Role of Insurance within a Wider System of Risk Financing and Management - Literature review Example

Role of insurance within a wider system of risk financing and management Introduction Organisations 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 Risk In 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 financing Risk 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. Role of insurance with respect to risk financing and management By definition, insurance is an agreement by which an insurance firm (that is the insurer) agrees to pay an amount of money or offer an item of value to another (that is either the insured party or the recipient) in case the insured entity is injured, dies, or incurs loss to his or her property as a result of particular, stated contingencies (Miller & Jentz 2007, p. 715). Although some writers such as Miller and Jentz (2007 p. 715) argue that insurance is a plan for transferring and distributing risk, others such as Edwards (1995, p. 28) suggest that insurance is a strategy for smoothing the cost of a loss, rather than a loss reassigning mechanism. That is, in the long-term losses have to be paid for out of premiums which also have to account for the insurer’s overheads and profits (Anderson & Brown 2005, p. 2). Insurance is therefore used to assist guarantee at a regular annual cost the prospective financial stability of an organisation against the consequences of irregular no-speculative business risks (Edwards 1995, p. 28). Even though the insured entity has to pay premiums which are then used to compensate it in case of loss, insurance can be termed as a technique of risk transfer since the financial loss is transferred to another party (the insurer) (Fried, Shapiro & DeSchriver 2008, p. 263). In business, there are several types of risks because the future is uncertain. Risks take different forms. They can be production risks, financial risks, risks due to uncertain market conditions, social risks, and even those caused by natural calamities such as floods and earthquakes, or those resulting due to fire. Production risks result from events such as breakdown of machinery, bad weather, use of faulty materials and tools, inefficiency of labour, and so forth. Financial risks emanate from instances such as reduction in sales, which can cause a decline in cash flow and consequently affect the organisation’s ability to repay debts and eventually end up in bankruptcy. Social risks result from occurrences such as lockouts, strikes, political disturbances, riots or any legal rules and regulations passed by the government restricting the business activity. Risks due to uncertain market conditions are those which result due to fluctuations in demand for the goods or services produced, bad debts, as well as losses incurred on account of selecting the wrong choice of media for advertisements. In addition, an organisation’s property can be destroyed by incidents such as lightning, tsunamis, floods, cyclones, and so forth. There are also other risks like theft, embezzlement of finances and foods, accidents in the work premises, and loss of good will (Talloo 2007, p. 231). An organisation may not anticipate all the above losses to occur, but can be certain that some types of risks may occur. For instance, a transportation company cannot be certain that one of its trucks will be involved in an accident, but will insure it just in case an accident occurs because trucks are generally involved in risk on the road. As well, a supermarket may not be sure that a fire can engulf one of its stores, but insurance will be a convenient strategy should an electric fault cause a fire that eventually destroys all the stock. In essence, businesses need to protect themselves from any of the risks discussed above or any other that they may anticipate – and this introduces insurance as a means of managing the risks. An organisation will typically have a risk management plan that comprises approaches and methods for recognising and dealing with any identified threats. Basically, in preparing such a plan organisations have to ask themselves the following three queries: (1) what can go amiss?; (2) what can be done to avert the occurrence of loss and in response to a harm or loss?; and (3) if an incident arises, how will the organisation deal with it? (Insurance Bureau of Canada 2012). By asking the three questions, an organisation is able to determine the kinds of risks it is exposed to, what it can do to prevent the risk and what it can do in case a particular risk occurs, and how it can compensate for the risk. This typically describes risk management, risk financing and insurance since the organisation is able to forestall risks through risk management; it is able to deal with actual risk occurrences through risk financing, and one of the ways to facilitate this is by having an appropriate insurance scheme. Risk management offers a clear and planned approach to recognising risks. When an organisation has a lucid comprehension of all risks, it is able to gauge and prioritise them and take proper actions to decrease losses. It is important to note though that just like insurance, risk management does not get rid of risks. Nevertheless, having a working operational risk management custom and tools such as insurance shows that the organisation is committed to loss reduction as well as prevention. An effective risk management plan also makes firm a better risk to insure (Insurance Bureau of Canada 2012). As the most common form of managing risk, insurance is a valuable risk financing tool. Not all organisations could have the funds or reserves necessary to absorb risk on their own and pay the lump sum cost after a loss. It should be noted however that purchasing insurance on its own does not constitute risk management – as a meticulous and heedful risk management plan is the best way of being committed to preventing loss (Insurance Bureau of Canada 2012). In addition, insurance has never been known to prevent a risk incident from occurring (Reuvid 2010, p. 58). Nonetheless, it is possible that even with a meticulously planned risk management plan, a business may still incur losses because the business environment is changing as do the potential risks. Insurance therefore serves in this regard. Arkell (2011, p. 4) notes that insurance serves to promote financial stability and security at different individual and organisational levels; it encourages technical methods of reducing risks; and it also creates additional incentives for controlling losses. In essence therefore, insurance is one of the risk management services because it is an arrangement that provides individual