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What is Risk Financing?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 06 November 2016
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Risk financing is a term used to describe the consumption of resources that occurs when a company sustains financial losses in the course of conducting business. The financing has to do with securing resources that can be used to offset the losses, allowing the company to manage the losses without negatively impacting the day to day operation of the business. There are several different ways that risk financing is managed, including the establishment of reserves set aside for this type of issue, sharing the risk with a third party, or even obtaining insurance that effectively transfers the risk to an insurance provider.

One of the more common means of managing risk financing is to utilize insurance coverage to cover potential losses associated with a given business project. Here, the idea is to transfer the risk involved with the venture to the insurance provider by taking out a policy that will honor claims for redress in the event that certain events come to pass with that project. While expensive, this type of financing strategy does offer the benefit of knowing that even if the project ultimately fails due to one or more events covered in the terms of the policy, the losses will be settled without having to utilize other company assets.

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A company may also choose to manage risk financing in-house by establishing reserves of funds that can be used to settle the debts associated with a failed project. This approach effectively allows the business to provide itself with a form of self-insurance. The funds are usually placed into some sort of interest-bearing account and earmarked as backup funding for use in emergency situations only. This helps to segregate the balance of that account from corporate operating funds. Should the project in question fail, resources within this emergency reserve can be used to settle the debt without having to dip into the general operating fund and possibly jeopardize 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 venture, each partner agrees to assume 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 debts associated with a failed venture, which in turn means less of a chance of adversely affecting the financial well being of any of the partners.

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NathanG
Post 4

@SkyWhisperer - If by “tools” you mean software programs, I don’t know—there may be. The tools that are used are mainly processes, which break down into analyzing risk, planning for risk, tracking risks using metrics and then in the worst case scenario implementing risk contingency plans (i.e., financing to offset losses).

SkyWhisperer
Post 3

Are there risk management tools that make this job easier?

NathanG
Post 2

@hamje32 - The fact is that risk is a part of any worthwhile endeavor, and yes, there’s usually a price tag on it. This works on both the micro as well as the macro scale. Companies have their own financial risk management strategies, but so do individual players within the company such as project managers.

Project risk management is a part of any project—identifying early on what the risks are, and trying to prevent them or at least cut them short. If a project manager says a software project will be complete in 3 months, and it takes 9 months, you'd better believe there’s money involved (and the project manager may be out the door by then). The losses in this case come out of the company budget; there's no insurance program to bail him out.

hamje32
Post 1

Risk pooling is a great way to reduce financial risk, not only within a company but also among several companies as well. I lived in Asia for quite some time and worked within what is known “the ring of fire.” That is an area prone to natural disasters like earthquakes and floods. Many businesses in this area did not have enough of their own insurance to protect them in the event of catastrophic losses, so what they did was to join a risk pooling insurance program among several islands in the region.

This came after a study was conducted by the World Bank in which they analyzed risks in the area and made recommendations on the best way to

spread that risk among all countries involved. Their study identified the kinds of risks, possible costs and the regulations that would be needed. We didn’t skip a beat in joining the program, because our country worked in one of the developing nations and needed all of the protection we could get.

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