In personal life or business, unfortunate events can cause growth to stall. Risk transfer is a vital risk management tool that gives individuals and businesses the ability to protect themselves and pursue growth opportunities. Entities should be aware of the advantages of assigning potential liability to others, and as a best practice, should arrange for insurance contracts accordingly. Entities should make an informed decision about risk transfer that enhances financial stability, nurtures growth, and ensures more resilient growth.
Introduction to Risk Transfer
In today’s ever-evolving business landscape, managing risks is critical to ensuring the long-term success and sustainability of a company. This includes identifying potential hazards, assessing their potential consequences, and implementing mitigation measures.
Risk Transfer is the mechanism by which a company can shift risk to a third party. The main goal is to mitigate the financial impact of adverse events so that the business can focus on its core activities. One familiar technique of risk transfer is insurance, where a business pays a premium to purchase an insurance policy that protects it from unforeseen events. Insurance companies that bear the risk of a company can also transfer that risk to reinsurance companies, which provide insurance to insurance companies.
What is Direct Risk Transfer (DRT)?
Not all risks can be bought, so there is also Digital Risk Transfer (DRT), which is the process of transferring risk between peers. Peers can include insurance or reinsurance companies, corporate risk transfer buyers, protection seekers such as multinational organizations or sovereigns, and capital market institutional investors. Companies can delegate the burden of carrying the financial consequences of a risk to another entity. By using this strategy, companies can focus on their core competencies while reducing the impact of potential hazards. DRT involves the direct transfer of risk without the involvement of intermediaries or third parties.
Benefits of DRT
- Financial Protection: DRT provides businesses with financial protection against unforeseen events. By transferring risks to other parties, companies can mitigate the potential losses.
- Enhanced Risk Management: By leveraging the expertise and resources of insurance providers or other parties, businesses can tap into specialized knowledge and experience in risk assessment and mitigation.
- Business Continuity: By transferring risks, companies can ensure business continuity even in the face of unexpected events.
Value Addition for DRT using DLT
DRT can be built on Distributed Ledger Technology (DLT) and can be implemented to pay claims to customers based on external events. There are three major entities involved in the Direct Risk Transfer process:
- Insured or policyholder: The entity that buys insurance to transfer risk and become risk-free.
- Investor: The entity that invests or purchases assets in the form of derivatives to provide protection.
- External Event Trigger: The entity that provides information about calamities.
The insured pays a premium to the insurer to purchase an insurance policy. The investor also earns a premium by making derivative investments. If an external event such as a calamity occurs before the maturity of the investment made by the investor, the insurer receives the claim coverage. If the investment matures and no external event like a calamity occurs, the investor may receive a partial or full premium upon the investment made.
Benefits of using Blockchains in DRT
- Efficiency gain: The traditional manual processes can be accelerated by integrating blockchain technology, thereby increasing the efficiency of the system.
- Better security and transparency: Blockchain technology enables policyholders to view all policy-related information and track the progress of claims in the event of an external mishap. This helps to improve trust among policyholders and reduce fraud.
- Automated Payouts: Smart contracts enable automated claim processing and payouts.
With the increase in uncertainties around the world, it is essential to be risk-free. Using risk transfer mechanisms and blockchain technology, it is possible to mitigate future financial risks caused by mishaps and reduce out-of-control risks. Direct risk transfer offers businesses a strategic approach to managing and mitigating potential risks.