Role of insurance within a wider system of risk financing and managementIntroductionOrganisations and individuals alike are exposed to different kinds of risks and need to be protected from these risks. There are two types of business risks: non-entrepreneurial risks such as fire, pollution or fraud; and entrepreneurial risks that result from unwise decisions made by a business such as poor market forecast, ineffective new product launch or losses associated with establishing a new firm (Sadgrove 2005, p. 3). This does not mean that risk is associated only with unwise decisions made by a firm since even good decisions could have bad outcomes.
It therefore follows that most management decisions are associated with risk. Although not all risks are catastrophic, some losses can cause significant damage. Thus firms need to secure themselves from these risks whether or not they are deemed to be catastrophic, and this is where insurance comes in. However, insurance is only just one way to protect a firm from risks. Against the background information above, this essay critically evaluates the role of insurance within the wider system of risk financing and management.
To start with, the essay defines the terms risk, risk financing and risk management and discusses the implications of insurance in the context of these terms. In this regard, the essay also discusses the advantages and disadvantages of insurance to firms as they strive to finance and manage risks. Definitions of risk, risk financing and risk management RiskIn insurance, a risk implies the likelihood of a loss or other unfavourable occurrence that has the potential to get in the way of an organisation’s capacity to execute its operations, and for which an insurance claim can be lodged (Insurance Bureau of Canada 2012).
The risk is always associated with the loss aspect because the word “risk” itself denotes a danger of loss. Risk financingRisk financing refers to any measure that is taken to cater for the cost of a loss or probable loss (Young 2005, p. 128). The aim of risk financing is to guarantee economic provision of resources to finance the upturn of an organisation from property loss, liability claims from workers and other affected parties, personal harm or death affecting the efficient operation of business activities, and business disruption losses (usually loss of revenue for a pre-determined period) (Edwards 1995, p.
27). Risk management Risk management refers to the activities that are undertaken to reduce exposure to loss (IBM 2006, p. 3). Risk management ensures that an organisation is able to identify and understand the nature of risks that are likely to affect it. It also ensures that the organisation prepares and executes a reliable plan to avert losses or lessen the effect in case a loss occurs (Insurance Bureau of Canada 2012). It can be noted from the definitions above that risk financing and risk management are two related phenomena.
According to Fried, Shapiro and DeSchriver (2008, p. 263), risk financing is a passive activity compared with risk management. Risk management is designed to prevent loss, whereas risk financing is designed to help settle a financial dispute after the occurrence of a loss (Fried, Shapiro & DeSchriver, 2008, p. 263). This statement is however disputable since the definition of risk financing above suggests that these are the measures taken to cater for the cost of a loss or potential loss.
The same point of argument is put forward by Epstein, Metz and McLaughlin (2012, p. 123), who note that risk financing is the utilisation of funds to cover the financial impact of unexpected losses, or to cover the costs related to unplanned adverse events. Insurance, risk financing and risk management are therefore related because while risk management involves identifying possible loss exposures and designing strategies to minimise their negative impacts on the organisation’s mission, risk financing ensures that any loss that may arise is adequately covered and is therefore compensated.
Notably, one of the methods used to achieve this indemnification is insurance. Along the same line, the University of California, Los Angeles (UCLA, 2008) notes that the most common form of managing risk is insurance.