protection against the risk or losses emanating from different types of perils (Arkell 2011, p. 6). Although insurance does not directly manage risks, it helps to transfer the impact of risks in that the ensured party can be assured that any loss will be compensated. But in essence, there is no consensus that insurance actually transfers risks (Reuvid 2010, p. 58). For instance, if an oil refining company insures itself against fire, this does not mean that the company will have protected itself against fire. A fire can still occur and cause interruption of the company’s activities. The good thing is that the resultant loss will be covered by the insurance scheme. Therefore, as pointed out by Ontario (2009, p. 5), obtaining the appropriate insurance for an organisation is a vital tool in an organisation’s risk management initiatives. From the viewpoint of risk management, insurance is an “after-the-fact” approach to loss control since it compensates only for a loss that has already been incurred (Ontario 2009, p. 5), Advantages and disadvantages of insurance with reference to risk financing and management Advantages The role played by insurance in modern business presents a number of benefits to organisations as stated below. The information is derived from Talloo (2007, p. 236), Hopkin (2012, p. 60), and Padmalatha (2011, p. 505). i) Security against risk of loss: The key reason for taking an insurance policy is to ensure that an entity is protected against loss. Knowing that any business risks can be handled effectively through the insurance arrangement, business enterprises can focus on managing their business without fearing the possible risks. Therefore, through risk financing and risk management, insurance ensures that businesses give better attention to meeting their goals, which promotes the expansion of commerce. ii) Distribution of risk: Since the burden of risk is taken by the insurer, the insured does not have to bear a heavy burden in the event of loss due to a certain risk. The transfer of risks ensures smooth functioning of business. iii) Capacity to face cut-throat competition: There is no doubt that modern businesses have to deal with high competition. The higher the degree of competition, the higher the extent of business risks. But through sharing risks, businesses can be assured that their activities will not be disrupted in case of any loss due to risk. This facilitates the long survival of business enterprises. iv) Specialisation of labour: When a business enterprise takes an insurance policy, it can rest peacefully and devote its entire attention to managing the business affairs. This means that the burden of any compensating any loss is borne by the insurer rather then the business. This specialisation means that the business can pay more attention to meeting its objectives. v) Optimum utilisation of capital: With an insurance policy, a business enterprise does not have to set a side an extra sum of money to cover for a potential loss. Such funds can be invested in other areas of the business’s operations, meaning that the firm can focus on making more wealth. vi) Advancement of loan: When a business’s assets are insured, its credit worthiness goes up. This is because the business is regarded to be better equipped at managing and mitigating the impact of various types of risks. The business can therefore attract more sources of capital, which further helps to shield it from risks. Insurance companies also help by granting loans and provision of underwriting facilities to business enterprises and investing in the securities of large business enterprises. vii) Insurance can also offer access to specialist services as part of the insurance premium. These services may encompass advice on loss control. For instance, motor vehicle insurance companies constantly advise their clients on how to minimise traffic accidents. Disadvantages Although insurance seems to play a significant role in financing and managing risks. It has a number of disadvantages as listed below. i) Certain risks can only be partly insurable. These include riskier areas such as terrorism, earthquakes, gradual pollution or other long-term liabilities (Edwards 1995, p. 29). ii) Premiums are often based on the claims experience of a pool of similar insured entities. In such instances, the premiums paid do not reflect effective risk control or good claims history of a particular client (Edwards 1995, p. 29). iii) Insurance has a high mark up covering overheads and profit. Essentially, insurance never pays for every aspect of a given loss (Edwards 1995, p. 29). This is because insurance policies have certain deductibles that have to be paid by the insured entity. Therefore, an insurance policy does not guarantee a 100 per cent cover for a risk. iv) The service offered by many insurance companies is perceived to be poor; for instance, there may be claims disputes or delayed payments (Edwards 1995, p. 29). In addition, difficulties may arise in quantifying the financial costs associated with a certain loss. There may also be disputes regarding the extent of the cover that have been bought and the exact terms and conditions of the insurance agreement (Hopkin 2012, p. 60). v) There also a point of view that insurance may promote carelessness with regard to risk management. This is because when it is known that an insurer will pay for a certain loss, the insured entity may tend to be less cautious as opposed to a situation where the perceived risk is self-financed (Head 2004). vi) There is no insurance against criminal liability; for instance, there is not compensation for fines and prison sentences (Edwards 1995, p. 2). This means that insured entities will have to find means to cover for losses arising from such cases despite having other insurance covers. Conclusion Insurance remains one of the most common methods of dealing with risks. Risks can either be financed or managed. Risk management initiatives are meant to prevent the occurrence of risk, while risk financing involves deals with preparedness to settle a loss or a probable loss due to a risk that an entity is exposed to. In both cases, insurance applies because it can be used by firms to transfer their losses to other parties. This does mean that insurance helps to avert risks, but as a risk financing and management strategy, it helps firms to recover from their losses because the risks they are exposed to are covered. For insurance to be facilitated, the insured parties have to pay premiums, and this presents a number of advantages and disadvantages which have been discussed in the essay. 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