Risk Financing

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Risk Financing
The objective of risk financing, the third element in the risk management
process, is to have the necessary financial resources available following the
occurrence of a loss so that the continuity of the operations of the firm or
organization can be preserved. Basically, the finance alternatives include internal
funds available to the firm and external fimding or compensation that can be
obtained from other economic agents.
Michael Smith in Williams and Heins (1989, Chap. 14 ) argued that
restoring a damaged asset is rational when its restoration increases the market
value of the firm. He explained that both the restoration and the commitment to
restoration contribute to the value of the firm. The emphasis on restoration or
61
on replacement may explain the importance of insurance to finance contingent
losses.
According to Doherty (1985, p.30) when the loss financing arrangement is
set in place in anticipation of a possible loss, the procedure can be defined as
preloss-financing. The commitment to restoration is usually made before
any loss has occur, but the decision to secure funds can also be set in place after
the loss. This arrangement is called postloss-financing.
The strategy that is adopted for dealing with assumed risks may give rise to
either greater or lesser costs, and hence will offset expected profits. If a firm
decides to absorb the costs of losses within its own financial resources, the
strategy may be speculative in nature. The decision to finance the expected
losses should be made on the same basis as any fmancial decision such as the
investment in plant or equipment, whether to buy or lease and so forth. In most
cases, the optimal strategy will combined both the retention of part the costs by
the firm and external funding arrangements or compensation.
Retention can be used successfully when losses are predictable and within
the funding capacity of the firm. However, this involves a close examination of
the financial strength of the organization to ensure that retained losses do not act
contrary to the other objectives of the firm. The rationale for retention is that
self-funding of losses that are within the financial capacity of a firm is generally
more economical than seeking external funds or transferring the risk through an
insurance mechanism to obtain compensation for losses. However, the
insurance mechanism is certainly the most important preloss-financing tool and
it is critically important for high severity of losses.

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