What is Transfer of Risk?

Malcolm Tatum

A transfer of risk is a situation in which one party assumes the risk associated with a particular transaction or event that is currently carried by another party. Most often, the term is related to the coverage offered by insurance companies, or investment settings in which the purchaser of a security assumes all or a portion of the risk carried by the issuer of that security. Depending on the circumstances, a transfer of risk may be in effect for a short period of time, or be an ongoing phenomenon that spans a number of years.

Man climbing a rope
Man climbing a rope

In terms of insurance transactions, the coverage provided by the carrier effectively reduces the transfer of risk that would otherwise be carried by the holder of the policy. With health insurance, the holder is basically paying the insurance provider to assume the risk that the holder may require costly medical services at some point in the future. In like manner, the issuer of an auto insurance policy is taking on the risk that a driver could be involved in a serious accident that totals a covered vehicle and costs a great deal to replace.

With international trading situations, the transfer of risk is often connected with the potential for a central or national bank within a given nation to not accept currency issued by a different country or select group of countries. This could be due to a government mandate that declares the currency inconvertible, or possibly due to changes in the internal banking structure of the nation that leads to disallowing the acceptance of particular currencies. Here, the party assuming the risk would take on the task of converting the currency to one that is acceptable and completing the transaction.

There are usually some provisions that limit the transfer of risk. For example, home insurance policies may specifically disallow events that are more likely to take place than others. This may be in the case of the provider excluding wind damage if the insured property is located in an area that is prone to hurricanes or tornadoes. In like manner, health insurance may restrict coverage on any pre-existing health issues, either permanently or for a specific period of time after the activation of the coverage. In this manner, the party who serves as the recipient in a transfer of risk can have some control over the degree of risk that is assumed, keeping it within a range that is considered acceptable.

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