Insurance

Business risks insurance

Business Risks Definition

A guiding principle of any enterprise in a market economy is the desire to obtain a greatest possible profit. However, such desire is limited by the possibility of incurring losses. In other words, the concept of business risk appears when it comes to the market success of the company.

Identifying business risks is crucial for every company willing to occupy leading positions on the market.
Risk is an essential element of any successful business and it begins in a place where the responsibility of the parties according to the agreement ends. Risk and profit are in direct mutual dependence, that’s why looking for the additional ways to maximize profit, an entrepreneur increases risk too.

It should be noted that risk is an essential part of all aspects of the company’s activity. Alternativeness is the most important feature of risk and means the need to opt between two or more possible solutions. Lack of choice indicates the absence of risk, i.e. when there is no choice, there is no risk at all.

In a modern business environment risk has acquired a total, universal and global nature,because changes in the economy of certain countries and industries exert a significant impact on other market players. Market economy, the main factors of which are competition and volatility in supply and demand,leads to uncertainty in obtaining a final result. An entrepreneur is never completely sure of the success of his business because an unbelievable amount of risk factors influences it. Moreover, having successfully determined some of them, a businessman may be completely unaware about the existence of others that may also hit him badly at any moment.

But it is not a correct approach to regard the risk only as a negative phenomenon. Actually, it is the risk that mobilizes human efforts, stimulates a search for new and necessary knowledge and promotes the desire to get involved in an activity that brings not only satisfaction but real financial results as well.

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People demonstrate different attitude to risk. Some consider it is negative, while others readily accept it. However, true entrepreneurs have long ago realized that entrepreneurship is impossible without a justified amount of risk. That’s why they are greatly concentrated on identifying and managing business risks in their day-to-day business activity.The issue of risk should be studied first of all to learn how to control it and then determine the ways to get a positive outcome.

The risk is manifested in different ways and it cannot be completely avoided. It can be reduced to certain reasonable limits or refused at all. To determine which way is preferable is a task of financial analysts and researchers. At the same time, it’s not enough only to identify the possible business risks to get an adequate grasp of the situation. It is also necessary to determine the likelihood of the risk’s practical realization and the potential level of harm it can cause to the company.

Main types of business risk

Presently the economists outline more than 220 different business risk types and scientific literature does not provide a single and mutually accepted approach to understanding this matter. Nevertheless, an overwhelming majority of economists and practicing risk managers agree that business risk types list includes the following items:

  • operational risk;
  • market risk;
  • commercial risk;
  • credit risk.

Operational risk

Operational risk is the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events (including legal risk), differ from the expected losses. The above definition was first introduced by Basel II regulations and primarily was meant to use by financial institutions. However, it appeared to be equally acceptable for other businesses and now it is a standard definition of operational risk. A greater part of operational risks is associated with human activity. For example, direct and indirect losses may arise from human errors in terms of compliance with internal regulations and procedures, errors in management decisions, theft, abuse and low level of staff qualification. Moreover, even in cases where the damage was caused by the dysfunction of the telecommunication, computing or information systems, errors made by people lay in the basis of most of them.In order to minimize operational risks and avoid possible losses, it’s necessary to perform identification and collection of data concerning internal and external factors of operational risks on a regular basis.

Market risk

Market risk is the risk of losses due to unfavorable changes of market prices as well as a risk that the market parameters such as interest rates, exchange rates, stock prices and commodity prices are expected to remain volatile during a particular period of time.Market risk is of macroeconomic nature. This means that macroeconomic indicators of the economic system are the main sources of market risks.Market risk manifests itself in three standard forms:

  • price risk that includes stock risk (the risk of reducing the value of securities) and commodity risk (the risk of changes in prices of goods);
  • currency risk which is the risk of losses associated with unfavorable changes in foreign currency exchange rates and precious metals prices;
  • interest rate risk which is the risk of potential losses resulting from unfavorable changes in interest rates of assets and liabilities.

Commercial risk

Commercial risk arises when commercial activity of the company is less successful than was expected initially. For example, sales may fall because competitors reduced market prices or offered a more competitive product to the customers. Commercial risk may result from mistakes in corporate planning, organization of production, marketing and sales strategy. Risk of losing profit is one of the most significant types of commercial risks. There may be various reasons for it like loss of property,failure to fulfill obligations,changes in market conditions,introduction of new technology, etc. The main objective of management in such case is to reduce business risk to an acceptable minimum ensuring effective performance of production, careful research of markets for products and services and flexible response to the changes that take place on the markets.

