How to Utilize Financial Risk Management for Your Business
The relationship between risk and asset management What is „risk management‟. • Some of the key Business Planning The asset lifecycle integrates organisational functions including Planning and Finance. there is a significant inverse relationship between risk management and 5) Banks and financial institutions (investment companies, financial Both profitability and liquidity are the core concerns of corporate managers. It is. Basically, a business will utilize financial risk management to forecast .. Maintaining a strong relationship with financial institutions, banks and.
It is important that these factors be managed efficiently by insurance companies, to avoid financial failure and bankruptcy to the firm. In the 21st century has seen great efforts to risk management. Babbel and Santomero [ 9 ] note that insurers should assess the various types of risks they are exposed to and devise ways of effectively managing them. They further suggest that insurers should accept and manage at firm level, only those risks that are uniquely a part of their services.
This will reduce the risk exposure. Risk management is a viable economic reason why firm managers, might concern themselves with both the expected profit and the distribution of firm returns around their expected value, hence providing a rationale for aligning firm objective functions in order to avoid risk.
Proper risk management is important in the daily operations of any insurance company to avoid financial losses and bankruptcy. This is in line with Jolly [ 10 ] contribution that preventing losses through precautionary measures is a key element in reducing risks and consequently, a key driver of profitability.
The efficiency of risk management by insurance companies will generally influence their financial performance. Gold [ 11 ], asserts that insurance companies could not survive with increased loss and expense ratios.
Meanwhile, risk management has been linked with shareholder value maximization proposition. A firm will only engage in risk management if it enhances shareholder value; Banks [ 8 ] contributed that it is important for each firm to retain and actively manage some level of risk if it is to increase its market value or if the probability of financial distress is to be lowered; Pagano [ 12 ], confirms that risk management is an important function of insurance institutions in creating value for shareholders and customers.
Firms with efficient risk management structures outperform their peers as they are well prepared for periods after the occurrence of the related risks. This study hopes to come up with an expected positive relationship between risk management and performance of insurance companies. In the aftermath of global financial crisis and corporate failures, entity stakeholders are demanding greater oversight of key risks facing the enterprise to ensure that stakeholder value is preserved and enhanced.
Considering the importance of these two control systems, the possibility of incorporating ERM into the existing performance measurement system needs to be explored. It is expected that risk management will complement performance measurement system by identifying and mitigating risks in achieving strategic objectives. Empirical evidence regarding this link in insurance sector is still lacking particularly in Ethiopiatherefore, this paper investigated the linkage between risk management and performance.
The following paragraphs present few related empirical studies on risk management and organizational performance. A study by Eric [ 13 ] revealed that risk management techniques are applied in the insurance companies of the country, Uganda. The findings on the financial performance of the insurance companies for this study also show fluctuating ratios as measured by ROE.
A study by Mohsen et al. The 6-year average level of performance for ROA and ROI ratios as dependent variables and total risk management, innovation and market-book ratios as independent variables and firm size and financial leverage are considered as control variables. In addition, their results confirm that the findings of previous researches in terms of functional and practical behaviours approach.
A study by Tony et al. Their research was based on a broader set of performance measures that places it in the middle ground with previous research which had demonstrated non-conclusive results on the relationship between ERM and firm performance. Furthermore, they indicated that more research is needed to investigate the relationship between ERM and firm performance on a much larger sample and for a much longer period of time.
Other studies like Mua et al. Their finding shows that risk management strategies that focus on technological, organizational, and marketing factors, individually and interactively improve the performance of new product development.
However, Gordon [ 6 ] examined the relationship of enterprise risk management and performance. Finally, they stated that for implementing ERM firms should pay attention to the contextual variables that are surrounding the firm.
Likewise, Gupta [ 7 ] examines the risk management in Indian companies and explore the reasons for the adoption or lack of adoption of integrated approach to risk management. He shows that even though effective risk management can improve organizational performance, companies do not have adequate infrastructure to implement enterprise wide risk management. He concludes that a deep change in risk perception is required to build up risk culture across business segments and incentivize risk management adoption.
Risk Management Techniques Meredith [ 14 ] and Rejda [ 15 ] indicated that insurance companies use various techniques for managing risks. Johnson also stated that a company with any degree of risk exposure would develop a philosophy that explicitly indicates its approach to risk management techniques. Techniques used to manage risks according to them include: Loss Prevention and Control Kiochos [ 16 ] states that to prevent or to minimize the chance of loss, insurance companies generally advise that some preventive measures be taken.
