Definition: Many companies buy insurance to hedge against the different kinds of risks, such as the risk of property damage, risk of fire, risk of plant destruction, the risk of liabilities, etc.
When a company buys the insurance, it pays a premium to shift the risks to the insurance company. Which insurance company the firm prefers over the others depends on the advantages and disadvantages offered by each. The main advantages are:
- It has the expertise to price the risk reasonably due to its considerable experience in the same field.
- It also has the experts who give advice on measures to reduce risks and may offer reasonable premium policies to the clients who follow their advice.
- Due to the specialization, the insurance company may provide low-cost claims administration service.
- It has the capacity to pool risks since it holds a large and diversified pool of assets.
As against the above advantages, there are following limitations:
- The administrative cost is very high
- Often, the insurance companies face the problem of adverse selection wherein it is difficult to distinguish between the good and bad risks.
- The high loading cost, which represents the difference between the premium amount and the expected payoff from the insurance policy.
Thus, insurance is the most common form of hedging tool which companies use to protect themselves against the uncertain losses.