One of the most common means of managing risk financing is to use insurance coverage to cover potential losses associated with a particular business venture.
Risk financing is a term used to describe the consumption of resources that occurs when a company suffers financial losses in the course of its business activities. Financing is all about raising funds that can be used to offset losses, allowing the business to manage losses without negatively impacting the day-to-day running of the business. Risk financing is managed in various ways, including setting up reserves for this type of issue, sharing the risk with third parties or even obtaining insurance that effectively transfers the risk to an insurer.
One of the most common means of managing risk financing is to use insurance coverage to cover potential losses associated with a particular business venture. Here, the idea is to transfer the risk from the company to the insurance company, by contracting a policy that will honor compensation claims in the event that certain events occur with that project. Although expensive, this type of financing strategy offers the advantage of knowing that even if the project ultimately fails due to one or more events covered by the policy, the losses will be settled without using other company assets.
A company may also choose to manage risk financing in-house, establishing pools of funds that can be used to pay down debt associated with a failed project. This approach allows the company to provide itself with a form of self-insurance. The funds are usually placed in some type of interest bearing account and set aside as backup funds to be used only in emergency situations. This helps separate this account balance from corporate operating funds. If the project in question fails, the funds in this emergency reserve can be used to pay down debt without drawing on the general operating fund and possibly jeopardizing the financial stability of the company.
Risk financing can also be managed with what is known as risk pooling. Assuming there are two or more partners in the business, each partner agrees to take a percentage of the risk and creates their own reserves to manage that risk. The end result is that no one partner has to face paying off all the debts associated with a failed business, which in turn means less chance of negatively impacting the financial well-being of either partner.