Insurance companies do not transfer risks for numerous reasons. First, let’s talk about what transfer of risk is and how it works.
What Is Risk Transfer?
Business agreements that involve risk transfer are agreements whereby one party pays another to mitigate losses that may or may not occur. The insurance industry operates according to this tenet. Transfers of risk can occur between individuals, between individuals and insurers, or between reinsurers and insurers.
How It Works
A risk transfer is a risk management technique in which individual or corporate loss is shifted to a third party if there is an adverse outcome. Third parties have compensations for bearing risks by periodic payments from individuals or entities. Insurance is a typical example of risk transfer. A person or entity purchasing insurance is protecting itself against financial risks. Car insurance, for example, provides financial protection for individuals in case of traffic accidents that could result in bodily damage or injury. As a result, the person is shifting the risk of a traffic collision resulting in significant financial losses to the insurance company. Individuals will generally need to pay a periodic premium to the insurance company to cover these risks.
Methods Of Risk Transfer
In general, there are two methods of transferring risk:
Insurance Policy
Purchasing insurance is a standard method for transferring risk. In purchasing insurance, an individual or entity is shifting financial risk to the insurance company. Such risks typically incur a fee – an insurance premium – from insurance companies.
An Indemnification Clause In Contracts
Additionally, contracts are for transfer risk from one entity to another. An indemnification clause in an arrangement ensures that the opposing party will compensate for potential losses. By definition, an indemnification clause says that parties to the contract will pay each other if they suffer harm, liability, or loss.
Why Do We Not Transfer All Risks By Using Insurance?
Insurance companies can’t and won’t accept the transfer of all risks for many reasons. It is essential to know that there are two types of risks: pure risks and speculative risks. Insurance companies do not insure theoretical risks. An investment that could prove beneficial if it fails is investing in a business and insuring against it failing. Risks based on speculation are not covered by insurance since they are the upsides and downsides that every business owner faces. However, companies may bet on a fall in the currency to increase profits when money drops. However, that is not insurance as we understand it. A common term for this strategy is “hedging your bets.”
Moreover, some risks may seem uninsurable if they are against the public interest or encourage loose morals. A good example would be insurance against having your driving license revoked due to repeated accidents. Since the consequences of your actions aren’t as severe, if you have coverage against this, you may end up driving more recklessly as you don’t have to worry about financial consequences. Additionally, some occurrences are so uncommon that insurers do not wish to set up policies to cover them. Many insurance intermediaries set up special schemes to address the unique problems that some people and organizations face – but these schemes must generate sufficient premiums to cover the overhead involved in administering them and provide a pool of funds to settle claims.
