Contractual Risk Transfer: A Brief Introduction

Throughout our series of articles on the various aspects of risk management, we have discussed different methods of treating risk or exposure to loss. These treatments have been primarily concentrated on internal controls or risk management techniques. This article will present a brief introduction to a form of one risk management technique discussed in an earlier article, that being Risk Transfer. Even more specifically the use of contractual risk transfer.

Let's take a brief look back to reacquaint ourselves with risk transfer. Risk transfer is just that, the transfer of risk to another party using either pure contractual methods or financial methods.

Insurance is the most common method of transferring risk and involves a combination of the two commonly accepted methods. Financial in a sense that a premium is paid to transfer the risk of the insured to the insurer and contractual, in that the premium purchases protection offered by the insurance contract.

This article will treat specifically the use of the pure contractual method in which to transfer risk. The design and introduction of any contractual risk transfer is largely the work of attorneys. Because of this, the presentation of this topic will center on background and intended use of the contractual risk transfer and an overview of it's importance as a risk management tool used in concert with other methods and not to deal with the design of actual agreements or argue their viability.

Loss transfer by contract should be used

1. when a loss may be too great for safe retention,
2. if loss transfer is the most efficient way to handle the loss exposure,

or

3. if there is a legal reason or obligation for the loss transfer.

Losses may also be transferred by tort law, statue, one's own acceptance, and the creation of another entity to accept risk. These final methods do not give the risk manager or responsible party much control and while important, do not weigh heavily in the risk management planning function.

Most contracts involve risk transfer and in some cases, the transfer is inherent to the contract itself. Although contracts have legal limitations on transfer provisions, the chance of legal transfer are as far reaching and broad as the creativity of their authors.

Each type of contract has features that dictate the reason for transfer and the scope of the transfer. Summary provisions of the contract are usually to cursory to be totally useful. Therefore, extra caution and attention should be paid to the possible misuse of the contract, in terms of risk transfer. Many negotiations center on the mad rush for quick transferral of risk. Without cautious and paced review of the transfer clause, an entity could be saddled with the easy acquisition of risk without full knowledge of it's acceptance.

If properly handled and cautiously administered, the contractual transfer of risk serves as a useful device and can be used to accept or transfer acceptable levels of exposure.

When considering using a contractual risk transfer, you should look to several situations for direction: who the transfer is to affect and can they manage or control the transfer, and possible division of losses to other parties of the contract that would be liable without the contract, including possible third party interest.

While this method involves tremendous advantages, there can be several problems in loss transfer. They are

1. legal enforceability,
2. the cost of the transfer,

and

3. inability of the other party to manage the risk and accept losses.

To assist in the easy transfer of risk, the contract should be clear and specific with regard to intent of the transfer. The transfer should involve financially responsible parties and the management of risk should be within the capabilities of the contracted parties.

Administrative Control

Regardless of the size of the county or it's contracts, it is important to have an orderly, efficient contract administration program for the control of contractual risk transfer. This administration relies exclusively on the cooperation and communication of the various departments entering into contractual agreements and the administrator of the contract. This includes everyone who drafts contracts offered by the county as well as those who accept contracts for the county.

From the beginning, the general objective should be to give clear instructions to all personnel regarding the grave consequences of accepting risk hidden in innocuous, "plain vanilla" contracts and the need to submit all contracts to the responsible party for review and evaluation.

One trap in any organization is the routine contract, the contract used year-in and year-out. Legal issues are constantly changing and may affect a contract that has routinely been renewed or accepted over time. A control system should be put in place to monitor and periodically review these contracts for clarity and intent.

With regard for the review process itself, a county must continually review the process itself to determine that all of the parties affected by the contract have input. For example, the insurance company should generally be appraised of any provisions which may place undue exposure in there corner. In summary, the best program for contract administration, from a risk management perspective, must continue to evolve and change as needed. In review, the successful use of contractual risk transfer is dependent on clearly established the intent of the transfer and it's careful administration. The Wisconsin County Mutual Insurance Corporation and any insurance company depends on the open exchange of information and thoughts with regard to contractual risk transfer. Please do not hesitate to contact your insurer for input and discussion centering on your intent when implementing contractual risk transfer.

Entire books have been written on the subject of contractual risk transfer. This article was intended to portray the importance of risk transfer and it's administration. Because of the confines of space detail review and questions regarding this topic could not be fully examined. Please contact me, your agent or insurance carrier if there are any questions.