What are the benefits and drawbacks of transferring risks to third parties?

In my experience, if you don’t have proper governance, controls and oversight in to said 3rd parties, it will not favor well. The benefits to using 3rd parties can be lucrative, but it doesn’t negate your risk responsibilities, period. It’s a partnership between both parties. Something you both enter into with expectations and outcomes identified and agreed upon. Not doing so is reckless and usually more costly in the end.

While there are benefits to transferring risk, it is vital to remember that the ultimate responsibility still rests with the person or organization. A transfer of risk does not absolve anyone of the responsibility if a risk event occurs. For this reason it is essential to know exactly what the 'Cost of Risk' is when you take into account all the costs that could be associated with resolving a risk event, despite having transferred the risk.

Transferring risk to third parties create a lot of efficiencies in one's workflow on an operational level, especially for a small business. But the drawbacks must be considered carefully. Personally speaking, I love the efficiencies from the day to day management perspective, but have protocols in place to monitor and consistently review performance. The reduced control is something that carefully needs to be considered as you review each situation.

Deciding when to transfer risks hinges on a strategic evaluation of their probability, impact, and the associated costs. Typically, risks that are low-probability but have high-impact consequences are prime candidates for transfer, especially when the transfer cost is less than potential losses. Insuring against fire or theft is a classic example. Conversely, high-probability, low-impact risks are often retained, especially if transferring them might forfeit potential advantages. For instance, outsourcing customer feedback might save time, but could sacrifice direct customer relationships and insights. Decisions should always weigh costs, benefits, and strategic implications.

Advising C-suite on the most effective means to transfer risk is crucial to developing reliable operational functions. It is best to do your research before entering into an arrangement where any degree of risk is transferred. Consider requesting a sample report or template generated by the third party to show metrics and KPIs that measure the success rate as a mechanism to monitor the relationship once implemented. Also ensure to set up clear expectations and impress upon the third party that while risk exposure is transferred, any negative impact will reflect on your firm and could result in legal ramifications. A good third party with your best interests in mind will have no problem evidencing any verbal promises.

It’s worthwhile to remember that the overall ownership remains despite a particular risk being outsourced. In addition to having a robust contractual arrangement that clarifies responsibilities and deliverables for each party, it is also important that third-party’s credentials be vetted to assure that they can actually stand by their part of obligation.

A winning strategy would be to build on-house capacity to manage risks closer to burning layer and consider well documented transfer arrangements to third parties with established credentials and capacity to withstand a few major shocks. eg. More and more multinationals are building captive capacity to manage the losses in the ‘burning layer’ and only looking at proper risk transfer for loss events of catastrophic nature that the P&L may get seriously impacted with.