Reviewed by Jun 11, 2021| Updated on
The process of determining how an organisation will pay for losses in an effective and least costly way is called risk financing. It identifies risks, determines the ways of financing, and monitors the effectiveness of the chosen financing method.
Risk financing, basically, helps a business to align the risks it is ready to take with its ability to pay for those risks. The potential cost of their actions and the possibility of those actions leading them to reach their goal must be estimated.
Businesses lay down their priorities to verify if they are taking the required risks to achieve their goals. It is also important to examine if the right kind of risks is taken to reach these goals, and the cost of taking such risks are accounted for financially.
There may be many options for the companies to protect themselves from risks, such as self-insurance, captive insurance, commercial insurance, and other risk transfer mechanisms. The effectiveness of these mechanisms vastly depends on the size of the company, its financial situation, the kind of risks the company has taken, and the company's overall objectives.
Whatever risks the company chooses to take, risk financing chooses the least-costly risk among them and ensures that the company has the required financial resources to recover and continue with the operations in the case of a loss event. The process of risk financing includes the company listing down and broadcasting the expected losses over a period of time. This event is followed by determining the net present value of each of the listed risks that need coverage.
How efficiently a company manages events that call for risk financing indicates a company's potential for long-term growth and its competitiveness. The way in which risk financing is handled brings out the financial health of an organisation in the form of identifying and monitoring key metrics.