Financial insurance is a business practice that helps a corporation hedge (protect) against risks of loss implicit in its activities. Top management typically ensures that trading activities, domestically or internationally, do not cause a firm major operating losses. Financial risk insurance may relate to lending activities or financial market transactions.
Financial Insurance Defined
Financial insurance is a business arrangement that ensures that a corporation engaging in certain types of transactions may recover losses if counterparties (business partners) in these transactions do not meet financial promises. For example, a firm may buy credit insurance to protect against the risk of loss arising from a customer default. Financial insurance may also be used in securities exchange transactions. As an illustration, a bank that signs a financial derivatives agreement with a counterparty based overseas may buy insurance coverage to protect against losses.
Financial insurance is pivotal in modern economies because business uncertainties rise as a firm engages in multiple activities across many markets or countries. Consequently, top leadership wants to prevent significant losses in corporate activities. For instance, financial insurance may be used to limit maximum losses that a company incurs in a transaction if it buys coverage up to a certain threshold (80 percent coverage limits the financial loss to 20 percent, for example).
Types of financial insurance products may vary, depending on the industry, the company size and legal status. For example, a global investment bank that engages in buying and selling multiple securities on financial exchanges may purchase insurance coverage for its credit and equity transactions. By doing so, the bank hedges against the risk of losses that may arise if a business partner files for bankruptcy or the value of its stock portfolios decreases by a certain percentage.
Financial insurance, as any type of insurance coverage, benefits the policyholder and the economy. A company that purchases coverage in a credit transaction ensures that its operating losses are limited in case of a partner's default or temporary inability to meet financial commitments. In addition, senior managers know that an insurance company performs credit checks for all business partners before providing coverage, which means the risk of default is low. The economy also benefits from financial insurance because it helps prevent "domino-effect" bankruptcies that may occur if a large company defaults and its customers also file for bankruptcy.
International Financial Insurance
Financial insurance may be more critical in the global marketplace because international business activities have risks that may not exist in domestic transactions. If, for example, a large pharmaceutical company operating in 34 countries wants to expand in other regions, it may face political or foreign exchange risks. The firm can, however, purchase coverage from an international risk insurer to hedge those risks.