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"Risk Transfer" is often used in place of "Risk Sharing" in the mistaken belief
by 趙永祥 2015-03-10 09:19:46, 回應(0), 人氣(1421)

                                     A discussion issue as follows.

"Risk Transfer" is often used in place of "Risk Sharing" in the mistaken belief

Governmental Counseling consultant, Small and Medium Enterprise Administration,Ministry of Economic Affairs,Taiwan.

The term of 'risk sharing' is briefly defined as "sharing with another party the burden of loss or the benefit of gain, from a risk, and the measures to reduce a risk."

The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that you can transfer a risk to a third party through insurance or outsourcing. In practice if the insurance company or contractor go bankrupt or end up in court, the original risk is likely to still revert to the first party. As such in the terminology of practitioners and scholars alike, the purchase of an insurance contract is often described as a "transfer of risk." However, technically speaking, the buyer of the contract generally retains legal responsibility for the losses "transferred", meaning that insurance may be described more accurately as a post-event compensatory mechanism. For example, a personal injuries insurance policy does not transfer the risk of a car accident to the insurance company. 

The risk still lies with the policy holder namely the person who has been in the accident. The insurance policy simply provides that if an accident (the event) occurs involving the policy holder then some compensation may be payable to the policy holder that is commensurate to the suffering/damage.

Some ways of managing risk fall into multiple categories. Risk retention pools are technically retaining the risk for the group, but spreading it over the whole group involves transfer among individual members of the group. This is different from traditional insurance, in that no premium is exchanged between members of the group up front, but instead losses are assessed to all members of the group.

Dr. Chao (Faculty, Dep. of finance and institute of financial management in Nan Hua university, Taiwan)
9-Feb.-2015

Comments

  • James Andrae

    James

    James Andrae

    Risk Management Specialist

    This is spot on. In the 90s & (prior to GFC) companies "transferred" risks by buying or selling credit derivatives, only to discover that this strategy was only as good as the ability of the last holder to pay up on a claim. And so started the mini crash of developing countries especially Asia. The risks were at best transferred but created new ones in their wake. The credit worthiness of the counterparty. The best risk transferred is the one you don't have to begin with. It is all in the contract Ts & Cs. Get that right, accept what you have left and then look to optimise exposures.

  • Edward Chao

    Edward Chao

    Governmental Counseling consultant, Small and Medium Enterprise Administration,Ministry of Economic Affairs,Taiwan.

    Dear James 
    I agree with your comments. In fact,the buyer of the contract generally retains legal responsibility for the losses "transferred", meaning that insurance may be described more accurately as a post-event compensatory mechanism. The best risk transferred is the one you don't have to begin with, but you have to take continuous care on it. 

    Thanks for your comments. 

    Edward

  • Guan Seng Khoo, PhD

    Guan Seng

    Guan Seng Khoo, PhD

    Head, ERM, GRC at Alberta Investment Management Corporation (AIMCo)

    That's why I prefer to use the term risk mitigation or response (which may not necessarily mean the risk can be totally eliminated) because in reality you can't really transfer risk (as risk is like energy) - it merely transforms into another form of risk, unless you are no longer the owner (or have the exposure anymore)!

     Edward Chao likes this
  • Edward Chao

    Edward Chao

    Governmental Counseling consultant, Small and Medium Enterprise Administration,Ministry of Economic Affairs,Taiwan.

    Dear Guan Seng Khoo, 
    Perhaps, risk mitigation or response is a better term to explain the meaning of "Risk Transfer", thanks for your comments in this issue. 

    Sincerely, 
    Edward.

     Guan Seng K. likes this
  • Guan Seng Khoo, PhD

    Guan Seng

    Guan Seng Khoo, PhD

    Head, ERM, GRC at Alberta Investment Management Corporation (AIMCo)

    Gam sia, Gam sia! I'm Hokkien (by dialect). Keong Hee Huat Chye!

  • Donald J. Riggin, CPCU, ARM

    Donald J.

    Donald J. Riggin, CPCU, ARM

    CEO, ART of Captives Consulting LLC

    Folks, while I like philosophical discussions as much as the next guy, let's temper that with a dose of old fashioned horse sense. Guan Seng Khoo (above) said, "in reality you can't really transfer risk." I respectfully disagree. In reality, risk is transferred all the time. In theory, (as in quantum physics), risk may or may not be transferred. Or, it might be both transferred, and not transferred at the exact same time! (Was this one of Zeno's 4 paradoxes? Probably not.) 

    "Risk transfer" is the only reasonable and acceptable description of the insurance transaction. It means moving a risk of financial loss, of whatever quantity or quality, from one balance sheet to another balance sheet. Moreover, the transaction is memorialized in a contract commonly accepted by both parties - the insurance policy. 

