The recent crisis has been a forceful reminder that economies are still at risk of being affected by – sometimes violent – shocks. The economic implications of such shocks can vary markedly across the population. For example, young people have been particularly badly hit by the recent financial crises, with their unemployment rate increasing twice as much as the overall rate across the OECD and the BRIICS. Such dissimilar implications of macroeconomic shocks reflect in part the greater sensitivity of certain groups to general economic conditions, but they are also likely to depend on policies and institutions. For instance, during the recent financial crisis youth unemployment increased more in countries with higher statutory minimum wages (see figure below), and more rigorous analysis confirms that this was more than mere coincidence.
Young people have been particularly badly hurt by the recent financial crisis, and especially so in countries with high minimum wages
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Source: International Labour Organisation (ILO) and OECD calculations.
More generally, institutions shape the distributional effects of macroeconomic shocks. Some of the institutions that improve risk-sharing are also good for growth or jobs, thereby providing obvious directions for reforms. Examples are well-designed short-time working schemes, competitive product markets, low taxes on labour, and prudent fiscal policy. Others, such as high minimum wages or strict job protection, can come at a cost, and particular care is therefore needed in designing them.
The OECD analysis identifies two broad types of institutional set-ups for sharing income risk, namely “social protection” and
“reallocation-facilitating” institutions. Social protection institutions include unemployment benefits, job protection, minimum wages and strong unions. Pro-competitive product market regulation and low tax wedges on labour are examples of institutions that help to share risk by enabling resources and workers to be reallocated more easily. Based on these two institutional set-ups, OECD and BRIICs countries are categorised into four broad groups:
(i) Countries that provide income risk sharing mainly via social protection institutions, such as most countries of continental Europe.
(ii) Countries that rely mainly on reallocation-facilitating institutions, such as English-speaking and Asian OECD countries.
(iii) Countries where neither class of institutions are developed, typically OECD and non-OECD emerging economies.
(iv) Countries that rely strongly on both types, mainly the Nordic countries.
A stylised classification of risk-sharing models across the OECD and the BRIICS
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Source: Ahrend, R., J. Arnold and C. Moeser (2011), “The Sharing of Macroeconomic Risk: Who Loses (and Gains) from Macroeconomic Shocks”, OECD Economics Department Working Papers, No. 877, OECD Publishing.
A risk management technique involving the transfer of risk to a third party
What is Risk Transfer?
Risk transfer refers to a risk management technique in which risk is transferred to a third party. In other words, risk transfer involves one party assuming the liabilities of another party. Purchasing insurance is a common example of transferring risk from an individual or entity to an insurance company.
How It Works
Risk transfer is a common risk management technique where the potential loss from an adverse outcome faced by an individual or entity is shifted to a third party. To compensate the third party for bearing the risk, the individual or entity will generally provide the third party with periodic payments.
The most common example of risk transfer is insurance. When an individual or entity purchases insurance, they are insuring against financial risks. For example, an individual who purchases car insurance is acquiring financial protection against physical damage or bodily harm that can result from traffic incidents.
As such, the individual is shifting the risk of having to incur significant financial losses from a traffic incident to an insurance company. In exchange for bearing such risks, the insurance company will typically require periodic payments from the individual.
Methods of Risk Transfer
There are two common methods of transferring risk:
1. Insurance policy
As outlined above, purchasing insurance is a common method of transferring risk. When an individual or entity is purchasing insurance, they are shifting financial risks to the insurance company. Insurance companies typically charge a fee – an insurance premium – for accepting such risks.
2. Indemnification clause in contracts
Contracts can also be used to help an individual or entity transfer risk. Contracts can include an indemnification clause – a clause that ensures potential losses will be compensated by the opposing party. In simplest terms, an indemnification clause is a clause in which the parties involved in the contract commit to compensating each other for any harm, liability, or loss arising out of the contract.
For example, consider a client that signs a contract with an indemnification clause. The indemnification clause states that the contract writer will indemnify the client against copyright claims. As such, if the client receives a copyright claim, the contract writer would (1) be obliged to cover the costs related to defending against the copyright claim, and (2) be responsible for copyright claim damages if the client is found liable for copyright infringement.
Risk Transfer by Insurance Companies
Although risk is commonly transferred from individuals and entities to insurance companies, the insurers are also able to transfer risk. This is done through an insurance policy with reinsurance companies. Reinsurance companies are companies that provide insurance to insurance firms.
Similar to how individuals or entities purchase insurance from insurance companies, insurance companies can shift risk by purchasing insurance from reinsurance companies. In exchange for taking on this risk, reinsurance companies charge the insurance companies an insurance premium.
Risk Transfer vs. Risk Shifting
Risk transfer is commonly confused with risk shifting. To reiterate, risk transfer is passing on (“transferring”) risk to a third party. On the other hand, risk shifting involves changing (“shifting”) the distribution of risky outcomes rather than passing on the risk to a third party.
For example, an insurance policy is a method of risk transfer. Purchasing derivative contracts is a method of risk shifting.
Additional Resources
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep learning and advancing your career, the additional CFI resources below will be useful:
- Actuary
- Commercial Insurance Broker
- Safe Harbor
- Subrogation