The document discusses residual risk and alternative risk transfer methods. It defines residual risk as the risk remaining after known risks have been mitigated or eliminated. Various risk mitigation techniques like avoidance, reduction, transfer, and acceptance are described. Insurance is provided as the primary example of risk transfer, allowing individuals and companies to transfer risks to insurers. The document also notes that insurers can transfer risks through reinsurance.

1. Residual Risk Financing

2. • Introduction
• Responsibilities for Risk Transfer
• Alternative Risk Transfer
• Factors Affecting Insurance as a Risk Financing
Tool
• Balancing the Options
• Summary

3. • Residual risk refers to the risk of loss or harm
remaining after all other known threats have
been eliminated, factored in, or countered.
• It is the risk that is still present after all efforts
have been made to eliminate or minimize risks
associated with an investment or business
process.
• After assessing the risk related to an investment
or business project, we might not know about the
residual risk, or we may be aware of it but know
there is not much we can do about it.

4. Continued…
• Regardless of whether or not we are aware of the
remaining risk after factoring out all the known
ones, whoever carries out the investment or is
involved in the business project assumes the
residual risk.
• When we purchase an asset, we are exposed to
several different risks – many of which are not
unique to the asset we bought.
• There are risk that all assets are exposed to, such
as
– a change in interest rates,
– a rise or decline in the stock market average, or
– the overall change in the GDP (gross domestic
product) growth rate.

5. Introduction
• In finance, residual risk is the volatility of a
stock once prices are controlled for general
market movement.
• The idea is that the total risk of a stock is
composed of two factors:
– the ups and downs of the economy as a whole
and
– the fluctuations caused by the actions of the
individual firm.

8. • Car seat-belts and residual risk
• Before seat-belts were introduced, the risk of serious injury
or death from vehicle accidents was extremely high.
• After they were fitted into cars and legislation forced
people to wear them while their cars were moving, the
incidence of serious injury and death declined considerably.
• Even though the installation and use of seat-bets reduced
the overall severity of injuries and risk of death, the risk
was still there – that remaining risk is the residual risk.

9. Dealing with residual risk
• Individuals, companies, governments and other
entities have four ways of dealing with risk:
• avoid it
• reduce it
• accept it
• transfer it
• We can transfer the residual risk to an insurer by
taking out an insurance policy

10. Inherent vs. residual risk
• – Inherent Risk: is the risk that an investment, project, or any
activity poses if no controls or other mitigating factors are in place.
• Inherent risk is also known as the risk before controls or gross risk.
• – Residual Risk: – is the risk that is still there after controls have
been taken into account. It is what is left over after all efforts to
mitigate or eliminate risk have been exhausted.
• Residual risk is also called risk after controls or the net risk.
• In accounting, inherent risk is the risk of a mistake (misstatement)
in the financial statements appearing due to an omission or error
that did not result from a failure of controls

12. Formula to Calculate Residual Risk
• The general formula to calculate residual risk is:
– Residual Risk = Inherent Risk – Impact of Risk Controls
• Inherent risk is the amount of risk that exists in the absence of
controls or other mitigating factors that are not in place. It is
also known as the risk before controls or gross risk.
• The impact of risk controls is the amount of risk eliminated,
mitigated, or hedged by taking internal or external risk
controls.
• Thus, when the impact of risk controls is subtracted from the
inherent risk, the residual amount that remains is this risk.

13. Continued…
• Let us look at residual risk examples so that we can find out what the
residual risk could be for an organization (in terms of potential loss).
Consider the firm which has recently taken up a new project.
• Without any risk controls, the firm could lose $ 500 million. However, the
firm prepares and follows risk governance guidelines and takes necessary
steps to calculate residual risk and mitigate some of the known risks. After
taking the internal controls, the firm has calculated the impact of risk
controls as $ 400 million. This impact can be said as the amount of risk loss
reduced by taking control measures.
• Now, inherent risk = $ 500 million
• Impact of risk controls = $ 400 million
• Thus, residual risk = inherent risk – impact of risk controls = 500 – 400 = $
100 million

14. How companies try to Mitigate Risks?
• 1 – Avoid the Risk
• 2 – Risk Reduction
• 3 – Risk Transfer
• 4 – Risk Acceptance

15. How companies try to Mitigate Risks?
#1 –
Avoid the
Risk
Companies may decide not to take on the project or investment to
avoid the inherent risk in the project. A Company may decide not to
take a project to develop technology because of the new risks the
Company may be exposed to. However, in avoiding such risks, the
Company may be exposed to the risk of the competitor firm developing
such a technology. The Company may lose its clients and business and
maybe pose to the threat of being less competitive after the
Competitor firm develops the new technology. Thus, avoiding some
risks may expose the Company to a different residual risk.
#2 – Risk
Reductio
n
Companies perform a lot of checks and balances in reducing risk.
However, such a risk reduction practice may expose the Company to
residual risk in the process itself. Consider a production and
manufacturing company that has the list of procedures to be
performed in the manufacturing line, which checks the risks involved at
each stage of the process. However, human or manual errors expose
the Company to such risk, which may not be mitigated easily.

