cedric loss financing assignment

8/2/2019 Cedric Loss Financing Assignment

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NAME : CEDRIC T MUNYORO

REG No : R095479B

PROG : HBBS II

COURSE : FINANCIAL RISK MANAGEMENT

LECTURER: MR JECHECHE

Question : Discuss the major methods that are used to

finance losses. Explain as clearly as possible

how loss financing differs from internal risk

reduction.

Due Date : 05/05/2011


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Introduction

Due to a number of risks that banks and financial institutions are exposed to, managers

are now trying by all means to avoid them as a means to maximize shareholders

wealth. Finance losses has been one of the methods that have been widely used as

managers now need to minimize the loss they incur from those risks, so they properly

manage their portfolio of risk.

Finance Loss and Risk

Van Horne (2005) describes loss financing as a group of techniques used to acquire

funds to pay for or compensate loss. The main aim here is to look for funds that would

benefit the organisation in the future as revenue that would be earned would be more

than the cost of funds that is used in the loss financing process. Risk is the probability

that ex-post differs from the ex-ante or the actual may differ from the expected. In

simple terms, it is the standard deviation of an investment made by the firm. By

standard deviation, I mean total variability of an investment, therefore the variability if

it results in losses need to be financed.

Methods used to finance losses

The management of and control of risk is one the important aspects of business

practice. Inadequate management and control of risk can lead to insolvency and not

abide to rules that are implemented by regulators such as Basel Committee on risk such

as credit risk, market risk and operational risk. The strategies to manage risk include

transferring the risk to another party, avoiding the risk, reducing the negative effect of

the risk, and accepting some or all of the consequences of a particular risk.

The risk management process involves identification of risk in a selected domain of

interest, planning the remainder of the process, mapping out the social scope of risk

management, identifying and objectives of stakeholders and the basis upon which risks

will be evaluated, defining a framework for the activity and an agenda for identification,


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developing an analysis of risks involved in the process and developing mitigation or

solutions to risks using available technological, human and organizational resources.

For this reason, risk management is thus essential for the management of any business.

Risk cannot be avoided, but it can be defined and managed. There are three major

methods of risk management:

Loss financing Loss control Internal risk reduction

LOSS FINANCING METHODS

Risk managers rely on a variety of methods to help companies avoid and mitigate risks

in an effort to position them for gains. The four primary methods include exposure or

risk avoidance, loss prevention, loss reduction, and risk financing. A simple method of

risk management is exposure avoidance, which refers to avoiding products, services, or

business activities with the potential for losses, such as manufacturing cigarettes. Loss

prevention attempts to root out the potential for losses by implementing such things as

employee training and safety programs designed to eradicate risks. Loss reduction

seeks to minimize the effects of risks through response systems that neutralize the

effects of a disaster or mishap. Below are risk financing techniques:

i. Risk Retentionii. Insuranceiii. Hedgingiv. Other contractual risk transfer


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Risk Retention

Pike et al (2003) describe this approach to risk financing as that in which firms hold

precautionary cash balances or maintain a lower than average borrowing level in order

to be better able to absorb anticipated losses. The means by which a company can

finance a risk are:

Using cash available at the time Borrowing from central funds External loans

Advantages

a) It assists a company in budgeting for losses and ensures that funds will beavailable.

b) Cash flow is improved with investment income earned on the funds

Disadvantages

Involves using cash available, central funds or credit lines may dislocate the normal

working pattern in that working capital is depleted by use of cash resources as well as

the cost associated with central funds and credit lines.

Insurance

Insurance is as an agreement that in return for regular payments (premiums), a

company will pay compensation for loss, damage or death. It finances losses in that

some of the risk is transferred to the insurer. An insurance policy does not make you

rich but it takes you back to the position you were before.


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Advantages

a) Each type of risk has its own policy so the firms can choose which risks tofinance. For instance businesses usually insure low frequency/ high severity

losses such as a fire occurrence.

b) Funds that would have been held as precautionary balance (under riskretention) are channelled to the most productive segment of the business other

than to lay idol when they could earn income for the business.

