Risk passing on

Risk shifting (alternatively also known as risk transfer ) is a form of risk management in risk management that takes place by transferring a risk from one risk carrier to another.

General

In addition to risk provisioning , in which equity is used as a risk-bearing instrument, risk transfer is one of the passive risk management instruments . With this method of risk control, the risk position , which also represents the risk-causing asset position, remains in the company portfolio. In contrast to active risk management measures, there is no reduction in the likelihood of occurrence or the scope of the risk that may arise, but the consequences that are intended to intercept the effects of the risk are passed on. A distinction is made between the partial or full transfer of the risks to be hedged to a third party, the so-called counterparty . For this transfer, the company must provide something in return . This usually takes the form of a premium that is paid to the third party. The policyholder transfers a certain risk to the insurer , for which he pays an insurance premium . In addition to passive risk management, there is also active risk management. The instruments of active risk control include, for example , risk avoidance , risk reduction and risk limitation, which can be used to shape the risk structure in the company.

The contractual conclusion of insurance is both the most important and the most frequently used control instrument in the context of risk transfer and is one of the conditional financial instruments. Further instruments of risk transfer include factoring, franchising, leasing and unconditional financial stocks, which include futures and forwards.

It should be noted that despite the transfer of risk and the contractual conclusion, residual risks remain. For example, it can happen that the sum insured is less than the amount of damage incurred and the financial compensation is insufficient to cover the damage that has occurred ( underinsurance ). Further risks for the contracting party arise from the issuer risk or the insolvency of the contractual partner .

Risk strategy matrix

The existing risks can be controlled using individual risk control instruments or a combination of several of these. When choosing and weighting the appropriate instruments, the company- specific risk preferences as well as the type of business activity and the industry are relevant. It is important to cord the whole thing in such a way that no opposing effects arise. Since every company has an individual risk profile, there is no generalized possibility of which measure is best suited to control the existing risk. The Risk Strategy Matrix can be used as a useful guide to this problem. It provides clues as to which risk control instrument could be used to counteract the potential damage. The extent of the damage as well as the probability of occurrence are considered. The higher the probability of occurrence and the extent of damage of the risk, the more urgent the need for action. Company risks that are in this area can be minimized, for example, through risk avoidance or risk transfer. While risk avoidance decimates the likelihood of occurrence, risk transfer only lowers the extent of damage for the company. Risk shifting can also be used in the middle area of the risk strategy matrix.

If the risk has both a low probability of occurrence and a low extent of damage, the risk should not be passed on.

Risk shifting to insurance

The most frequently used instrument for passing on risks is the conclusion of appropriate insurance policies . When risks are passed on to insurance companies, the insurer assumes the risk in return for payment of insurance premiums, after prior contractual agreement. The transfer can take place completely or only partially. Since the insurer exposes himself to a risk by taking on the risk, the individual risks are integrated into the collective of the insurance company. The insurance premiums of the collective are thus available to the insurer in the event of an individual policyholder's claim in order to be able to cope with the necessary insurance benefits. There is also the option of taking out reinsurance, which enables the primary insurance company to reduce its risks by transferring its underwriting risks to the reinsurance company.

The amount of money to be paid by the policyholder depends on various factors, including the potential extent of damage and the amount of the deductible. One premise when transferring risks to insurance companies is above all insurability . Not all risks can be insured. However, it is difficult to draw a clear line here. The assessment of insurability is based on theoretical and / or factual economic aspects. The theoretical criteria are based on randomness, estimability, uniqueness, independence and size:

The uncertainty about the reason, the amount or the point in time at the occurrence of a claim is defined as randomness, here the uncertainty for the insurer and the policyholder is as high as possible.
The estimability is determined by the possibility of determining the spread and expected value of the probability distribution of the damage to be insured.
In order to be able to assess the clarity, the exact data of the insured event (e.g. insured risks, persons, property, damage and insurance benefits) are required.
In this case, independence means that a given risk has to be insured more often as a group, without there being a relationship between the individual losses, i.e. they do not all occur in the same event. The risk should therefore be diversifiable for the insurance company.
The insurer must also meet its insurance benefits in the event of major damage. That means the size (height) of the highest possible damage must be limited upwards.

From a factual economic point of view, it is meant that both the insurer and the insurer, taking benefit / misuse considerations into account, want to achieve a net benefit from passing on the risk. Property and casualty insurance is the main area of insurance. So almost exclusively losses of property, plant and equipment and material items of current assets are insured and thus passed on to insurance companies. Insurance can only be taken out for credit risks for financial items.