    Yes, technically the transferred risk still lies with the policyholder, but in law that plays no part whatsoever. When counterparties (insurer and client) are engaged in a legal dispute, the notion that the client technically retains the risk is ignored for good reason. The payment of premiums (consideration) as prescribed by the contract issuer (insurance company) renders this technical argument moot for lack of applicability and materiality. 

    Of course the insurance company could go bankrupt; technically, the insurer is a credit risk to its customers, but the likelihood of that occurring is usually extremely low. And even with enormous amounts of counterparty/credit risk, the transaction is still one of risk transfer; the quality (or lack thereof) of the risk-taking party doesn't change that fact. It might be a bad risk transfer, but a risk transfer it remains. Remember, counterparty risk is a matter of credit risk management, that's all. If the risk transfer fails for one reason or another, the risk holder will deal with it. 

    The term, risk transfer, has been used in US Tax Court and US Supreme Court cases to describe an important concept. Risk transfer and risk distribution, are the generally accepted circumstances required for an insurance transaction to exist. (Insurance is not defined in US law.)

    Finally, 2 of the above posters said this: "the best risk transferred is the one you don't have to begin with." Huh? If you're right, every business in the world should cease operations, because that's the only way to not have a risk to begin with. I could go on…

  • Edward Chao

    Edward Chao

    Governmental Counseling consultant, Small and Medium Enterprise Administration,Ministry of Economic Affairs,Taiwan.

    According to businessdictionary website said that there have two definitions on "Risk Transfer"

    * management strategy in which an insurable risk is shifted to another party (the insurer) by means of an insurance policy.

    * shifting through non-insurance means, such as a warranty. See also transfer of risk rule.

    (http://www.businessdictionary.com/definition/risk-transfer.html#ixzz3TkiQV3Mc)

    "Risk Transfer" had been commonly accepted in the underlying tenet behind insurance transactions. The purpose of this action is to take a specific risk, which is detailed in the insurance contract, and pass it from one party who does not wish to have this risk (the insured) to a party who is willing to take on the risk for a fee, or premium (the insurer).


    For example, whenever someone purchases home insurance, he or she is essentially paying an insurance company to take the risk involved with owning a home. In the event that something does happen to the house, such as property damage from a fire or natural disaster, the insurance company will be responsible for dealing with any resulting consequences.

    Risk transfer is a risk management and control strategy that involves the contractual shifting of a pure risk from one party to another. One example is the purchase of an insurance policy, by which a specified risk of loss is passed from the policyholder to the insurer. Other examples include hold-harmless clauses, contractual requirements to provide insurance coverage for another party's benefit and reinsurance. When done effectively, risk transfer allocates risk equitably, placing responsibility for risk on designated parties consistent with their ability to control and insure against that risk. Liability should ideally rest with whichever party has the most control over the sources 
    of potential liability.

    In addition, in today's financial marketplace, insurance instruments have grown more and more intricate and complex, but the transfer of risk is the one requirement that is always met in any insurance contract.

    According your recognition, the term, 'risk transfer' has been used in US Tax Court and US Supreme Court cases to describe an important concept. Risk transfer and risk distribution, are the generally accepted circumstances required for an insurance transaction to exist. I fully understand and agree. In our normal life, risk transfer is occurred in transaction behavior, the transaction is still one of risk transfer; the quality (or lack thereof) of the risk-taking party doesn't change that fact. We can understand that 'risk transfer' can be viewed as the reduction of risk to a position by buying an insurance policy or taking an offsetting position. For example, a person may reduce the risk of loss due to medical expenses by buying health insurance. Likewise, a person may reduce the risk of loss to a long position by entering an equal but opposite short position.

    I'm very appreciated with your professional viewpoints. Thanks for your comments about this issue,

    Sincerely, 
    Edward

     James Andrae likes this
  • Guan Seng Khoo, PhD

    Guan Seng

    Guan Seng Khoo, PhD

    Head, ERM, GRC at Alberta Investment Management Corporation (AIMCo)

    Thank you both. As long as all of us are comfortable with the "local" definition, without getting too detailed or preoccupied with the semantics, e.g., often CDSs create the illusion of risk "transfer", when in reality, risk transformation has its unintended consequences................, I'm happy to agree and disagree!

  • Donald J. Riggin, CPCU, ARM

    Donald J.

    Donald J. Riggin, CPCU, ARM

    CEO, ART of Captives Consulting LLC

    Indeed, an interesting discussion. At the end of the day it's just semantics, as Guan Seng Khoo has observed. I'm quite familiar with the non-insurance methods of transferring risk, but I think that risk transfer, regardless of technique, is just one thing: Moving negative financial outcomes from one party to another. 

