This post discusses risk financing. In this post, you will understand the meaning of risk financing and ways of financing risks.

WHAT IS A RISK?

Risk is the uncertainty of financial loss. A risk is anything that may affect the achievement of an organisation’s objectives. It is the uncertainty that surrounds future events and outcomes. Risk is the expression of the likelihood and impact of an event with the potential to influence the achievement of an organisation’s objectives.

Risk (uncertainty) may affect the accomplishment of the goals. Hence, it benefits enterprises or businesses to manage their risk exposures. Risks may be harmful or beneficial to a business. From a business perspective, there are good and bad risks. Good risks connote business opportunities, and bad risks connote threats or adverse events.

Hence, every opportunity that creates value may be considered a good risk. Bad risks include ignoring regulations or failing to implement effective policies and procedures. Risks (good or bad) should be well-managed. The implication is that management of risks entails costs that may be financial or non-financial. Therefore, understanding the ‘cost of risk’ before discussing risk financing techniques is good. 

THE COST OF RISK

Risk expenses are the cost incurred in financing risks or losses if they materialise or occur. Risks can be retained internally or transferred to another company, e.g., transferred insurance. Hence, the cost of risks can also be described as a ‘cost of risk expenses’ or ‘cost of risk financing. 

Understanding the cost of risk is essential to ensure effective loss control and mitigation. This is necessary because:

1) Risk management decisions must be made before losses occur.

2) The magnitude of actual losses in each period can be determined after knowing the fact, i.e., frequency and severity of risks.

3) Before losses occur, the cost of loss reflects the prediction or expected value of losses in the future. 

4) The cost of losses can be determined ex-post (after the fact) and estimated ex-ante (before the fact). In essence, the cost of losses can be determined before or after knowing the frequency and severity of accidents.

COMPONENTS OF THE COST OF RISK

The cost of risk has five main features:

1. Expected cost of losses
2. Cost of loss control
3. Cost of loss financing
4. Cost of internal risk reduction
5. Cost of residual uncertainty

WAYS OF CONTROLLING RISKS

Adequate mitigation strategies/controls can reduce adverse risks and increase opportunities, but not all risks can be eliminated. Such risk is known as ‘residual risk’. Residual risk is the level of risk after evaluating the effectiveness of controls. Risk control should be based on residual risk levels.

There are five primary ways of controlling risks, consisting of: 

1. Risk avoidance,

2. Risk retention or acceptance,

3. Risk mitigation or reduction,

4. Risk transfer, and

5. Risk Sharing means sharing risks through loss-sensitive insurance contracts.

RISK FINANCING

Risk financing is concerned with providing or generating funds to pay for losses or offset the financial or economic effect of unexpected losses experienced by a firm. Risk financing involves retaining risks and adopting an explicit financing strategy to ensure adequate funds are available to meet financial needs should a disaster occur. Such financing can be established internally by accumulating funds set aside for future use or obtained externally through prearranged credit facilities.

OBJECTIVES OF RISK FINANCING

Goals of risk financing include: 

1) To ensure losses are paid or financed,

2) Maintaining an appropriate level of liquidity,

3) Maintaining uncertainty of loss outcomes,

4) Managing the cost of risk, and

5) Complying with legal requirements, e.g., compulsory insurance.

RISK FINANCING TECHNIQUES

Generally, risk financing techniques can be classified into two broad categories: 

1. Risk transfer, and 

2. Risk Retention.

Risk retention is a risk financing technique whereby losses are retained by generating funds within and outside the organisation to pay for losses. Risk transfer involves transferring risk through insurance and non-insurance techniques to shift the financial consequences of loss to another party.

Business risks can be managed and reduced internally. This is known as ‘Internal Risk Reduction’. Business risks can be reduced internally through (1) diversification, and (2) investments in the information.