He also commented that insurance companies can only reimburse financial loss but not intangible things such as valuable information and files. Loss prevention refers to the measures that reduce the frequency of a particular loss for example: Rejda [ 15 ] insurers generally advise their clients to instil good housekeeping habits in their employees, such as not smoking on the premises or smoking only in designated areas. Insurers also give advice to clients, for example to prevent fire - on fire prevention measures.
These advisory services are either for free or are considered as value added service with the insurance package. An experienced insurer also advises on the preventive measures that could be installed in the building [ 1516 ], also states that insurance companies can put in place measures that reduce the severity of a loss after it has occurred. Installation of an automatic sprinkler systems that promptly extinguishes fire and segregation of exposure units so that a single loss cannot simultaneously damage all exposure units such as having warehouse with inventories at different locations.
He further argued that insurance companies should be careful because where a policyholder successfully shows that an insurer breached the covenants of good faith and fair dealing, the insured can receive, all damages caused by the breach Alexander [ 17 ].
Any ambiguity or uncertainty in a policy or in a choice of wording or in meaning is resolved in favour of the policyholder and against the insurer. Loss Financing In insurance companies, Alijoyo [ 19 ] indicated that this is a broad category that involves risk retention, risk transfer and diversification as measures of loss financing. It is primarily concerned with ensuring the availability of funds in the event of losses. Risk retention Retention is the act of keeping the possibility of loss with no attempt to transfer that loss to another party.
The method is appropriate when the risks of loss or the loss exposure is either too small with little impact or too great to be able to do anything with it. Risk retention is regarded as self-insurance. In insurance companies, retention is used with other risk management techniques.
For example, most insurance policies include a deductible so that the insured retains a portion of the loss. Financial risk management is one of them.
- Analyzing the Relationship Between Risk Management and Business Finance
- Risk Management Techniques and Financial Performance of Insurance Companies
Financial risk management is the response or plan of action that an organization will implement to address the financial risks it is facing, and is likely to face in the future. It encapsulates the practices, procedures, and policies that will be used as guidelines on the acceptability of financial risks and their mitigation.
In other words, management will make it clear what financial risks are acceptable to them through these policies. Basically, a business will utilize financial risk management to forecast and analyze financial risks, and identify the procedures or actions that must be implemented in order to avoid them, or minimize their impact.
Identifying the financial risks, and their sources or causes. Measuring the level and impact of the financial risks and their effects. Determining plans and strategies to address the risks, and implementing them. In addition to these three activities, financial risk management also involves continuous monitoring of the risks taken and taking careful note of the exceptions, if any. Analysis is also required, which means that documentation of the risks and their results must be prepared.
Businesses pour a lot of resources on its risk management initiatives, and the same goes with the matter on financial risk management. In fact, most businesses pay more attention on their financial risk management, considering how it impacts the financial aspect of the business. The Financial Risk Manager FRM Companies may organize their own financial risk management team from qualified employees within the organization. Large corporations have their own dedicated Risk Management Department, headed by a Chief Risk Officer, and with several units or divisions focused on the specific risks being managed.
Certainly, another option, and one that has gained a lot of traction in recent years, involves seeking the services of independent risk management specialists. The Financial Risk Managers FRMs are professionals that have the required certification to conduct financial risk management activities.
They are the ones who are responsible for conducting the initial activities of the risk management process, specifically the identification of financial risks, the determination of acceptable financial risk levels, evaluation of the impacts or effects of these risks, and formulation of plans and strategies to minimize them.
What FRMs do NOT do, however, is to make the decisions on what strategy to choose, what policy to enforce, and even how much to invest. Those are the responsibilities of top management, who will only use the output of FRMs to guide them in their decision-making. They do not tell management what decision to make; rather, they equip and empower management to be able to make an informed decision.
It is an ongoing process, which is a given, since financial risks can come from all directions, at any time. Prior to starting the financial risk management process, there should be a clear understanding of the goals and objectives of the organization, since these will dictate the direction of the entire undertaking.
Identify and prioritize the financial risks that apply to the business.
First, let us take a look at the most common types of financial risks that businesses are exposed to. Credit risk, or default risk, which arises from the inability of one party to pay or fulfill its obligations to another, such that they will be in default. If a company is unable to collect its receivables from customers, they will have poor cash inflow and lost income.
