A surety bond is a three parties contract between: (1) the principal which obtains the bond and pays the premium, (2) the oblige which is the beneficiary of the bond, and (3) the surety company, generally an insurance company, which guarantees the obligation of the principal towards the oblige.
Under a surety bond, the loss faced by the oblige may be caused intentionally or not by the principal. In practice, a no loss situation is expected otherwise the insurance company would not grant the bond. The premium covers only the surety's investigation costs, the transaction costs, and a margin for profit for the company. If a loss does occur, the surety company can turn to the principal for reimbursement. A surety bond is not an insurance contract.
Contracts of Sale, Supply, and Services
Contracts relating to the distribution of goods and services also provide transfer of risk. Producers and distributors often offer to their costumers some guarantees against defects of products. Examples are the warranties offered by the seller and the manufacturer on the performance of a car (new or used) or service contracts on computers, television, home equipment, etc.
When a firm enters into an arrangement to lease equipment or facilities for its own use, the contract usually stipulates that the provider must bear the burden of any damage to, or destruction of the property. The transfer may include responsibility regardless of the cause of the damage, and also legal responsibility for all legal liabilities arising out of the use of the equipment or facilities. As in the case of transfers regarding damage to, or destruction of property, the transfer may be conditioned upon the circumstances giving rise to the liability.
Hedging is based upon the assumption that in efficient money or commodities markets the present cash value and the future price will move in the same direction. Any gain or loss in a cash position today, due to an unforeseen circumstance, will be offset by an equal gain or loss from the future position. If the price of a commodity (or a currency) should drop today, there will be a loss
on a cash position compensated by a corresponding gain in the future (short-term or long-term ) position. Hedging with future contracts or forward contracts is a very useful and worldwide practice in many forms of trade. Another interesting application of hedging are the put and call options in stock markets.
The limited liability of the corporate form of organization could be consider as a form of risk transfer. Loss in excess of business assets is borne by the creditors rather than by the owners. The issue of capital structure is probably one of the most studied and debated in all finance. If the firm is heavily leveraged, the limited liability of shareholders means that bondholders must bear most of the risk while shareholders gather most of the potential returns.
According to the Black-Scholes option pricing model, this option becomes more valuable as company cash flows increase in variability. The result is a transfer of wealth from bondholders to shareholders because the risk of default has risen but bondholders are not compensated for the added risk. Shareholders, other things being equal, have an incentive to engage in risk-increasing activities (highly risky projects) that have the potential of high returns.