DEFINITION of ‘Risk Financing’
The determination of how an organization will pay for loss events in the most effective and least costly way possible. Risk financing involves the identification of risks, determining how to finance the risk, and monitoring the effectiveness of the financing technique that is chosen.
INVESTOPEDIA EXPLAINS ‘Risk Financing’
Risk financing is designed to help a business align its desire to take on new risks in order to grow, with its ability to pay for those risks. Businesses must weigh the potential costs of its actions against whether the action will help the business reach its objectives. The business will examine its priorities in order to determine whether it is taking on the appropriate amount of risk in order to reach its objectives, whether it is taking the right types of risks, and whether the costs of these risks are being accounted for financially.
Companies have a variety of options when it comes to protecting themselves from risk. Commercial insurance policies, captive insurance, self-insurance, and other alternative risk transfer schemes are available, though the effectiveness of each depends on the size of the organization, the organization’s financial situation, the risks that the organization faces, and the organization’s overall objectives. Risk financing seeks to choose the option that is the least costly, but that also ensures that the organization has the financial resources available to continue its objectives after a loss event occurs.
Companies typically forecast the losses that they expect to experience over a period of time, and then determine the net present value of the costs associated with the different risk financing alternatives available to them. Each option is likely to have different costs depending on the risks that need coverage, the loss development index that is most applicable to the company, the cost of maintaining a staff to monitor the program, and any consulting, legal, or external experts that are needed.