Insurance and Hedging Processes - Essay Example

Risk Transfer: The Similarities and Differences Between Insurance and Hedging Processes Risk Transfer: The Similarities and Differences Between Insurance and Hedging Processes Risk transfer is a matter which is really critical to take seriously into consideration, and there are many issues within it that need to be included in the discussion of this matter, and that includes making note of both the similarities and differences of the two main processes that take place in the matter of risk transfer, and those are insurance and hedging processes. Both have their positive and negative points, and thus both are considered as being useful and sedimentary in regards to the matter of risk transfer. Basically effective risk management "typically involves application of pre- and post-loss mitigation techniques combined with varying levels of risk transfer. In some cases, the decision to transfer risk is driven by competitive pricing or by the desire to eliminate surprises and fluctuations in cost" (AON, 2007). Generally if you are transferring risk to different parts of any type of industry, there will be certain complicated legal structures that are going to be involved, and there is a certain complexity here which basically means that having poor management of risk transfer instruments could possibly expose firms to serious and significant risk, and yet on the other hand risk transfer instruments can reduce the impact of economic downtowns, in that they are able to allow firms and industries to diversify their risks more widely, and this is why this matter is one which is so incredibly crucial to take into serious consideration. Insurance and hedging are two different processes that are used in regards to risk transfer, however there are similarities and differences between these two processes that need to be seriously looked at and made note of. Basically insurance is considered as being "one of the methods for handling risk for individuals and corporations. The commission on Insurance Technology of the American Risk and Insurance Association defines insurance as 'the pooling of fortuitous losses by transfer of such risks to insurers who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk" (Goto, 1997). The role of insurance management in regards to risk transfer is influentially great, and this is in regards to risk management in particular; risk management is basically considered as being defined as the executive decisions that surround the management of pure risks, and "As such, risk management is a much broader concept than insurance management because insurance is only one of several methods for dealing with risk. Risk management attempts to identify the pure risks faced by the firm or organization, and uses a wide variety of methods, including insurance, for handling these risks" (Goto, 1997). Insurance in incredibly important and in fact critical in regards to this particular situation, and it is a basically statistics-based type of pooling instrument which is used for risk management based on the law of that of especially large numbers; furthermore, it has a certain essence which, if used appropriately, seems to be rather similar to that of an option contract. Then there is hedging, which, in finance, is "an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity" (Wikipedia, 2007). Hedging basically allows for the control of risk, as although risk is basically inherent to any type or form of business activity, much of this risk is unwanted and it cannot be avoided without hedging. "Someone who has a shop, for example, can take care of natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract" (Wikipedia, 2007). From this example we can quite clearly see the difference between wanted risk or risk that can be handled, and unwanted risk, and thus the importance for a process such as hedging. Catastrophic risks are very important to take into consideration here, and these types of losses in particular are considered as being in the upper layer, in that they occur rarely for the most part and yet they are the most devastating, and the severity overall is of such a scale that the viability of the entire enterprise is actually threatened. "The reason why catastrophic risks are considered to be unavoidable insurable risks lies in their nature, which tends to make the pooling technique break down and become unworkable. Catastrophic risks, such as hurricanes or earthquakes, are classified as unknown risks and are characterized by a fundamentally non-linear phenomenon in which chaotic patters emerge easily, and it is also very easy to predict the probability of the expected loss" (Goto, 1997). One of the main differences between insurance and hedging is the fact that not all hedges are financial instruments, whereas insurance always involves financial instruments. On the one hand there is insurance, which is basically an investment which is used in order to protect something, and then on the other hand there is hedging, which is a certain investment which is rather used to reduce the undesired risk that is evident by matching cash flows. There are also many similarities between insurance and hedging however, and in fact, insurance is actually a form of hedging, in that it is "a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a potential loss, from one entity to another, in exchange for a premium and duty of care" (Wikipedia2, 2007). As well, the best way to think of hedging is actually to think of it as a form of insurance, as when someone decides to hedge, they are basically insuring themselves against a possible negative event, and so the two are really quite similar, and in a lot of ways are actually the same