RISK FINANCING TECHNIQUES

Major ways of financing business risks include:

1. Risk Retention,

2. Self-insurance,

3. Insurance (including traditional and loss-sensitive insurance contracts),

4. Hedging,

5. Diversification,

6. Investment in information, 

7. Derivatives, and

8. Other contractual risk transfers.

RISK RETENTION

Risk retention is a risk management technique whereby a company decides to absorb and accept, partly or wholly, potential loss rather than transfer the risk to an insurer or other party. The company consciously retained the risk’s consequences rather than transferring the risk to an insurance company or other party. 

Risk retention technique is the intentional decision of an organisation to handle and manage specific risks internally rather than transferring them to insurance or any other third party. Consequently, the organisation’s risk is self-financed and managed. Risk retention approach is the extreme opposite of the risk transfer approach in that it upholds the principle of taking responsibility for one’s actions. Risk retention is appropriate for high-frequency, low-severity risks with small potential losses.

Retention can be either active (i.e., planned and conscious retention) or passive (i.e., unplanned retention).

Active Risk Retention

 Active risk retention means that an individual or organisation is consciously aware of the risk and deliberately retains all or part of it. Active retention entails prior risk awareness, with a conscious provision to finance losses arising therefrom. Active risk retention might be used for two primary reasons. First, risk retention can save money. Second, the risk may be retained voluntarily because commercial insurance is unavailable or can only be obtained by paying prohibitive or huge premiums.

Passive Risk Retention

Risk can also be retained passively. Passive retention entails a lack of awareness about risk, thereby accepting the risk unknowingly or unconsciously. Certain risks may be retained unknowingly due to ignorance, indifference, or laziness. Passive risk retention may be harmful to an organisation if the retained risk can adversely impact its activity and continual existence.

FUNDING FOR RETAINED RISKS

Retained risks (retention) may be funded within or outside a firm. There are two ways of funding retained risks: 

1. Funded retentions; and 

2. Unfunded retentions. 

Furthermore, there are three general methods of paying for retained losses: 

1. Pre-loss Funding: This means that the fund is set aside to finance risk before the occurrence of a loss. Pre-loss funding usually involves establishing a funded account to finance losses arising from consciously or actively retained risks.

2. Current-loss Funding: This means that the fund is not set aside in advance to finance retained risks, but the loss is financed from the company’s working capital or miscellaneous fund when needed. Current-loss funding implies paying for losses out of current earnings or operating capital.

3. Post-loss Funding: This means that the fund is not set aside before the loss, but an arrangement subsequently to raise funds to finance the loss. Post-loss funding entails borrowing funds to pay for a loss.

There are two forms of risk retention: Internal and external risk retention.

1. Internal Risk Retention: an in-house (within an organisation) technique whereby a firm consciously accepts to bear financial consequences of risk from its operating fund or miscellaneous reserve.

2. External Risk Retention: This is a technique for managing risk where a firm transfer the financial consequences of risk to an insurance company or other third party. An organisation can also transfer its risks to Risk Retention Groups.

RISK RETENTION GROUP 

A risk retention group is a corporation or other limited liability association functioning as a captive insurance company and organised to assume and spread the liability risk exposures of its group members and member-owners. Risk-retention groups allow similar businesses to form groups to provide self-insurance. Commonly found in the United States of America (USA), The United Kingdom (UK) and some European Union (EU) countries. 

Risk-retention groups started emerging in the mid-1980s due to the passing of the Federal Liability Risk Retention Act of 1986 in the USA. The 1986 Act requires that all owners of Risk Retention Groups must be insured with the Risk Retention Group and engaged in similar businesses or activities. The Act requires that each group be licensed in at least one state in the USA to accept liability risks in all states.

SELF-INSURANCE

Self-insurance is a risk management method whereby an individual or an organisation sets aside money to finance and mitigate an unexpected loss. By principle, one can self-insure against any damage, such as flood or fire. Most people choose to buy insurance against potentially significant and unusual losses.

