Lewis & Ellis, LLC

The value of risk transfer

Life Insurance and Annuities
by Bonnie Albritton
Insurance companies take on risk regardless of how careful they are to mitigate it, which is why risk transfer is essential.
Insurance companies take on risk regardless of how careful they are to mitigate it, which is why risk transfer is essential.

Risk transfer is an important concept in many industries, but it's especially critical for insurers. Here, we'll delve a little deeper into the value of a well-executed transfer of risk and how to complete it properly for all parties involved.

What is risk transfer?

Insurance companies take on risk regardless of how careful they are to mitigate it, which is why risk transfer is essential. The process involves mitigating risk by buying their insurance through reinsurance companies. Similar to when the insurer charges an individual for their projection through a premium, reinsurance companies charge the traditional insurance company a premium for taking on the risk. Most insurers don't have the resources available to take on this responsibility alone, which is where risk transfer and risk management come in. When insurance companies are overwhelmed with risk, the additional risk is transferred to the reinsurance company.

As with any insurance policy, the insurer agrees to compensate the policyholder up to a certain amount for specific kinds of losses — in this case, losses due to risk. This concept can be applied to nearly every kind of client-facing insurance.

Keep in mind that risk transferring and risk-shifting are different concepts. In a risk transfer, the risk is removed completely through a third party — in this case, the reinsurance company. This can be compared to risk shifting, which is where the risk is distributed within the main party involved to mitigate the dangers.

How has risk transfer changed?

The basic concept of risk transfer has remained unchanged for many years, but as the world around us transforms, the methods and importance of risk transfer have changed along with it.

The importance of risk transfer has come to the forefront of every business owner's mind. The past two years have exposed the fact that the future is unpredictable and uncertain, especially when it comes to the insurance industry. Between natural disasters, global health concerns and other increased challenges, insurance companies have taken on a lot of risks.

Risk transfer is a major way for insurers to protect themselves from going under, which is what can happen when the liability becomes overwhelming. When the insurance company takes on too much risk, they will have to increase the premium price considerably to protect themselves. By transferring the risk to a reinsurance company, the premium prices can remain relatively affordable. This idea works well because reinsurance companies can handle complex risks that average insurance companies can't. As times change, the policies in which risk transfer operates evolve to meet the changing environment.

There are many additional advantages to participating in risk transfer. For example, risk transfer holds benefits for insurance companies to reduce pension liability.

How to protect the insurance company

As is obvious at this point, risk management is essential to maintaining a successful and forward-moving insurance company. Risk transfer through reinsurance should be a valuable part of your protection plan for the business.

How reinsurance works

We have already gone over the basic definition of reinsurance, which is, minimally, insurance for insurance companies. Sometimes, it's also referred to as stop-loss insurance. In a few different cases, insurers are obligated to make good on a claim they were not expecting. This possibility is what makes the company vulnerable to the impacts of taking on too much risk.

The reinsurance company adds the traditional insurance company's risk to its portfolio for the client to remain solvent and reduce impactful liability. By transferring the risk to this third party, the insurance company can take on and sell larger policies that involve more risk. In addition, reinsurance makes substantial liquid assets available to insurers in case of exceptional losses.

In America, there are regulations in place to ensure that reinsurance companies are solvent enough to secure the risk for the ceding insurers or the insurance company that is purchasing insurance for themselves. This ensures that insurance companies can operate efficiently and without a constantly looming threat of bankruptcy.

De-risking strategies

Pension risk transfer (PST) is a strategy where the pension provider transfers risk associated with the plan. This can happen through intentional negotiations with insurance companies to take on the responsibility for paying those guaranteed benefits. When this occurs, the insurance company may be forced to offload the risk that they took on through reinsurance methods.

Real-life examples
There are plenty of tangible examples from both sides of the coin when it comes to risk transfer and management. We can see what happens when a company does not appropriately recognize that it took on more liability than it could handle. Additionally, there are plenty of real-life situations where an insurance company was saved because of its well-done risk transfer strategy.

Property insurance in Texas and Louisiana

In 2017, Hurricane Harvey ripped through the states of Texas and Louisiana and left behind $125 billion in damage, according to the National Hurricane Center. Aside from the extreme impact on residents, insurance companies were inundated with claims. The Texas Department of Insurance reports that 765,000 claims were made to private insurers, TWIA and the Texas FAIR Plan Association.

Their report included 412,000 residential property claims and about 211,000 automobile claims. To begin with, these areas generally posed a greater risk, so their premium prices were higher than other locations that are less exposed to the dangers of risk transfer. However, some insurance companies managed their risk by transferring it to a third party and were able to make it through the difficult time. This example reveals what can happen when liability and loss collide.

Contractual risk transfer

When the risk is transferred using a legally binding contract, it excuses the ceding company from financial or legal responsibility. The contract essentially protects the first business because the company that takes on the risk is well equipped to handle the potential for incoming claims. Ideally, risk transfer protects the insurer from liability and in turn benefits the policyholders because their premium prices will be lower as a result. Simply, the more risk an insurance business is under, the higher the premium will be to compensate. This is where risk transfer comes into play and offers a viable solution when done correctly.

It is also important to have a reliable partner who can give your team the right information and data regarding your company's potential risk. To learn more about your current risk, ways to mitigate it, and other risk management strategies, reach out to Lewis & Ellis today.

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