    Think of the concept of risk having 2 separate and distinct properties, (1) potentially negative financial outcomes, and (2) one of the consequences of life: business activities, property ownership, driving a car, crossing the street, getting out of bed, and so on. All we can do is mitigate some of the negative financial consequences; insurance being the most prevalent risk transfer tool. The first property of risk is binary; the risk is either retained or transferred. Even the most onerous legal disputes between insurer and client as to whether or not a loss is compensable eventually settle if favor of one of the two litigants, (except Jaundyce v. Jaundyce).

    Regarding the illusion of risk as mentioned above; it's an illusion because in reality some risk transfer schemes are just as likely to fail as to not fail, such as a CDS. But a CDS, just like an insurance policy, does indeed transfer the financial consequences of risk to a counterparty, but its value as a risk transfer tool is a matter of degree. Compared to the security available through a highly rated insurance company, a CDS's volatility and susceptibility to market risk greatly reduces its efficacy as a pure risk transfer tool. If the risk transferor isn't aware of this, well, that's his problem.

     Guan Seng K.Edward Chao and 1 other like this
  • Guan Seng Khoo, PhD

    Guan Seng

    Guan Seng Khoo, PhD

    Head, ERM, GRC at Alberta Investment Management Corporation (AIMCo)

    Thanks Donald. I guess where I'm coming from is when the term is used outside of the insurance industry as in the typical COSO ERM or ISO 31K framework, where it's often used in the context of risk "reduction", which I don't believe in, or in banking, when instruments in the banking book are transformed into the trading book, e.g., via securitization. 

    But thanks again to everyone for sharing here. Have a marvellous week.

     James Andrae likes this
  • Kathryn M

    Kathryn M Tominey

    Owner, Red Mountain Consulting, LLC

    Just a thought, legalisms aside, if you lack capability to perform mission (product or service) essential work and outsource you are still accountable to clients and shareholders. Many CEOs & mgt teams are indifferent to this as long as they collect their annual bonus - based on very short term results.

    You do remember why we had to bailout AIG don't you? Making book via naked CDSs without understanding underlying products which had ratings - arguably fradulent ratings - suggesting high quality.

    Anyone putting that much effort into acquiring financial insurance is sending a message about how much they believe in their product.

     Edward ChaoJames Andrae like this
  • Guan Seng Khoo, PhD

    Guan Seng

    Guan Seng Khoo, PhD

    Head, ERM, GRC at Alberta Investment Management Corporation (AIMCo)

    Thanks, Kathryn, that's what I was alluding to in my CDS' comment, together with the roles played by monolines, e.g. AMBAC, etc.

  • James Andrae

    James

    James Andrae

    Risk Management Specialist

    Donald, very solid legal points. I love a good philosophical discussion. It is as always a matter of semantics and perspective. Our experiences may be different, I don't believe it makes either of us more right or wrong. It does however open the mind to other perspectives which is always a good thing. 

    Insurance while a risk transfer mechanism actually creates other risks as you alluded. Credit, Legal, Cost, Timing. Kathryn above raised very important valid points. Perspectives, agendas, rorts, etc. 

    Risk Management should always try to minimise reliance on the legal process if things go wrong. (This is why I spend way too much time analysing contracts). While the process marches along, in the meantime a company may be seriously negatively affected, face bankruptcy at the extreme, share price fluctuations, credit downgrades etc. Bonuses not paid, people fired. 
    It always becomes a matter of size of the insurance claim, 100K not much of a problem, $100M is often open to "debate" in the court system. My experience is that CEOs and Boards don't like the court process and always look for heads to roll. 

    From a risk management perspective that's not good enough because of the domino effect on business' other activities that assume cash flows will be made whole in the proper time. Very few companies have a few "lazy" hundred million just hanging around. I repeat the best risk you have is the one you don't have and there are numerous examples from physical power plants to the financial markets. 
    In the financial markets, peculation aside, hedging can cause new and some unforseen linked risks. There is a famous issue now about a company being trading a commodity and having 40 - 50% of the liquidity in that market. They got it right, but could not get out of their trades. Greed. The best risk is the risk you don't have. Don't expect the market to accept losses when you are the major provider of liquidity. Stick to a lower threshold. If a company is that big that it needs 50% of the market liquidity then it need to review its operational risk management to account for the lack of reliance on the market hedges. 

    The GFC and Asian Crisis were in essence, liquidity and counterparty credit issues on the whole.