The theory is that since the insurance company aims to profit by paying premiums above the expected losses, a self-insured person should be able to save money by setting aside the money in emergency funds, which would have been paid as insurance premiums. Self-insuring against certain risks may be more affordable than buying third-party insurance. The more gradual and minor the failure, the greater the likelihood of a person or firm opting to self-insure themselves.

The cost associated with self-insurance include:

1. The cost of maintaining in-house reserve funds to pay losses,

2. Taxes on income from investing these funds, and

3. Possible opportunity costs that can occur if maintaining reserve funds reduces the ability of the company to undertake profitable investment opportunities.

RISK TRANSFER

Insurance is a risk transfer mechanism. Insurance and reinsurance and contracts are subject to risk transfer practices. The primary insurance contract is between the insured and the insurer. Under the primary insurance contract, the insurer must reinsure (i.e., transfer part of the risk accepted under the primary insurance contract) with another insurer or reinsurer. This contract is known as reinsurance, which is between the reinsured (the primary insurer under the insurance contract) and the reinsurer (the reinsurance company). 

Furthermore, the reinsurance company must also reinsure (transfer part of the risk undertaken under the reinsurance contract) with another insurer or reinsurance company. This contract is known as retrocession. Under retrocession, the insured (who is the reinsurer under the reinsurance contract) is known as the retrocedent, and the insurer is known as the retrocessionaire. The retrocessionaire is also expected to reinsure or transfer part of the risks underwritten to another insurance or reinsurance company.

LEGAL PRINCIPLES OF INSURANCE 

The nature of the legal principles of insurance varies from country to country. Meanwhile, there are six principles of insurance, including utmost good faith, insurable interest, indemnity, subrogation, contribution, and proximate cause. See the post on the principles of insurance.

INSURANCE CONTRACTS

Businesses can purchase two significant insurance policies to manage risks: 

1. Traditional insurance contracts, and 

2. Loss-sensitive insurance contracts. 

TRADITIONAL INSURANCE CONTRACT

This is an insurance contract whose premium depends on the value at risk and feature of the subject matter insured (i.e., the item or risk insured) at the inception of the insurance contract.

CLASSES OF TRADITIONAL INSURANCE

Traditional insurance contracts include fire insurance, theft insurance, money insurance, credit insurance, business interruption insurance, contractors-all-risk insurance, goods-in-transit insurance, engineering insurance, motor insurance, marine insurance, aviation insurance, public liability insurance, product liability insurance, professional indemnity insurance, employers liability insurance, directors and officers liability, contingency insurance, life insurance, sickness and accident insurance.

LOSS-SENSITIVE INSURANCE CONTRACTS

Loss sensitive insurance contract is an insurance rating for which the final premium depends on the actual losses during the period the plan is in effect. Loss sensitive insurance contract is an insurance policy whose premiums depend on the loss experienced. This risk financing technique limits the insured’s costs if its losses are high and require a minimum premium if it experiences low losses or is loss-free. 

Loss-sensitive insurance incentivises firms to emphasise safety and loss control activities. With a loss-sensitive structure, a firm pays a lower premium for partial coverage of a loss above its deductible. The organisation can reduce retained costs by improving safety and claims handling procedures. Hence, the risk financing costs of loss-sensitive insurance contracts vary based on the actual loss experience.

Advantages of Loss-Sensitive Insurance

Advantages of sensitive Loss Insurance include lower premiums, savings through loss control and claims handling, improved cash flow and investment income, price stability, and lower cost of risk. Examples of loss-sensitive plans include deductible plans, retrospective rating plans, dividend plans, and retention plans.

LOSS FINANCING THROUGH HEDGING

Hedging is a way of financing risk and losses. Hedging is purchasing or selling one asset to offset the risks associated with another asset. Hedging is a transfer of risk without buying insurance policies. Generally, hedging is a contract that can be used to hedge (offset losses) risks. The asset held to offset the risk is often a contract, such as an option or futures contract. Hedging is a transaction that reduces the risk of an investment.

