Risk Transfer

Risk transfer is one of the main ways to manage risk. Instead of bearing a potential loss itself, a person or organisation pays another party to take on that risk.

Insurance is the most familiar form of risk transfer. A homeowner pays a premium to an insurer, which agrees to pay for damage from events such as fire or theft. Insurers, in turn, transfer part of their own risks to reinsurers.

Risk can also be transferred through contracts and financial instruments. Businesses use contract terms, such as indemnity clauses, to make suppliers or customers responsible for certain losses. They use derivatives, such as futures, forwards and options, to transfer price risks to others. Banks use securitization and credit default swaps to transfer credit risk.

For example, an airline worried about rising fuel costs can buy futures contracts to fix the price it will pay, transferring the risk of higher prices to the other party in the contract.

Risk transfer does not eliminate risk; it moves it to someone else. Its effectiveness depends on the other party being able to pay when needed, which introduces counterparty risk.