# Transfer of Risk: Definition and How It Works in Insurance

![Transfer of Risk](https://www.investopedia.com/thmb/gOFfloA3TSQNiGj1sVO2CL8pZ_g=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/transfer-of-risk-4187691-d95fbd1fc94f4f8d8783249bd32eb0e9.jpg)

*Individuals and companies can mitigate their financial losses by passing on the risk to another party through a risk transfer. — Investopedia / Joules Garcia*

> **Definition**
>
> A transfer of risk is a risk management strategy that transfers the responsibility and financial burden of loss from one party to another.

## What Is Transfer of Risk?

A transfer of risk means that one party passes on the responsibility of risk to another if there's a loss. Losses can result from damage, theft, or disaster. These transfers are necessary because some risks can't be tolerated by certain parties. Risks can be transferred between individuals, businesses, individuals and businesses, or insurers and reinsurers.

For instance, when homeowners purchase property insurance, they pay an insurance company to assume various specific risks associated with homeownership. Although common in the insurance industry, risk transfers can also take place in contractual agreements between businesses.  

### Key Takeaways

*   A transfer of risk shifts responsibility for losses from one party to another in return for payment.
*   Risk transfers are common in the insurance industry but also in contractual agreements.
*   This system works because some risks are beyond the resources of most individuals and businesses.

## Understanding Transfer of Risk

When purchasing insurance, the insurer agrees to indemnify, or compensate, the policyholder up to a certain amount for a specified loss or losses in exchange for payment.

Insurance companies collect premiums from thousands or millions of customers every year. That provides a pool of cash that is available to cover the costs of damage or destruction to the properties of some small percentage of its customers. The premiums also cover administrative and operating expenses, and provide the company's profits.

Life insurance works the same way. Insurers rely on actuarial statistics and other information to project the number of death claims it can expect to pay out per year. Because this number is relatively small, the company sets its premiums at a level that will exceed those death benefits.

> **Important**
>
> Reinsurance companies accept transfers of risk from insurance companies.

The insurance industry exists because few individuals or companies have the financial resources necessary to bear the risks of the loss on their own. So, they transfer the risks.

## Risk Transfer to Reinsurance Companies

Some risks are too big for insurance companies to bear alone. That's where reinsurance comes in.

When insurance companies don't want to assume too much risk, they transfer the excess risk to [reinsurance](https://www.investopedia.com/terms/r/reinsurance.asp) companies. For example, an insurance company may routinely write policies that limit its maximum liability to $10 million. But it may take on policies that require higher maximum amounts and then transfer the remainder of the risk in excess of $10 million to a reinsurer. This subcontract comes into play only if a major loss occurs.

## Property Insurance Risk Transfer

Purchasing a home is the most significant expense most individuals make. To protect their investment, most homeowners buy homeowners insurance. With homeowners insurance, some of the risks associated with homeownership are transferred from the homeowner to the insurer.

Insurance companies typically assess their own business risks in order to determine whether a customer is acceptable, and at what premium. Underwriting insurance for a customer with a poor credit profile and several dogs is riskier than insuring someone with a perfect credit profile and no pets. The policy for the first applicant will command a higher premium because of the higher risk being transferred from the applicant to the insurer.