Enterprise Risk Management: From Incentives to Controls, 2nd Edition

CHAPTER 8

Risk Transfer

Put simply, risk transfer is the act of moving risk from one entity to another. In more precise terms, it is the deliberate exchange of probabilistically different cash flows. Either way, it is most often taken to mean the movement of some of a company's risk to an external party—but it can also mean the shifting of a given risk to a different part of the same company, or the creation of a new subsidiary within that company for the specific purpose of managing that risk.

The most traditional way in which companies transfer risk is through the purchase of various kinds of insurance, with the three most common types being workers' compensation, general liability, and property/casualty insurance. When a business buys an insurance policy, some or all of the risk associated with any event covered by that policy is effectively transferred from the business to the insurer. The concept of insurance has been around for a long time: a form of marine insurance is mentioned in the Code of Hammurabi, written some 3,800 years ago.

The second common risk transfer mechanism is through derivative products such as futures, forwards, swaps, and options. Strictly speaking, a derivative transaction alters the characteristics of a company's cash flows through a financial obligation in a way that may adjust the nature or amount of risk to the company. Unjustly maligned as dangerously volatile transactions for hardened speculators, largely due to their involvement in a number ...