What is Risk Transfer?
Risk transfer is a risk management technique where risk is transferred from your organization to a third party. Transferring risk means that one party assumes the general liabilities of another party.
One example of risk transfer is purchasing insurance. A company purchases insurance to cover the costs for some unwanted event – say, a data breach – and therefore as a practical matter, the cost of that risk is transferred: from the business, to the insurance firm.
Other examples include indemnification clauses in contracts (or “hold harmless” clauses), contractual requirements to provide insurance coverage for another party’s benefit, and reinsurance.
Risk Transfer in Risk Management
Risk management is the process of minimizing the impact or preventing unfortunate events from occurring. By identifying, assessing, and controlling threats to your organization’s capital and earnings, you can better prepare for the unexpected by minimizing risks and extra costs before they happen.
In addition to identifying and analyzing possible risks, your organization should also determine the most suitable risk response by taking the following steps:
- Risk assessment
- Risk analysis
- Risk evaluation/prioritization
- Risk treatment/mitigation
- Risk monitoring/review
Usually, risk transfer takes place during the risk treatment/mitigation phase of a risk management program.
On a chart commonly referred to as a “risk register,” your organization should list each risk and give it a materialization score and rank, as well as a risk response or treatment. Risk treatment/mitigation typically comes in four options:
- Risk acceptance
- Risk avoidance
- Risk transfer
- Risk reduction
In cases where transferring risk makes the most sense, the potential loss from an adverse outcome is shifted to a third party. Usually, a policyholder will provide compensation to an insurer in the form of periodic payments (that is, insurance premiums) for bearing the risk.
Risk Transfer vs. Risk Sharing
The ideas of risk transfer and risk sharing are often confused because the two are similar, but each concept is slightly different from the other.
While the transfer of risk involves transferring risk to another individual or entity for a price, risk sharing involves sharing or dividing a common risk among two or more persons.
Also known as risk distribution, risk sharing means that the premiums and losses of those sharing the risk are allocated using a predetermined formula.
Methods of Risk Transfer
Purchasing insurance is perhaps the most common method of transferring risk.
When a policyholder purchases insurance from an insurance agent, he or she shifts financial risks to the insurer. In exchange for accepting such risks and providing insurance coverage, insurance companies typically charge a fee – the insurance premium.
Indemnification Clauses in Contracts
Also used in the transfer of risk, contracts often include an indemnification clause: a clause assuring that any potential losses will be compensated by the other party.
Also known as a hold-harmless or a save-harmless clause, an indemnification clause is independent of insurance coverages.
Examples of Risk Transfer
Insurance is probably the easiest to understand example of risk transfer. Insurance shifts the risk of incurring significant financial losses to an insurance company, and protects the business owner against financial risks.
In some cases, through subrogation, insurance companies reimburse the policyholder and then pursue legal action against the party at fault to cover any financial burden.
Although risk is most commonly transferred from individuals and entities to insurance companies, insurers are also able to transfer risk themselves. Reinsurance companies are firms that provide insurance contracts to insurance firms. And like insurance companies, reinsurance companies charge an insurance premium in exchange for taking the risk of loss.
Risk transfer is also common in industries like construction. Ultimately, risk transfer is the basis of every contract that a construction company signs. In exchange for services, construction companies agree to take on certain risks involved with the project.
Property owners also transfer risks quite often. For example, commercial property owners often face a variety of risks and challenges with their tenants. For this reason, property owners should always implement an indemnity clause or hold-harmless agreements that release the indemnitor from any consequences or general liabilities due to the actions of the indemnitee.
Why Transfer Risk?
Transferring risk removes liability from your organization and puts it elsewhere, either in the hands of an insurance company or back onto whoever signed your contract containing an indemnification clause.
Without insurance or a contract, injuries or property damage caused by a third-party might involve you in an unforeseen claim situation. When done effectively, risk transfer allocates risk equitability and places responsibility for any risk on the designated parties.
Otherwise, the most obvious reason for transferring risk is to protect your organization from potential financial liabilities.
Requiring service providers, lessees, vendors, and subcontractors to enter into indemnification clauses or hold-harmless agreements will help assure that they will hold you harmless and reimburse you for any monetary losses if you are held liable for their conduct.
Effective Risk Transfer Strategies
To establish an effective risk transfer strategy:
- Require certificates of insurance from subcontractors, tenants, service providers and other parties.
- Determine appropriate insurance coverage and limits.
- Develop a system that enables an annual review of certificates of insurance for multi-year relationships prior to the work starting.
- Enforce certificates of insurance requirements.
- Create a certificate of insurance filing system for annual review.
How ZenGRC Can Help
An effective and efficient risk management program is paramount for risk transfer. But without the right tool, risk management can be overwhelming.
Fortunately, ZenGRC from Reciprocity can help you better understand what you need for a successful risk program.
ZenGRC’s operational risk management software lets you address enterprise risk management (ERM) and cybersecurity risk across threats, vulnerabilities, and incidents from one application; and communicate current risk status and potential threats through risk heatmaps, dashboards, and reports.
With continuous risk monitoring, ZenGRC exposes compliance-related risks with intuitive and automated alerts and workflows so you can catch and remediate risks with real-time updates.
Schedule a demo today to learn how ZenGRC can fit into your business and help guide you to confidence in infosec risk and compliance.