Risk financing is a term used to describe the consumption of resources that occurs when a company sustains financial losses in the course of conducting business. The financing has to do with securing resources that can be used to offset the losses, allowing the company to manage the losses without negatively impacting the day to day operation of the business. There are several different ways that risk financing is managed, including the establishment of reserves set aside for this type of issue, sharing the risk with a third party, or even obtaining insurance that effectively transfers the risk to an insurance provider.
One of the more common means of managing risk financing is to utilize insurance coverage to cover potential losses associated with a given business project. Here, the idea is to transfer the risk involved with the venture to the insurance provider by taking out a policy that will honor claims for redress in the event that certain events come to pass with that project. While expensive, this type of financing strategy does offer the benefit of knowing that even if the project ultimately fails due to one or more events covered in the terms of the policy, the losses will be settled without having to utilize other company assets.
A company may also choose to manage risk financing in-house by establishing reserves of funds that can be used to settle the debts associated with a failed project. This approach effectively allows the business to provide itself with a form of self-insurance. The funds are usually placed into some sort of interest-bearing account and earmarked as backup funding for use in emergency situations only. This helps to segregate the balance of that account from corporate operating funds. Should the project in question fail, resources within this emergency reserve can be used to settle the debt without having to dip into the general operating fund and possibly jeopardize the financial stability of the company.
Risk financing can also be managed with what is known as risk pooling. Assuming there are two or more partners in the business venture, each partner agrees to assume a percentage of the risk, and creates their own reserves to manage that risk. The end result is that no one partner has to face paying off all debts associated with a failed venture, which in turn means less of a chance of adversely affecting the financial well being of any of the partners.