    Power plants often have unexpected failures, these are insurable events. The major condition is the proper maintenance of the plant. One man's process is another man's negligence. We can understand that the insurance company will rightly want to verify everything before maybe paying. There are cases where a 1 week shutdown took 2 years and longer to pay. The claims are mostly for physical damage and financial loss. This could easily climb to $100M+ depending. Repairing a power plant may cost $5M the losses on a SWAP could be any amount perhaps a further $95M. No COB is keen on this sort of risk. 
    The best risk is the one you don't have. Solution don't over commit power plant transaction SWAPS such that if it failed apart from the burden of repairs you will also have the financial SWAP payments to make. There is nothing lost except for speculative revenue and that could go either way. 
    Building infrastructure creates volumes of possible risks to the owner. Power plants can be built by the power company or by an external engineering firm. This transfers most of the risks but some do remain. Two major risks are that the generator will not work to specifications, or be completed on time. The power company contract specifies Ts&Cs that if not met they simply don't accept the new generator. So the "lemon" risk as well as others are not theirs. The best risk is the one you don't have. 
    While your points are valid Market Risk Managers do not live in a post risk world but in a pre risk world.

     Edward Chao likes this
  • James Andrae

    James

    James Andrae

    Risk Management Specialist

    It took some companies over 7 years to get paid 6c on the dollar after Enron failed. Reliance on the legal system, while just, did not make the participants whole. Insurance failures were kept commercially private so we will never know if the losses were covered or not. The best risk you have is the one you don't have. When the CEO and CFO of a fortune 50 company resign suddenly. Smart risk managers closed out positions and watched the debacle with amusement and got bonus. 
    If entering into a trade with a counterparty is reliant on a CDS for risk mitigation, then the best risk is the one you don't have. 1 don't enter into the trade to begin with. 2 Don't pay any bonus until the expiry or closure of the contract. Implement #2 and a whole lot of needless exposures are removed because the traders now have some skin in the game. 
    You stated “If the risk transferor isn't aware of this, well, that's his problem”. In a perfect world with perfect knowledge maybe. The global financial system is based on the blind hope that the other guy will “play by the rules” and be there to make you whole regardless of whether it is an insurance contract or swap. Blind hope because you can never see the true picture of the other counterparty, and, well, let’s leave the Credit Agency discussion to one side. It’s not only the illusion of risk but of transfer. The Transferors prior to the GFC had no idea who was really on the other end of the majority of the CDS deals. How was it their fault? 
    Market risk managers understand these limitations and on the whole tend to limit exposures as much as possible. 
    Of course you can't have no risks. You can even die in your bed sleeping. 
    But you should understand the domino factors in all risks and come back with the trade off scenarios and limit these whenever possible. 
    The point I think Edward is raising is to test whether risk managers understand that no risk is ever truly transferred or mitigated completely, so how do we live with that reality, post GFC. 
    I am certain that if the Central Banks and Finance Ministers had not stepped into the GFC, the global meltdown could have sent economies spiralling worse than the Great Depression. That was the risk they did not want to have. 
    They saved the world from calamity but also let some companies that could not be absorbed, fail.
    This was the wake up call. Edward is asking if we have altered our thinking since.

     Edward Chao likes this
  • Edward Chao

    Edward Chao

    Governmental Counseling consultant, Small and Medium Enterprise Administration,Ministry of Economic Affairs,Taiwan.

    Dear James, 
    I'm very appreciated and respect that you always point out the key concepts and useful viewpoints within your comments on a issue. I got some hints and implications from your comments. I also agree with Donald's comments which said above, 'the concept of risk having 2 separate and distinct properties, (1) potentially negative financial outcomes, and (2) one of the consequences of life: business activities, property ownership, driving a car, crossing the street, getting out of bed, and so on. All we can do is mitigate some of the negative financial consequences; insurance being the most prevalent risk transfer tool.' 

    I fully agree that your comments which said that "the best risk you have is the one you don't have and there are numerous examples from physical power plants to the financial markets." In addition, the global financial system is based on the blind hope that the other guy will “play by the rules” and be there to make you whole regardless of whether it is an insurance contract or swap. 

    In fact, the domino factors in all risks and come back with the trade off scenarios and limit these whenever possible. According to my recognition, risk transfer is a risk management and control strategy that involves the contractual shifting of a pure risk from one party to another. I sometimes discuss with the professional risk-control managers whether risk managers understand that no risk is ever truly transferred or mitigated completely but I find that some managers will ignore cultural and human factors which plays important roles in risk managements. 

    Thanks for Donald,Kathryn, Guan Seng Khoo, and your professional comments in this issue. 

    Thanks all of you with sincerity. 

    Sincerely, 
    Edward