thing. After all, with both you are getting insured in case something happens, and even if nothing ever does end up happening, with both hedging and insurance you are taking precautions to make sure that you are in protected in the event of something negative. When it comes to the way that past data and statistical analysis are used within a company to decide that of which types of risks the company is prepared to accept and the price or premium which is charged for accepting that risk, there is much information that needs to be understood and discussed here. First, in regards to the way that past data and statistical analysis are used within a company to decide what types of risk that particular company is prepared to accept, they are both incredibly important and influential factors here, as past data can be used to show what types of negative events are most likely to occur, and thus what most businesses should be most prepared to accept, and thus what they should insure or hedge themselves against. Using past data as a sort of reference is truly critical in many different regards in this type of situation, because we can use past experiences and records to show us what is common, and thus what is most likely expected and most likely to occur, and thus what we should be most prepared against. For instance, one of the most common negative actions that could happen is in regards to finances, and past data shows that in particular when a company takes too much risk, or does not take enough risk. It can often be confusing to understand both ends of the spectrum, however if you do, then you and/or your business is going to be incredibly more productive and positive overall. To prove this, we can look at past data, and we see for example that "Most 401(k) investors seem to understand that stock and stock mutual funds are going to give them the best returns in the long run. About 62% of 401(k) assets were invested in equities in 2002...and on the other end of the spectrumare the investors who overload on stocks. Nearly 30% put all or nearly all of their money either into their 401(k)'s equity funds or into their company's stock, with no exposure at all to fixed-income investments" (Pulliam Weston, 2007). Then there is also the matter of how we can use past data and statistical analysis are used within a company in order to decide the price or premium that they are charged for accepting that risk, and here as well past data is incredibly helpful and in fact rather critical to the matter overall. The price or premium will vary obviously depending on the particular risk that is in question, however using past data and statistical analysis we are able to get a rough or approximated idea in regards to what we can expect, and use that to put it towards the expectations of the business. There is much that needs to be discussed in this regards, and in particular what needs to be discussed is that of business performance management, which is a set of processes that are used in order to help organizations and businesses to be able to more properly optimize their overall business performance, and thus this is something which is truly critical, especially to a hopefully productive and profiting business. In order for a company to be truly successful, they not only have to use past data and statistical analysis, but as well they really need to be able to work and implement a business performance management program; as a business, when you do this, you will need to pose a number of different questions and as well take a number of different resultant decisions, and this includes that of the following: goal alignment queries, baseline queries, cost and risk queries, customer and stakeholder queries, metrics-related queries, measurement methodology-related queries, and results-related queries. Each of these is separate and yet similar to the rest in its own way, and you need to make sure that you take each and all into serious and thorough consideration, in order to be able to implement the best business performance management program possible. In conclusion from this, we can see many different things, however they are all in relation to how a business can truly take its best step forward and make its results the most positive that they possibly can. We have also learned about the similarities and differences of hedging and insurance, as well as how each relates and influences factors in regards to a business, and furthermore, we have seen how businesses are able to work, figure out the difference between risk that they can handle and unwanted or unnecessary risk, and all of this is critically important in order to get the best results possible in the end of it all. We have also seen how we can use past data and statistical analysis in order to be able to see how it can truly profit businesses, in particular how it can be used to determine which types of risks a company should and can be willing to accept, as well as how they can determine and cope with the price or premium that is going to go along with that particular risk. There are so many different strategies that can then be taken and used from this analysis, and losses, for instance, which are basically one of the most significant types of risks to a business, truly can be managed properly if the right insurance or hedging is used as well as past data and analysis in order to prepare the business to the best ability. If these strategies are used properly and appropriately in a business, then they will be able to help out a business tremendously, and this is why it is so incredibly crucial to make sure that you are fully and completely aware of all of them. References Allen, N. et al. 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