Disadvantages

a) The laws governing insurance are in favour of the insurer rather than theinsured. The insured does not have any bargaining powers, but is usually enticed

by the benefits. There are so many exemption clauses in an insurance contract.

Practically the law protect the insurer and not the insured.

b)A premium is not claimable once the insured is at risk notwithstanding that theloss has not continued for the full length of the contract or term.

c) Premiums may be too high in comparison with the perceived benefits.Hedging

According to Brealey (2001), a hedge is as a protection against a possible loss which

involves taking an action that is the opposite of action taken earlier. The use of

derivatives is as a hedging technique and there are four main types of derivatives that

are used;

Options Futures Contracts Forward Contracts Swaps


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Hedging entails that firms exchanges for an agreed price, a risk asset, for a certain

one. It is a means by which the firms exposure to specific kinds of risks can be

reduced or covered. Derivatives are used to finance losses that may arise from price

risk and credit risk. An example is that two firms may agree at a rate for

transactions to be carried in the future. In this way we can say they have hedged

against foreign exchange risk.

RESERVING

According to Bessis (2002), the reserving is a claim on asset for future expected losses

or project costs. Reserves are appropriate when the loss values are low but the like

hood of losses medium. This method informs the users of financial statements that

these losses are expected to setup a reserve. The firm places an appropriate amount

(usually the expected value of loss plus a certain multiple of standard deviation) on the

right hand side of the managerial balance sheet with an unfunded reserve the claim can

be paid for by any liquidity of the firms assets.

SELF-INSURANCE FUND AND USE OF CAPTIVES

This type of financing is often called self-insurance. As insurance is a means of

spreading risk among a number of individuals or organizations this is a misnomer.

Despite this it is a common term used in the insurance industry. Internal risk financing

ensures that each organization using this method does not have to pay a premium, all

they meet is their own expenses. This means that the better their risk control the less

losses they will have to pay.

Internal risk reduction

Internal risk reduction refers to reducing the amount of internally generated risk that a

company is exposed to. According to Molak (1997), internal risk reduction can only be

accomplished through implementing internal risk management and control systems.


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Loss financing differs from internal risk reduction in that in most cases risk reduction is

taken before a risk, which is trying to reduce the effect that the risk may have on a firm

whereas loss financing is normally undertaken after the risk has materialized and the

loss has occurred. Loss financing is focused more on a particular area that caused the

loss, for example the department, whereas risk reduction takes a holistic approach to

the whole organization and is part ofthe internal structures and controls.Conclusion

It is important that the cost of risk, which must not exceed the actual benefits of

managing it, is determined. It is, therefore, vital for the organisation to understand

various methods of loss financing to enable them to make appropriaterecommendations during the risk management process.

The risk management process aims to eliminate or minimise the potential effect,

should a loss event occur. A successful loss financing programme should ensure an

optimum mix between the reduction of insurance costs, through highly visible and

creative, alternative loss financing practices, and minimisation of losses through sound

control and prevention measures.

Since risk measurement and controls are established by regulators such as Basel

Committee, banks and other financial institutions should implement those policies as

they are made by professionals who are expects in the field of finance. Since risk results

in negative contribution to the firms assets, managers have to constantly monitor those

risks that arise from operations of the organisation as they can bring the organisation

activities to a halt.


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References

Brealey, R (2001) Fundamentals of Corporate Finance 3rd ed, McGraw Hill,

Boston

Bessis J (2002) Risk Management in Banking 2ND ED, John Wiley and Sons

New York

Molak V, (1997) Fundamentals Of Risk Management And Analysis, 2ND Ed

Lewis Publishers, New York

Pike J, (1999) Fundamentals of Corporate Finance 2nd ed McGraw Hill, New

York

Van Horne (1999) Financial Management 3rd ed, John Wiley and Sons

cedric loss financing assignment

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