Commodities (such as energy, metal or agricultural), foreign exchange or currencies, and interest rates are frequently hedged. The risk transfer is the exposure to loss from a decline or increase in an asset’s market price. The asset concerned is the hedging party holds for an extended period as a regular part of doing business.

LOSS FINANCING THROUGH OTHER CONTRACTUAL RISK TRANSFERS

Other contractual risk transfers allow firms to transfer risk to another party. For example, firms can engage independent contracts to perform some tasks. Outside the insurance context, contractual liability has a broad meaning or agreement that a court may enforce.

Factors Influencing Contractual Risk Transfer

Factors affecting contractual risk transfer include: 

1. Control of the risk – who is in the best position to control the risk? 

2. Knowledge of the risk – Does one party’s knowledge of risk make them more logical to assume risk? 

3. Statutory or common law limitations on risk transfer

4. Custom and practice – generally accepted modes: owner to the general contractor or general contractor to sub-contractor.

5. Bargaining position: The more competitive the marketplace, the more risk a company will likely accept in negotiations.

RISK FINANCING THROUGH DIVERSIFICATION

Diversification is another way of financing a loss or risk. Investors can eliminate diversifiable risks by holding a diversified portfolio. In contrast, non-diversifiable risk cannot be eliminated by investors through diversification. 

Diversifiable risk does not affect the opportunity cost of capital. This is because diversifiable risk and associated costs can be eliminated through diversification. Non-diversifiable risk increases the opportunity cost of capital. This is because diversification cannot eliminate non-diversifiable risk; hence, the fund must be set aside to manage the associated cost.

Diversification may be two primary forms: 

1) Diversification of operations, and 

2. Internal diversification.

RISK FINANCING THROUGH ‘INVESTMENT IN INFORMATION TECHNOLOGY

Investment in information is another way of financing a loss or risk. Firms can invest in information to obtain superior forecasts of expected losses. Investment in information can produce more accurate estimates and projections of future cash flows to reduce the variability of cash flows around the predicted value. Many firms specialise in providing information and forecasts to other firms and parties.

DERIVATIVES

Derivatives are financial products that derive their value from the price of an underlying asset. They usually exist as a contract between two parties, traded over-the-counter or on a stock exchange. Many underlying assets can be traded using derivatives, including forex, shares, indices, bonds, and commodities. No physical assets are traded when derivative positions are opened. Derivatives are suitable for professional and private investors wishing to hedge an open position or gain exposure to assets and markets without holding the underlying assets. Speculators may also trade derivatives with the sole purpose of making profits on short-term price movements.

THE DIFFERENCE BETWEEN ‘DERIVATIVES’ AND ‘INSURANCE CONTRACTS’

Characteristics of Derivatives

Characteristics of derivatives contracts include

1. Derivatives contracts focus on hedging ‘market-price risk’. 

2. Derivatives contracts involve many firms potentially in a specific contract. 

3. Basis risk (i.e., uncertainty regarding the effectiveness of a hedge) in derivatives contracts is high.

4. Contracting cost of derivatives contracts is low due to moral hazard, adverse selection, and bounding contractual performance. 

5. Derivatives contracts liquidity is low due to many firms potentially interested in a particular contract and contracting costs.

Characteristics of Insurance Contracts 

Features of insurance include:

1. Insurance contracts focus on ‘Firm-specific risk’. 

2. Insurance contracts potentially involve one or more insurance firms (insurers or co-insurers) in a specific contract.

 3. Basis risk (i.e., uncertainty regarding the effectiveness of a hedge) in insurance contracts is low.

4. Contracting cost is high depending on the moral hazard, adverse selection, and bounding contractual performance.

 5. Insurance contracts liquidity is low due to firms potentially interested in a particular contract and contracting costs.

See the video on Risk Financing: https://youtu.be/0xhBFxf6HRI