Risk Manager Can Make Optimal Use of Insurance Finance Essay

Recently, the subprime mortgage crisis and the European debt problems spread all over the world. Many companies were influenced by all kinds of problems and faced with risk loss. Therefore, corporate risk management becomes more and more important in operating business. There are several kinds of risk management strategies. However, insurance is the most common and popular tool among these numerous strategies. In the crisis, many companies survived rely on the insurance. This essay will discuss the risk management and show the different types of risk management strategies. And it will focus on what the position of insurance is and how the risk manager makes optimal use of insurance as part of an overall risk management strategy. Risk management is identification, assessment prioritization risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability or impact of unfortunate events. Risk management solves the corporate risk, including price risk, credit risk and pure risk. Most big companies have a risk management department to deal with pure risk. And the risk manager is the leader of the department. The risk manager identifies loss risk, measures the probability of loss and chooses effective risk management strategies in order to maximize the corporate value.

Risk Management Strategies

Risk management strategy has mainly three parts, including risk control, risk financing and internal risk reduction. First of all, risk control is divided in loss prevention and loss reduction which mean risk manager increase ability of preventing potential loss and reduce the amount of risk events. Secondly, risk financing includes retention, insurance transfer, hedging and other noninsurance risk financing transfer. In retention way, corporate has its financing plan or establishes a captive insurance company. However, corporate can also buy an external insurance to transfer the risk. Using hedging method, corporate can sign contracts to reduce the loss when the price or exchange rate changes. What's more, corporate can use the contracts to transfer the risk to other groups. Thirdly, internal risk reduction means corporate can prevent risk by itself, such as decentralising operating business or investing in an accurate future expectation.

Insurance

As the most common tool, insurance plays a significant role in corporate risk management. The shareholders are decentralised in many large companies. Although the corporate decentralisation reduces the risk as internal risk reduction, corporate receives more benefit from insurance. Insurance would reduce the cost of the claims processing and the loss control service and decrease the expected cost of loss control. It also decreases the probability of adopting the costly external capital for a new investment project and then increases the probability of accepting the new project. What's more, it reduces the possibility of financing dilemma and the expected tax. In others small companies and private enterprise, the capital and shareholders are not decentralised enough. These companies are more risky than the decentralisation companies. Thus, insurance is necessary to reduce the potential loss. If risk occur, insurance is effective in risk averse and risk transfer. Otherwise, the companies will suffer great losses. However, insurance is not the best choice for every part of operating business. The insurance expense is always higher than the actual loss. If the risk manager buys the whole insurance, it would cost a large expenditure. It reduces the shareholder value which is against the risk management goal. The cost of risk is divided in expected cost of losses, cost of loss control, cost of loss financing, cost of internal risk reduction and cost of residual uncertainty. Insurance is a kind of cost of loss financing. If risk manager increase the cost of loss financing, the change in cash flow will decrease. It is bad for corporate operation.

Make optimal use of Insurance

Therefore, a risk manager should think over whether to purchase the insurance or not. The first step of risk management is risk identification. The risk manager can identify by analysing financial statements, discussing with department managers, having surveys with staffs and talking with insurance agents and risk management consultants. After risk identification, the risk manager should assess the probability and amount of risk. And it can be sorted out as a probability distribution. Then, the risk manager can divide them into controllable risk and Uncontrollable risk according to the probability. For controllable risk, the risk manager should consider whether it is low potential loss or high potential loss. The low potential loss is not necessary to purchase the insurance because the loss is too low that does not influence the corporate value at all when the risk occurs. Instead, the risk manager had better to make a financing plan which is a way of retention. At the same time, the manager can also use loss control strategy, such as using some feasible ways to reduce the probability and loss amount of the risk. For example, the corporate can fix the machine regularly and check the process more frequently. Through this strategy, the manager can save the insurance expenditure and reduce the risk from the change in insurance market. Moreover, it reduces the moral risk and prevents the excessive insurance cost and implicit tax. Finally, the fund can be used instead of become a cost. In addition, if it is high potential loss, the risk manager should purchase an insurance to prevent the large amount of loss. When the risk occurs, the risk manager can transfer the significant loss to the insurance companies. Otherwise, the corporate value will have a severe reduction. For uncontrollable risk and other unpredictable risk, insurance is necessary because it has a high probability of potential risk. Uncontrollable risk cannot be reduced by corporate actions. Therefore, the risk manager should transfer the risk to the insurance company, avoiding the risk loss. Then the risk manager can make sure the corporate value isn't influenced by the risk loss. Additionally, some big companies establish a captive insurance company which is another kind of retention. The most important motivation of the captive is reducing expected tax. Besides, the captive can purchase reinsurance in one or more other insurance companies. What's more, some special risks cannot be insured by external insurance companies or they are expensive. The captive can insure all the risk which the parent company is faced with. If the corporate has a captive, the risk manager can make a decision easily. The risk cost will reduce and the corporate value will go up. Furthermore, the risk manager should make an insurance plan for the employees. This insurance plan includes medical insurance, life insurance, disability insurance and dental insurance. It seems a large number of funds to purchase insurance for every employee. There is a sharing plan and non-sharing plan. The corporate reduce the wages of employees with sharing plan while it remains the original wages of employees with non-sharing plan. However, no matter using the sharing plan or the non-sharing plan, the insurance cost comes from the employees' wages in the long run. With the employee insurance plan, both the corporate and the employees can reduce the tax expenditure. What's more, the insurance plan can reduce the liquidity of employees and increase the productivity. Finally, the risk manager improves the corporate value.

Conclusion

In conclusion, insurance is a useful tool in risk management. The risk manager can make an optimal use of insurance by risk assessment. The risk of high potential loss and the uncontrollable risk should apply the insurance while the risk of low potential loss can be solved by a financing plan. Besides, some large company can establish a captive insurance company and then purchase reinsurance. Last but not the least, risk manager should purchase insurance for employees.

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