Credit risk

Credit risk in its broad meaning is the uncertainty about the full and timely execution of the obligations taken by the borrower according to the agreement terms. Credit risk describes the economic relations that arise between the borrower and the lender while redistributing financial assets.For any enterprise, credit risk may also include a possible failure of a commercial bank to provide or extend the credit. In addition, it’s a risk of failure to pay interest on a loan and repay the principal amount of debt. If a bank loan was taken, credit risk increases along with the amount of the loan and the repayment period. Factors that determine credit risk are as follows: loan period, interest rate, repayment peculiarities, warranty of the loan agreement, loan currency and reliability of a commercial bank that provides the loan.

Business risk management

Business risk management is a set of methods used for analyzing and neutralizing the risk factors. These methods should be united in to a single system of planning, monitoring and correcting actions.

The risk management plan construction implies a consecutive performance of the following separate stages:

1. Identification of risks. This an initial stage that includes a systematic identification and classification of potential events that may negatively affect the business activity. For this purpose such methods and tools as classification schemes of risks sources and types, graphics, interviews and questionnaires are used.

2.Risk analysis and assessment. This is a procedure of identifying risk factors, determining the likelihood of adverse events and calculating the economic impact of the materialized risks. Commonly, companies use qualitative and quantitative methods of risk analysis and assessment. Qualitative methods are designed to detect types of risks and factors that cause them as well as to analyze their consequences and elaborate ways to minimize them. This part of the risk analysis should be performed on the stage of risk identification. Quantitative methods are based on mathematical approaches and statistical models and allow determine the likelihood of risk events and the scale of probable damages.

3. Choice of risk management methods and tools. There are four basic methods of risk management:

  • Cancellation or a refusal from a certain activity or its radical change that results in a disappearing of risk
  • Preventing and controlling which is an active influence on risk factors that requires an implementation of a set of measures aimed at minimizing losses after the negative event happened
  • Risk insurance that implies the reduction of losses at the expense of financial compensation obtained from special insurance funds
  • Risk absorption means the company accepts losses, if the damage from negative events is quite low.4.Responding to occurrence of risk event and taking the decision.

Specific response of the company in case the risk event did happen is determined by the risk type, risk management practices applied in the past and the level of expected losses. The plan of actions that should be performed, if a certain risk event happened, is called an uncertainty plan. Such plans are a part of the overall risk management plan and typically contain the results of risk identification, description of quantitative risk assessment, procedures used in managing risks and information about people responsible for management of different risk areas.5. Control and analysis of risk management methods and tools and evaluation of their consequences. If the company wants to receive a correct understanding concerning the effectiveness of risk management methods and tools, the implementation of this stage is very important. This stage also provides a lot of valuable information about possible improvements of standard procedures in case they repeat in the future.

As it was already mentioned above, companies may create risk management plans to specify the range of actions in case of risk event happens.Risk management plan is a document that contains a list of activities to prevent and minimize the consequences of potential risks. Such risk management plan is usually formed on a basis of a risks list. Preventive measures are determined before the implementation of some actions, while measures to minimize the negative effects may be made in the event of the risk appearance. To formalize the whole procedure and make it available for any department within the company, it’s possible to make the risk management plan template in a form of a table in MS Word.When elaborating risk management plan, Excel program by Microsoft may be of a particular benefit, since it allows support qualitative assessments with numerous quantitative methods.

Business risk insurance

Business risk insurance is one of the most widely used methods of risk management. The purpose of this strategy is to reduce the company’s participation in recovering the damages at the expense of transferring a part of responsibility for the risk to the insurance company.

This method is recommended to apply in the following situations:

1. The probability of risk realization, i.e. the appearance of damage, is low but the size of possible damages is quite large. Insurance is appropriate regardless of the risks types and quantity.

2. The probability of the risk realization is high, but the amount of possible damage is small. Insurance makes sense if the risks are numerous and both homogeneous or heterogeneous. Of course, the company may accept the losses provided by such risks, but if there is a great number of them, it may cause significant damage. That’s why insurance is the best solution in this case.