk removes it, when the original business may still bear the reputational and operational fallout.
- Buying insurance without reading the exclusions, so the event that actually happens turns out to be uncovered.
- Relying on a contract indemnity from a party with no money, which gives no real protection.
Questions
People also ask.
Is transfer of risk the same as risk avoidance?
No, because avoidance means stopping the activity, while transfer keeps the activity going and hands the financial consequences to someone else.
What are common ways to transfer risk?
Insurance, contractual indemnities, outsourcing, guarantees, hedging contracts and surety bonds are the usual routes.
How do you know if the cost is worth it?
Compare the price with the likely loss and ask whether the business could survive the worst case without the cover. If the answer is no, the cost is usually justified even when the loading looks high.
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