Market risk, which arises from a decline in the market subsequently resulting to reduced or lost value of investments. If the assets of the business will decline in value, but all else remain the same, the net worth of the company will also decline.
Liquidity risk, which arises when the assets or securities owned by the business cannot be immediately converted into cash when needed.
This results to the business being in danger of defaulting on its obligations, such as making loan payments to creditors and dividend payments to the owners and investors. The owners or members of the board of directors may end up becoming personally liable for the debts of the business.
Operational risk, which arises from problems or issues in the conduct of daily operations of the business, such as machine breakdowns, failure of business processes and manpower errors.
Mistakes committed may result to considerable financial losses, and that is simply one of the many operational risks that businesses have to deal with on a daily basis. Interest rate risk, which arises from drastic changes in interest rates, particularly the sudden drops that lead to financial losses. This is often an offshoot of the market risk, since interest rates are directly affected by movements in the economy.
Foreign exchange risk, which arises from movements in foreign markets.
The Relationship Between Profit & Risk
Foreign exchange rates of currencies will definitely have an impact on the earnings of a business with foreign operations or conduct foreign transactions. Identification of the types of financial risks will make it easier for the company to make a detailed assessment and analysis of the specific risks that it is facing. There are several ways for companies to identify and assess risks. Some of these processes are: This is the detection, assessment and monitoring of financial risks in the financial transactions of a business using mathematical computations or evaluations.
Usually, these calculations are for returns earned by the company on sales, investments and the like. Computations are also used on historical financial data for forecasting purposes.
Risk and Control Assessment. This involves taking a look at the internal controls of the company when it comes to all its financial transactions.
Risk Management Techniques and Financial Performance of Insurance Companies | OMICS International
Generally, a weak internal control system will indicate high financial risks. For example, the lack of a reliable system of check-and-balance of sales and collections of payments will increase the risks that payments of receivables by customers will not be recorded properly, and the money will be misappropriated into the hands of the collecting employees.
This is a process undertaken by businesses to assess that the company has adequate internal controls and policies, particularly in the accounting and reporting system. These will also pinpoint weaknesses in how transactions are recorded and accounted for. After identifying the specific financial risks that are applicable in the case of the business, there is a need to prioritize or rank them according to the gravity of the risks and their potential effects.
Usually, the risk that poses the bigger threats are those that are likely to result to higher financial losses and even bankruptcy. Determine the level of risk tolerance of the organization. If managers and employees are plagued by the presence of financial risks, every move they make, every decision and every action, will be guarded and laced with lack of confidence.
Thus, there should be a predetermined level of exposure to risk that the company is willing to accept or tolerate. Setting this level will provide them room to move, so they can focus on value creation, knowing that they are still operating within acceptable bounds in terms of risk. The factors to be considered when setting a threshold of financial risk are: Period or time horizon over which the financial risk is expected to take place. A company may find the risk to be greater if it is unable to collect its receivables over a three-year period than when customers are unable to pay within one year.Introduction to Risk Management
Cost-benefit analysis may show that certain costs are greater than the benefits derived from then. Generally, higher incurrence of costs is seen as more material and, therefore, more risky.
How to Utilize Financial Risk Management for Your Business
A company may set a certain ceiling or maximum amount for its materiality level, meaning if the losses exceed that level, then it is material and, definitely poses high risk. Volatility of economic and financial environment. Businesses that are in an industry with a volatile nature, such as the banking industry or industries subjected to frequent fluctuations of costs and interests, may set lower thresholds for financial risk.
Confidence levels of managers. This is largely personal, on the part of the members of management. There are several financial risk measures or calculation methods to arrive at a risk metric the result that is being quantified. Examples of risk metrics are: Formulate strategies to manage the risks.
This is where the business will identify the risk mitigation strategies that it will adapt to manage the financial risks it is facing. The choice of mitigation strategies largely depends on the specific risk that is being managed and the available resources to implement them.
Briefly, let us take a look at some of the most commonly used risk mitigation strategies for financial transactions, specifically for the different financial risks. Liquidity Risk The company would want to improve its liquidity by ensuring it will always have enough funds to pay its debts as they fall due, as well as other operating expenditures. Identification of periods of slow and low cash inflows through various forecasting techniques, and planning cash budgets around them; Close monitoring of cash inflows and outflows on a regular basis e.
Credit Risk As much as business would want to sell purely on cash basis, there are many that cannot do so, and have no choice but to also sell their products or services on credit.