On the policyholder's side, taking out insurance primarily depends on the risk-profit ratio, i.e. the ratio between the insurance premium to be paid and the risk minimized by the insurance. The insurance premium is made up as follows: the base amount is the so-called net risk premium, which covers the expected value of the total damage. In addition, there is the safety surcharge, which covers all typical insurance risks that do not correspond to the expected value and are therefore not already covered by the net risk premium. The sum of the net insurance premium and the safety surcharge results in the gross risk premium. In addition to the gross risk premium, there is now the operating cost surcharge and a possible profit surcharge, which results in the gross premium that is to be paid by the policyholder.

example

A company's property, plant and equipment includes a machine worth, for example, EUR 80,000. It is assumed that the probability that the machine is irreparably defective is 0.8% per year. In order to be able to purchase a new machine immediately in the event of damage and thus protect itself against the failure of the machine, the company would have to have EUR 80,000 available as capital at all times. With financing costs of 2%, for example, this constant provision of capital leads to costs of 1,600 EUR per year. Added to this is the average expected annual damage of EUR 640 (0.8% of EUR 80,000). Thus, with an individual protection against the failure of the machine, even if it should not fail, expenses of 2,240 EUR are incurred every year

If 200,000 companies at an insurance company insure themselves against the damage described above, based on the expected value of 0.8% per year, there will be an average of 1,600 defective machines per year and thus costs of EUR 16,000,000 ( 1,600 machines at EUR 80,000 each). This means that costs of EUR 80 would arise across the companies. In order to ensure sufficient security, it is assumed that the insurance company holds the 16,000,000 EUR as capital. This incurs financing costs of 10%, i.e. EUR 1,600,000, and EUR 8 per insured company. The insurance premium would therefore be EUR 88 in the example chosen. If you compare this with the value of EUR 2,240 that the company would have to assume per year in order to be financially prepared for a possible damage event, the advantages of transferring risk to insurance companies quickly become apparent. Even if the insurer charges an operating cost and profit surcharge, the company gets cheaper by transferring the risk to the insurance company.

Passing on risk to contractual partners

Another possibility of passing on risk is the transfer of risk to contractual partners . Certain contract variants and provisions are necessary for this. With this variant of risk transfer, non-insurable risks such as bad debt, transport or market price risks can also be taken into account. The aim is to reduce the extent of damage in the case of risks with a high probability of occurrence and a high degree of damage. As with insurance, there are fees for assuming the risk. d. Usually, however, not paid through premium payments, but through risk premiums / discounts, which are specified in the contractual conditions. The company's bargaining power influences the degree of risk passing-on and the price for it. The most common forms of risk passing-on are factoring, leasing and franchising.

Factoring

The basic principle of factoring is the sale of accounts receivable to a factoring company (factor) in order to guarantee the liquidity of one's own company. A customer (debtor) orders goods or services from a company and agrees a later payment term, this company activates a factor that checks the debtor's creditworthiness and buys the receivable from the company. The factoring user usually receives 90% of the claim immediately paid by the factor and processes the order. The customer then pays the outstanding invoice amount to the factor.

There are different types of factoring; risk is only passed on in real factoring. The default risk (del credere) is transferred to the factor, i.e. This means that if a customer B. becomes insolvent due to insolvency, the bad debt remains with the factor. Advantages for the factoring user are the 100% planning security as well as the shortening of the balance sheet and thus better creditworthiness of the company by removing the claim from the balance sheet. In the case of fake factoring, on the other hand, there is no transfer of risk, since the factor can reverse the purchase of the receivable and the del credere risk thus remains with the factoring user, so it is a type of credit transaction.

Legal bases are §433 BGB (purchase of things) and §453 BGB (purchase of rights). In addition to a sales contract, the assignment of the claim is necessary, through which the factor takes the place of the factoring user and can also assert the claims in his own name. The basis is the factoring contract between the factor and the factoring user. The amount of the claim minus the factoring fees and the interest results in the purchase price for the respective claim.

leasing

Leasing is considered a financing alternative in which a temporary use of an investment item is agreed. The leasing object is selected by the lessee and bought by the lessor; there is a leasing contract between the two, which, among other things, defines the term, the non-cancellable basic rental period and the leasing rates. At the end of the contract period, the leased object can be returned, exchanged or acquired by the lessee.

On the basis of their terms and conditions of termination, a distinction is made between operating leasing (short-term termination possible) and financial leasing. Therefore, a comprehensive transfer of risk only takes place with financial leasing, the investment risk, property and price risk are transferred to the lessee during the term. The investment risk is given by the fact that the leasing installments correspond to the amount of the acquisition or manufacturing costs and all ancillary and financing costs of the lessor. Material risk corresponds to the risk that the leased object has to be received, maintained and repaired during the term of the contract, while the price risk is to be seen in the fact that leasing installments have to be paid even after damage or failure of the leased object.

Despite the risks they bear, lessees benefit from leasing an investment property. These include the planning security that arises from the fixed monthly installments, the possibility of using the latest technologies, since a newer model can be selected for the next lease when a leasing contract expires, tax savings for companies, since leasing installments are deducted as operating expenses, and Simplicity after the end of the contract period, the lessor must bear the risk of increased loss of value (e.g. diesel affair) and the expense of selling the investment property.

Franchising

Franchising is a financing and sales system based on a partnership. The franchisor provides a franchise package, which includes a procurement, sales and organizational concept, the use of the name, the brand and certain property rights, the training of the franchisee and the support of the franchisor. Both franchisors and franchisees are legally and financially independent companies. The franchisee pays a fee to use the franchise package. Well-known examples of franchising are the fast food chains McDonalds and Subway.

