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"Risk transfer" and risk financing

NEWS_PUBLISH_DATE 23 April 2018

Insurance is often described as a means of transferring risk. The reason to consider in such a light can be seen in the following two examples.

Example 1

Let's introduce a car owner: he owns a car worth 12,000 Brits. pounds, which is one of the biggest investments he will ever make. The car may be stolen, damaged in an accident or cause a fire. An accident is possible that can cause serious injury to passengers or other people. How will the car owner deal with all these potential risks and their financial consequences if they occur? He does not know if some of them will ever be realized and if that happens, what will be the probable costs. There may be no accident at the end of the year or the car may be completely destroyed tomorrow! Insurance alone cannot prevent any of the risk events from occurring: what it will do is provide some form of financial security. The owner of the car can transfer the financial consequences of the risk to the insurer, against payment of a certain premium.

Example 2

The managing director of a company knows that it is exposed to a whole series of risks. He does not know if some of them will occur and if so, what the likely costs will be. How then will he be able to run his business? If there is a loss, the company will have to cover its costs at the expense of its customers by increasing the price of the product it creates or the services it provides. What costs will the company transfer? The company has no idea if there will be a loss at all, or what its value will be. The function that insurance performs in this case is that of a risk financing mechanism.

In return for a certain loss, such as the premium, a release from the uncertainty of a potentially much larger loss is achieved. The risks themselves are not eliminated, but the financial consequences of some of them are already known with greater certainty and can be financially secured accordingly.

It is clear that the risk as such remains with the business entity or the owner of the house, who are exposed to the risk, but effective arrangements can be made in advance to overcome the financial consequences of a potential risk event. The "risk transfer" phase is a fairly free way of expressing that this possibility exists. Increasingly, the more accurate term is used - risk financing.

 

Source: David E. Bland "Insurance: Principles and Practice"