RISK FINANCING STRATEGIES

Role of Insurance in Risk Management and Risk Financing Strategies

Role of Insurance in Risk Management and Risk Financing Strategies

Introduction

The importance of insurance as a tool to minimise risk and assist in risk management of corporations cannot be denied with its role being inevitable. It not only minimises risk but also lead towards prevention of risks which is of utter importance in this era of stringent economic conditions (Todd et al., 2000, pp. 238). This results in consequences that trigger economic growth and development through better outcome depicted by business operations. The impact of risk management strategies is so substantial that Enterprise Risk Management (ERM) programs are now established and implemented by disparate organisations across all the industries (Shimpi, 2001, pp. 12). Although, the extent to which specific firms implement ERM solutions differs widely across different industries but even then they are being increasingly used as they register significant impact on the value of the firm.

Discussion

Insurance is considered as of topmost importance among the two conventional risk management strategies, with the other being hedging (Adam & Fernando, 2006, pp. 296). It is not just the risk aversive attitude that prompts corporations and businesses to seek insurance. Diverse base of shareholders in any firm plays a key role in guiding the firms of all the loopholes and risks that they might be incurring with the undertaking of a particular strategy and thus they act as a steering committee that is usually consulted for the diversity of views they hold since they possess expertise in wider domain. As a result, firm specific risk could easily be diversified by the knowledge of the shareholders; rather they believe investing in insurance and paying premiums would invariably decrease their wealth eventually instead of adding value (Grillet, 1993, pp. 302).

The view changes though when it is considered under the domain of financing policies of the firm with significant positive impact (Froot et al., 1993, pp. 1644). It affects investment policy, reduces contracting cost along with the tax liabilities the firm could have borne (Seog, 2006, pp. 287). It assists organisations by saving cost in times of conflict of interest between managers and owners as well as between shareholders and bondholders. Furthermore, it helps transferring the entire cost of the organisation onto the third party when the firm is in the state of bankruptcy, in addition to the tax burden and the cost of the regulatory inspection and analysis conducted (Meyers & Smith, 1982, pp. 289). This is the fundamental justification behind the perception of insurance as an important player in the risk financing and management. This increases the probability of the firm gaining optimal return on equity and achieving capital efficiency.

It has been found by one research that monitoring mechanisms along with the managerial incentives prompt the use of insurance as a key strategy for risk financing and management. However, the same research goes on to point out that if the insurance is bought just to serve personal agendas and is more in the self-interest ...