The system offers advantages for both sides: The franchisor can transfer the risk to the franchisee, as the latter bears the risk of loss or failure, regardless of whether this is due to personal errors or defects in the franchise package. In addition, he can use the expansion function without having to use a lot of resources (human and financial). The franchisee, on the other hand, benefits from the awareness of the brand and the given structures; this and the independence lead to greater motivation of the entrepreneur. In addition, the focus can be placed on the customers and sales and secondary tasks can be passed on to the franchisor, so errors and costs can be reduced and starting a business is less risky.

Risk passing on to the financial market

Another form of risk shifting consists in the securitization and shifting of certain risks or groups of risks onto the financial market , called insurance securitization . In this context, securitization means “any bundling of cash flows induced by risk collectives and their transformation into tradable marketable securities”. The special purpose vehicle issuing such a security acquires insurance risks and sells them to an investor on the financial market. The funds raised through the sale are invested in a collateral trust. In return, the investor receives claims to interest and repayment, which are made by the policyholder's premium payment. If the insured event occurs, the policyholder is to be compensated by paying the purchase price up to the insured amount. Due to the large number of all financial market participants and their willingness to provide conditional debt capital, in contrast to an insurance company operating alone, a significantly higher sum insured can be covered in this way. This is based on the fact that the investors, who remain largely unknown, only bear a fraction of the total risk. In addition, the tightening of the legal framework with regard to the security capital of insurance companies and the associated rise in prices of traditional protection concepts not only favors an increase in efficiency within insurance companies, but also the ability to trade on the capital market ultimately has a positive effect on transparency, the provision of information and the general reduction of information asymmetries.

CAT bonds

CAT Bonds (Catastrophe Bonds) represent a form of securitization of insurance risks. These are bonds which, in contrast to regular government bonds, have a coupon and redemption as well as a derivative component that is triggered when a previously defined damaging event occurs. Depending on the contract, this event can be, for example, exceeding an index such as the PCS (Property Claim Service) or, in the event of an earthquake, exceeding a value on the Richter scale. Depending on the structure of the CAT bond, the interest and repayment payments are suspended in this case, or even the nominal value is used in full, which represents a total loss for the investor. For this reason, cat bonds correlate less strongly with global market events or the MSCI, which implies a lower beta factor and low volatility, which makes such instruments ideally suited to diversify a portfolio beyond an already existing degree.

Insurance derivatives

Insurance derivatives represent a further form of securitization of insurance risks . This group includes conditional financial instruments such as options, but also unconditional instruments such as futures and forwards. These are generally financial futures contracts in which the seller / buyer enters into the right or the obligation to sell an underlying to the buyer or from the seller at a price determined in advance on a certain date or within a certain period of time to buy. Specifically, this means that an investor sells short put options / futures on a damage index (PSC or Sigma index or similar) to the insurance company, which means that he receives a premium at the beginning of the contract. The future / option premium corresponds to the reinsurance premium. The insurer buys the opposing long put options / futures, which means that if the damage index rises, it also receives increasing compensation (so-called closing out), and its losses are thus hedged. Usually, however, the damage is limited upwards via a call option spread. In this constellation, call and put options with different exercise prices are bought and sold simultaneously. In contrast to CAT bonds, the seller of such forward transactions does not have to provide advance liquidity, which is kept in the collateral trust that is available at all times, but this creates a counterpart risk that comes into play when the option / futures are exercised. This tends to enable insurance derivatives to be implemented more cheaply and quickly.

Implications for entrepreneurs and insurers

For policyholders, risk transfer proves to be an effective means within risk management to counteract unavoidable risks such as earthquakes or tsunamis, which represent an existence-threatening, unavoidable risk for every company. In addition, risks whose probability of occurrence cannot be minimized within active risk management can be completely avoided. By passing on risk, security is not only created within the company in terms of incoming payments and the ability to plan payment flows / dates, it can also avoid expensive, short-term borrowing. Outside of operations, the company's valuation improves, which in turn has a positive impact on the company's cost of capital. In this way, long-term business relationships can be favored by a reduced risk of insolvency, which is particularly advantageous for medium-sized and smaller companies. For insurers, risk transfer measures represent an increase in cover capacity. This not only creates more favorable conditions for customers, but also a more transparent pricing policy.

literature

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Individual evidence

↑ Dieter Farny, Versicherungsbetriebslehre , 2006, p. 22
↑ A. Durrer: Alternative Risk Transfer via Financial Markets - New Perspectives for the Protection of Disaster Risks in the USA . In: Insurance Industry . Issue 51, p. 1198-1200 .

[1] Dieter Farny, Versicherungsbetriebslehre , 2006, p. 22

[2] A. Durrer: Alternative Risk Transfer via Financial Markets - New Perspectives for the Protection of Disaster Risks in the USA . In: Insurance Industry . Issue 51, p. 1198-1200 .