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What Is Risk Sharing?
Risk sharing is the economic phenomenon of spreading the uncertainties of potential losses across various stakeholders or organizations. Hence, it serves as a hedge during financial crises for parties engaged in high-risk businesses like financial markets, insurance, international trade, or public finance.
Such a mechanism has the power to save the banking, finance, and insurance industry from sudden downfall or collapse during the economic crisis. Therefore, the risk-sharing arrangement facilitates these businesses' sustaining their operations even if an unforeseen event occurs. Further, it helps these companies to become more competitive by ensuring sufficient funds and resources for expansion into new markets.
Key Takeaways
- Risk sharing refers to the strategy undertaken by firms engaged in banking, finance, insurance, international trade, and partnerships to limit their potential financial losses through the distribution of uncertainties among various stakeholders.
- It is one of the risk management practices that is essential for overall economic growth since it protects businesses from sudden collapse or bankruptcy during the financial crisis.
- The banks often resort to financial derivatives or syndicated loans to share their risk, while insurance companies choose to spread their uncertainties through the reinsurance of their assets.
Risk Sharing In Insurance Explained
Risk sharing is a critical aspect of risk management strategies adopted by businesses functional in sectors like insurance, financial markets, public finance, international trade, and partnerships. It is a mechanism that allows a company or individual to allocate a portion of their risk to the possibility of incurring a financial loss among other stakeholders or firms.
It, therefore, spreads such uncertainty among different parties, offloading the chances of solely bearing the overall loss (if it happens). In the insurance sector, the providers ensure risk sharing with their customers up to the sum insured. Meanwhile, they form a bundle of policies based on their risk profiles and sell the ones with high risk to the reinsurers who relish the premium amount derived from these insurance products and also bear the associated risk.
Risk management is essential for individuals, investments, and businesses to effectively manage their finances and the associated risk in their current and future endeavors. It requires proper analysis and evaluation of the potential financial loss and the associated costs. Risk sharing serves as a way to control or mitigate such losses to a certain extent. The banks often use credit and other financial derivatives, as well as syndicated loans, to limit their exposure to financial uncertainties. Similarly, players in the derivatives market can opt for credit default swaps, while businesses may seek mechanisms like public-private partnerships and securitization.
Examples
This practice can be seen in every aspect of modern business, where hedging, insurance, and partnership have become the new models of risk management. Let us understand its relevance through the following examples:
Example #1
Suppose Harry purchased a medical insurance policy from ABC Insurers in July 2019. His insurance policy covers almost all kinds of diseases up to $20,000 as of July 31, 2024. On August 08, 2024, Mr. Harry was admitted to the hospital, where he was diagnosed with liver failure. He was taken for a liver transplant surgery, whose overall cost would be $35,000. Now that Harry has medical insurance of $20,000, ABC insurer will bear the surgery expenses up to this amount. Thus, by providing medical coverage of $20,000, ABC insurer shared the risk of Harry's medical expenses to a certain limit.
Example #2
In 2023, the Bank of England (BoE) found that UK life insurance providers have become highly dependent upon risk-sharing strategies. This was evident from the sharp rise (more than 300%) in the assets being transferred to global reinsurers, amounting to £6 billion in 2023, compared to £1.9 billion in 2022.
The companies that were on top of this list were Legal & General, with £3.2 billion of assets for risk sharing, Pension Insurance Corporation, with £1.3 billion, and Phoenix Group, with £1.2 billion. Although the purpose was efficient management of pension liabilities, BoE fears it may adversely affect the savers' benefits by interfering with its transparency.
In the meanwhile. BoE's Prudential Regulation Authority has been planning to impose new regulations and conduct stress tests upon the firms to analyze their funded reinsurance avenues. The authority is more concerned about the investment and liquidity risks that these firms have distributed to the reinsurers.
Moreover, the other problem is the limited disclosure of such risk-sharing with the public, which has increased the concerns of the public trustees. Although the insurers claim that it is an effective step while emphasizing the financial strength and capabilities of their reinsurers, the regulatory bodies, trustees, and other stakeholders demand more transparency and information sharing in this context.
Advantages And Disadvantages
Advantages
- Risk sharing enables businesses to limit their exposure to huge financial losses that may even threaten their existence.
- Financial security helps businesses maintain sustainability and competitiveness.
- Risk sharing in financial markets can lower banks' interest rates, financial derivatives pricing, and insurance premium costs.
- From the macroeconomics perspective, such a mechanism can shorten the consequences of the global economic crisis on the banking, finance, and insurance sectors, saving these firms from collapsing.
- Businesses that adopt such strategies can shift their focus from financial stress to expansion, growth, and the pursuit of new opportunities.
- It results in the formation of strong relationships between the risk sharers by building trust and confidence in one another.
Disadvantages
- Notably, businesses share not only their potential losses but also their profits with the other parties in such an arrangement.
- However, insurance companies may lose decision-making power or control over the assets that have been shared with the reinsurers.
- Businesses sometimes become highly reliant upon such practices for risk management.
- It may adversely impact the credibility of the companies among the public trustees, who may find these firms opportunistic, irresponsible, and poorly managed.
- Such strategies can elevate the regulatory, legal, and ethical concerns of the authorities.
- The reinsurer's solvency and credibility may adversely affect the companies.
Risk Sharing vs Risk Transfer vs Risk Pooling
Although these three are different mechanisms in risk management, the risk sharing arrangement differs significantly from risk transfer and risk pooling in the following ways:
| Basis | Risk Sharing | Risk Transfer | Risk Pooling |
| Definition | It is an arrangement whereby two or more parties jointly take responsibility for the potential losses of the business. | It is the strategy adopted by a party to shift the burden of potential loss to another party. | It is a mechanism where the healthcare cost of any contributor is borne by their group of contributors and not by that individual alone. |
| Purpose | Properly allocate risk between the different parties to ensure that one party is not overly burdened with it. | Unload the uncertainties of one party and assign it to the other party, whether individual or firm. | Combined, they take the risk as a group even when it belongs to a particular contributor. |
| Mechanism | Mechanism Various parties share the risk in a particular proportion specified in the risk sharing agreement. | Risk shifts from one party to another through a formal risk transfer agreement. | A group of people come together to contribute funds and together bear the risk to offset losses. |
| Accountability | Each stakeholder is responsible for their portion of the risk. | The party that accepts the risk is responsible for bearing the potential losses. | Collective responsibility of risk-bearing and loss-bearing. |
Frequently Asked Questions (FAQs)
What is the purpose of risk sharing with providers?
What is the advantage of risk sharing in partnership?
What Are risk sharing instruments?
