Whether it is investing, driving or just walking down the street, everyone exposes himself or herself to risk. Risk is present when future events occur with measurable probability whereas uncertainty exists when the likelihood of future events is indefinite. Expected loss and variability around the expected loss are two common terms that we normally use to describe risk. Although there are consequences associated with it, a rational person will only take the risk if the benefits exceed the cost. In a business risk management, shareholder diversification results in reduction of risk as it potentially substitutes for corporate risk management and insurance. Diversification is somewhat similar to what insurer will do as both of them pool investments to amortize risk. The objective of corporate risk management is to maximize shareholders’ value. The valuation model that is used to assist managers in making investment decisions is simply the value of any investment calculated by summing its future cash flows discounted at an appropriate rate. Opportunity cost, which is equal to the expected return of an alternative investment having the same risk, is one of the components of cost of capital. Similarly, it is also equivalent to the sum of return on risk free securities and expected return for risk. Riskier cash flows indicate higher risk premium but investors can diversify their risk by dividing the cash flow risk into two components – diversifiable risk and non-diversifiable risk.
Risk premium only depends on non-diversifiable risk, which is also commonly known as systematic risk. Also, the total risk of cash flows can be calculated by summing both the diversifiable and non-diversifiable risk. Diversifiable risk does not affect cost of capital but non-diversifiable risk increases cost of capital. Insurance usually lowers diversifiable risk. Hedging and insurance that decrease systematic risk will reduce the opportunity cost of capital. Nevertheless, the counterparty that yields additional systematic risk will demand compensation for bearing the risk because the systematic risk must be borne by someone. However, the cost of paying the counterparty will cause the expected cash flows to fall thus shifting systematic risk. Consequently, opportunity cost of capital and expected cash flows will decline unless all parties value the cost of bearing systematic risk equally, then the two effects will balance each other and thus, the firm value will not change. Risks can be categorized in various ways based on purposes. Market risk, credit risk and operational risk are three categories of risk used in Risk Management. Market risk, which is often hedged with derivatives, occurs when market prices change in a given direction. Credit risk is a risk that a counterparty to a financial contract is unable to realize its obligations under the contract and can be hedged with credit derivatives.
On the other hand, the operational risk or sometimes called as pure risk, is a risk that summarizes the risks a firm undertakes when it attempts to operate within a given field or industry. Comparatively, pure risks can be large relative to business resources and has minimal opportunity for gain to the enterprise. However, the main problem nowadays is the liquidity risk, which is a risk that a firm will not have sufficient cash to cover its current financial obligations and will become insolvent, especially when credit is not available. Besides, there is also a risk ultimately borne by shareholders which is the risk associated with the values of assets and liabilities where the value of capital is the difference between assets and liability. Loss control, loss financing and internal risk reduction are three methods of managing risks. There are numerous techniques by which risk exposures may be controlled. For instance, risk prevention technique concentrate on reducing the frequency of losses while risk reduction technique is associated with reducing the severity of a loss when it occurs. Besides that, hold harmless and indemnity agreement are also one of the effective methods to transfer risk between two parties. The hold harmless agreement occurs when the indemnitor agrees to hold the indemnitee harmless from tort liability arising out of the indemnitor’s negligent act or omission.
Although quite similar with the hold harmless agreement, an indemnity agreement is an arrangement when one party agrees to pay the other party for any damages regardless who is at fault. Additionally, the party who holds harmless another party is commonly required to purchase insurance or obtain a letter of credit. In vicarious liability, principal is liable for the damages caused by an agent while performing duties for the principal. Rationally, this gives principal incentives to choose agents wisely. The difference between an employee and an independent contractor is that if a person performs services that can be controlled by an employer, then that person is not an independent contractor. Legally, employers are not vicariously liable for their independent contractors but with certain exceptions made today, employers can use it to hold them liable. As risk imposes a lot of costs on business and individuals, tradeoffs must be made. Large losses, which are one of the components of cause of risk, can affect indirect losses. Hence, reducing the probability of large losses can lessen indirect losses. Therefore, managers need to consider reduction in expected indirect losses when making risk management decisions. Diversification also has an effect on both direct and indirect losses. Although expected direct losses does not change when diversification occurs, expected indirect losses decreases when diversification occurs because it reduces the maximum probable loss.
Insurance involves paying a premium to the insurer, which consists of pure premium and premium loading. However, insurance is actually a tradeoff for corporations. If a firm is not insured, then there will be an increase in the likelihood of having to raise a new capital. Although raising external capital is costly, if uninsured loss exceeds available internal funds, company can issue equity or borrow against future cash flows to pay the loss if it occurs. Hence, managers must compare premium loading to the expected cost of raising new funds when deciding whether to purchase insurance. Besides, insurance also decreases the likelihood of bankruptcy. Probability of bankruptcy adversely affects the terms at which other claimants contract with the firm. Claimants might require compensation for the expected costs that they would incur if the firm went bankrupt. Other claimants require compensation for the risk of financial distress because they are risk averse and not diversified. Hence, it can be seen that insurance improved the contractual terms between the insurance company and the firm. By decreasing the likelihood of financial distress, the contractual terms with other claimants can be improved and investment incentives of owners of firms may result in underinvestment or overinvestment. Incentive to pass up good projects is considered as underinvestment while incentive to adopt risky bad projects is considered as overinvestment.
Buying insurance can decrease the likelihood of financial distress. It decreases the likelihood of underinvestment and overinvestment problem in risky assets. Moreover, insurance also helps to reduce expected tax payments because taxes on earnings with insurance are less than expected taxes without insurance. A firm will have a lower taxable income when tax rate is high and increase taxable income when tax rate is low. Essentially, insurance transfers income to years when firm is taxed at a lower rate. However, it does have an effect on financial accounting. Firms will have more volatile reported income and balance sheet numbers. Less volatility might make assessing managers easier. Above all, by diminishing diversifiable risk, the firm does not only lessen risk for diversified shareholders but also increases shareholder value by reducing the costs of obtaining services and expected tax payments. Management compensation contracts, market for corporate control, monitoring shareholders with large stakes and major creditors may be the several factors that would be expected to motivate managers to maximize shareholder value. But major creditors only rely on the credit rating agencies to monitor the creditworthiness of bonds and similar securities issued by firms. In order to issue bonds and other securities, firms have them rated by one of the three rating agencies – Standard & Poor’s, Moody’s or Fitch. However, these rating agencies have done a very poor job and have been driven by profits and a divergence of interest only.