16. Continued…
#3 – Risk
Transfer
Most of the Companies and individuals buy insurance plans from
insurance Companies to transfer any kinds of risks to the third party.
While buying an insurance plan is the basic tool to mitigate all types
of risks, but it too has some amount of residual risks. Suppose a
Company buys an insurance scheme on a fire-related disaster.
However, the Insurance Company refuses to pay the damage, or the
insurance company goes bankrupt due to the high number of claims
for other reasons. Thus, risk transfer did not work as was expected
while buying the insurance plan.
#4 – Risk
Acceptan
ce
After taking all the necessary steps as mentioned above, the investor
may be bound to accept a certain amount of risk. This is called risk
acceptance, where the investor may neither be able to identify the risk
nor can mitigate or transfer the risk but will have to accept it. Also, he
will have to pay or incur losses if the risk materializes into losses. Such
a risk acceptance is generally in the case of residual risks, or we can say
that the risk which is accepted by the investor after taking all the
necessary steps is the residual risk.

17. While risk transfer and risk acceptance are the two methods to
counter such risk, however, the organizations must follow
additional steps as below:
• Identify and mitigate all known risks to the Company.
• Follow the risk framework to avoid any loss or damages.
• Identify governance, risk, and compliance requirements and
formulate policy for the same.
• Determine the strengths and weaknesses of the risk framework and
try to enhance it.
• Define the organization’s risk appetite, its capacity to take risks, and
resilience to losses in case of an event.
• Identify and take necessary action to offset the unacceptable risk.
• Buy insurance against losses to transfer the risk.
• Lastly, the organization should accept the risk as it is and maintain a
resource buffer.

18. ALTERNATIVE RISK TRANSFER

19. • 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.

20. • 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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

27. What is Risk Transfer?
• Risk transfer can be defined as a mechanism of risk
management that involves the transfer of future risks from
one person to another, and one of the most common
examples of risk management is purchasing insurance
where the risk of an individual or a company is transferred
to a third party (insurance company).
• Risk transfer, in its true essence, is the transfer of the
implications of risks from one party (individual or an
organization) to another (third party or an insurance
company). Such risks may or may not necessarily take place
in the future. Transfer of wagers can be executed through
buying an insurance policy, contractual agreements, etc.

28. How does Risk Transfer Work?
• One of the most common areas where risk transfer takes
place is in the case of insurance. An insurance policy can be
defined as a voluntary arrangement between the individual
or an organization (policyholder) and an insurance
company. A policyholder gets insured against potential
financial risks by purchasing an insurance policy from the
insurance company.
• The policyholder will need to make regular and periodic
payments to the insurance company for ensuring that his or
her insurance policy is not getting lapsed on account of the
failure of making timely payments, i.e., premiums. A
policyholder might choose from a variety of insurance
policies offered by various companies.

30. Risk Transfer Example
• A buys car insurance for $5,000, which is valid
only for the physical damage of the same, and
this insurance is right up to 31st December
2019. A had a car accident on 20th November
2019. His car suffers from severe physical
damage, and the cost of repair of the same
accounts to $5,050. A can claim a maximum of
$5,000 from his insurance provider, and the
rest cost will be solely borne by him.

31. Types of Risk Transfer
• Insurance
• Derivatives
• Contracts with indemnification clause
• Out sourcing

32. Insura
nce
In an insurance mechanism, an individual or a
company can purchase an insurance policy from the
preferred insurance company and accordingly
safeguard itself from the implications of financial
risks underlying in the future.
The policyholder will need to make timely payments
or premiums to ensure that the undertaken
insurance policy remains valid and does not fail on
account of failure to make timely payments.
Deriva
tives
It can be defined as a financial product which attains
its value from a financial asset or an interest rate.
Derivatives are mostly bought by firms to protect
against financial risks like the currency exchange
rate, etc.

33. Contracts
with an
Indemnificat
ion Clause
Contracts with indemnification clauses are also used by an individual or
an organization for risk transfers. Contracts with such a clause ensure
the transfer of financial risks from the indemnitee to the Indemnitor. In
such an arrangement, the future economic losses shall be borne by the
Indemnitor.
Outsourcing Outsourcing is a type of risk transfer where a process or a project is
outsourced for transferring various kinds of risks from one party to
another.