What Is Risk Financing?

Risk financing (loss financing), also known as loss financing, refers to various means of obtaining funds and using them to pay or compensate for foreign exchange risk losses.

Risk financing

Risk financing is suitable for SMEs and is determined by the characteristics of venture capital.

(1) Financing companies must be companies that have high and new technology and are engaged in the development of high and new technology products. Such enterprises are usually small and medium-sized enterprises, and because of the high uncertainty of technology and the market, the enterprises have a very high level of uncertainty. High risk, but at the same time has potential high profitability; technological innovation can greatly improve the production technology and product characteristics of the enterprise, and may even produce brand-new products, once successful, they will get rich profits . The high profitability of technological innovation is exactly the main reason that venture capital is optimistic.

(2) There is often a partnership between venture investors and financing companies.

(3) The investors of the venture capital not only contribute capital, but also participate in the planning and management guidance of the technologically innovative enterprises that are financing. The value-added services provided by venture capital for financing enterprises help to improve the governance of small and medium-sized enterprises, standardize the operation and management of enterprises, and improve the quality and comprehensive competitiveness of enterprises.

(4) Risk financing is different from bank loans. Venture investors do not intentionally avoid risks like banks, but actively enter high-risk areas and actively manage risks. Venture capital is an investment behavior that is bundled with enterprises to develop. It does not evade the risk of funds. As long as the venture capitalists are optimistic about the venture, they can get the assistance of venture capital. Therefore, the focus of venture capital activities does not lie in the current profits and losses and creditworthiness of venture companies, as well as the quantity and quality of mortgaged assets, but in their development prospects and growth potential. Venture capital also does not use credit with a fixed rate of return.

(5) Technological innovation-oriented enterprises mainly conduct risk financing during the entrepreneurial period and growth period of the enterprise.

(6) Venture capital is a form of equity investment with a long term and does not increase the debt burden of the enterprise. It is very suitable for financing technological innovation of small and medium-sized enterprises with tight funds. It is worth mentioning that for investee companies, risk financing is actually the least risky, and all risks are borne by investors; therefore, the selection of projects by venture capital companies is extremely strict and requires a series of research procedures and market viability. survey. Once invested, venture capital requires great returns, and venture capital focuses on maximizing profits.

According to the period of implementation of risk financing measures, risk financing technologies can be divided into the following three categories: contemporaneous risk financing, prior risk financing, and ex post risk financing.

Concurrent risk financing means that the risk management unit can raise lost funds from operating income at any time. If the company has sufficient operating income, the cost of loss can be regarded as a short-term expense, and no special plan needs to be made in advance to raise funds for risk management. Generally, individuals or organizations unfamiliar with risk management often use this financing method. The advantage of risk financing over the same period is that the risk management unit does not need to raise funds in advance for possible losses, which can improve the efficiency of the use of funds. The disadvantage of the same period of risk financing is that when the loss occurs, it may cause a decrease in operating income and may affect the normal production and operation activities of the risk management unit.

Advance risk financing refers to the risk management unit that has accumulated a portion of the funds to compensate for losses in advance. If the loss caused by a risk accident is very large, the enterprise should use a certain method to allocate the loss to several financial budget periods, and accumulate a certain amount of funds to compensate for the loss before the loss occurs. For example, employees pay contributions during the work period to meet the pensions that may be required for future ageing. This financing method is advance risk financing. For another example, in order to prevent employees from paying a large amount of medical expenses, the financing method of commercial insurance for employees is also advance risk financing. The advantage of advance risk financing is that it can raise funds for possible losses caused by risk accidents in advance, can cope with the occurrence of risk accidents at any time, and can maintain the continuity and stability of production and operation activities of the enterprise. The disadvantage of advance risk financing is that it may cause a decrease in the efficiency of fund use and increase the cost of risk financing. For example, the investment and operation of social insurance funds will increase the management cost of funds, may cause losses in fund investment, and may lead to problems such as corruption and misappropriation of funds. However, the accumulation of funds can cope with large amounts of expenditure that may occur.

Post-mortem risk financing refers to the risk management unit's raising funds to compensate for losses after a risk accident occurs. If the compensation for losses caused by a risk accident is distributed in several budget periods after the risk accident, it is post-mortem risk financing. For example, companies borrow money from other companies after a fire accident. This financing method is after-the-fact financing. The advantage of this financing method is that it does not occupy the operating funds of the risk management unit and has a relatively high use efficiency of funds. The disadvantage of this financing method is that after the risk accident occurs, it may be difficult to raise funds to compensate the risk, which will affect Normal production and operation activities.

The method by which a risk manager finances possible losses is the risk financing method. According to different risk-bearing subjects, risk financing can be roughly divided into two categories: risk retention and risk transfer. Risk retention refers to the financial consequences of the loss of the unit facing the risk, that is, the risk management unit raises funds for the loss and loss compensation caused by the risk accident. Risk transfer means that the risk management unit transfers the possible losses or financial consequences of loss compensation to other units to bear, that is, other units raise funds for losses and loss compensation caused by risk accidents. There are two main types of financing for risk transfer: one is insurance financing and the other is non-insurance financing. Insurance financing refers to the use of insurance contracts by risk management units to raise funds for compensation losses; non-insurance financing refers to the use of non-insurance contracts to raise funds for compensation losses by risk management units. Obviously, whether it is insurance financing or non-insurance financing, it is not possible to eliminate the losses caused by risk accidents through risk transfer, but to avoid the consequences and financial burden of loss accidents through risk financing. Other units take the initiative or passively Bear the financial consequences of the loss.

Risk financing cost refers to the amount of funds that a risk management unit may need to manage risk. The cost of risk financing mainly includes the following aspects:

(1) The risk management unit pays the salary of the risk manager. For example, salary, benefits, pension insurance and other expenses of risk management managers and risk management investigators.

(2) Management costs paid for risk control measures. For example, management expenses such as the cost of installing safety facilities and installation costs.

(3) Compensation costs required to compensate for losses. For example, the cost of replacing and repairing the lost production equipment are the costs of compensating for the loss.

(4) Expenses or interest expenses required to raise risk management funds. For example, transfer of corporate property risk, liability risk, etc. to insurance costs that insurance companies need to pay.

(5) The opportunity cost of obtaining other profits. The funds occupied by risk financing will affect the profits of other aspects of the enterprise, which is the opportunity cost of risk financing. For example, if a company establishes a risk management fund, it will affect the investment of these funds into production to obtain production and operating profits.

Which method of risk financing is used requires a comparison of the costs and benefits of risk management. If the total return is greater than the total cost, you can use the risk retention financing method; if the total return is less than the total cost, you can use the risk transfer financing method. If the risk management plan designed by the risk manager can provide the same guarantees as the insurance company, then the plan can replace the insurance purchase behavior, while avoiding the transaction costs of purchasing insurance. For example, a company owns many cars. In order to reduce the loss, the car can be parked in multiple places. In this way, the company's vehicle is unlikely to be damaged at the same time. Losses, you can take the way of risk retention, without having to adopt insurance to transfer risk. In short, different ways of risk financing affect the management cost of risk financing. The principle for risk management units to select risk financing methods is to obtain the maximum security guarantee with the minimum financing cost.