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Because objective risk is the actual number of losses in a given time span for a given
sample, it may differ significantly between different samples, even if those samples have
the same expected losses. Statistically, objective risk is commensurate with the variance,
and therefore, the standard deviation, of the sample.
Note that in the 2 hypothetical samples below, both have the same expected loss, but
different objective risks. Because of the wider variation of losses from City 1, an
insurance company would require greater reserves to pay for losses in City 1 than in City
2, where the number of losses are closer to the mean. Thus, even though both cities have
the same expected loss, City 1 has a greater
2 what is Difference between Pure risk and
Speculative risk
Pure Risk
Speculative Risk
Many people buy insurance in order to gain security and peace of mind. Comprehensive
insurance policies can protect our assets, our health, and our loved ones. Insurance
contracts function by shifting the risks you face every day to your insurance company.
Read on to learn more about this transfer of risk.
The transfer of risk is an essential tenant of insurance contracts. When you purchase an
insurance policy, the insurance company will agree to indemnify you for a certain
amount of loss in exchange for your payment of a set premium. An insurance policy,
which is a legally binding contract, effectively passes the risk from the party who doesn't
want to take it on (the insured, or purchaser of the policy), to the party who is willing to
take on the risk in exchange for a fee (the insurance company). For example, if you buy
a home, you will likely also purchase a homeowners insurance policy. By doing so, you
are essentially paying an insurance company to take on the various risks that are
associated with owning a home.
Risk Pooling
Risk can be transferred from insured individuals to insurance companies, and can also
be transferred from insurers to reinsurers. This is known as "risk pooling." An insurance
company will collect millions of dollars in premium payments each year. The company
will spend these premiums meeting company expenses and also paying out claims as
necessary. The company uses actuarial statistics and other information to calculate
premiums to make sure that the amount of premiums collected exceeds the amount that
the company has to pay out.
Reinsurance Companies
However, because the dollar value of the risk that insurance companies typically take
on exceeds the amount of capital that they maintain for paying out claims, insurance
companies often pass on some of their risk to reinsurance companies. Reinsurance
basically provides insurance companies with insurance against loss. This comes in
handy in the case of catastrophic loss, such as large-scale natural disasters that cause
insurers to issue many payments at once.
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1. They make profit by selling a product for more than it costs to produce. This is the
most basic source of funds for any company and hopefully the method that brings in the
most money.
2. Like individuals, companies can borrow money. This can be done privately through bank
loans, or it can be done publicly through a debt issue. The drawback of borrowing money is
the interest that must be paid to the lender.
3. A company can generate money by selling part of itself in the form of shares to investors,
which is known as equity funding. The benefit of this is that investors do not require interest
payments like bondholders do. The drawback is that further profits are divided among all
shareholders.
In an ideal world, a company would bring in all of its cash simply by selling goods and services
for a profit. But, as the old saying goes, "you have to spend money to make money," and just
about every company has to raise funds at some point to develop products and expand into new
markets.
When evaluating companies, it is most important to look at the balance of the major sources of
funding. For example, too much debt can get a company into trouble. On the other hand, a
company might be missing growth prospects if it doesn't use money that it can borrow.
Angel equity. If you must sell an ownership stake to get your company off the ground, start by
finding a respected industry executive who is willing to invest a reasonable amount and give
your venture credibility with other investors.
11. Smart leases. Leasing fixed assets conserves cash for working capital (to cover inventory),
which is generally tougher to finance, especially for an unproven business. Warning: Don’t put
so much money down that you end up spending the same amount of cash as you would have
had you bought the asset with a down payment. The cost of a lease may be slightly higher than
bank financing (see source No. 10), but the cost of the down payment you did not have to make
is likely to be less painful than the dilution you suffer from giving away equity.
10. Bank loans. Banks are like the supermarket of debt financing. They provide short-, mid- or
long-term financing, and they finance all asset needs, including working capital, equipment and
real estate. This assumes, of course, that you can generate enough cash flow to cover the
interest payments (which are tax deductible) and return the principal.
Banks want assurance of repayment by requiring personal guarantees and even a secured
interest (such as a mortgage) on personal assets. Unlike other financing relationships, banks
offer some flexibility: You can pay off your loan early and terminate the agreement. VCs and
other institutional investors may not be so amenable.
9. SBA 7(a) loans. Of all the federally sponsored debt-financing programs, this is the most
popular, and perhaps the best. It loosens the flow of credit by guaranteeing the lender against a
portion of any loss incurred on the loan. Not to say that banks aren’t careful when making 7(a)
loans: They are required to keep the non-guaranteed portion on their books.
The interest rate can vary based on the size of the loan, with smaller amounts costing a little
more. Shop around. Some banks reap servicing fees and nice profits by selling the guaranteed
portion of the loan to insurance companies and pension funds; in those cases, a lender may be
willing to offer you a better rate.
Say you need to raise $200,000 for a building. A bank may offer $150,000 on a first mortgage at
a variable interest rate of prime, now 3.25%, plus 200 basis points, for a total of 5.25%. The
local development entity might lend you another $30,000 on a second mortgage at a fixed-
interest rate of 4%, without seeking equity shares or warrants. (Without the development
corporation’s contributions, you would have to scare up $50,000 in equity–expensive.) If you
don’t have the cash flow to cover the interest, the development organization may offer extended
terms. Some loans are interest-only for the first year or two, and even the interest payments can
be accrued for a certain time period.
Development groups may not agree to finance an entire operation, but they make snagging the
remainder from other private sources a lot easier. Talk to your local chamber of commerce to
find these programs. (Also checkwww.infinancing.com for a list of the types of development
finance organizations).
6. Vendors: Dick Schulze built Best Buy with financing from large consumer electronics firms–in
other words, his suppliers. This way, your financiers do not control your growth; you do. Just be
sure not to enslave yourself to a handful of powerful suppliers in the process.
5. Friends and family members. If you’re lucky, friends and family members might be the most
lenient investors of the bunch. They don’t tend to make you pledge your house, and they might
even agree to sell their interest in your company back to you for a nominal return.
4. Small Business Innovation Research (SBIR) grants. Getting past the paper-intensive
application process and SBIR grants can be a great way to turn your intellectual property into
mailbox money. For more on these grants, check out How To Get Uncle Sam To Fund Your
Start-Up.
3. Tax Increment Financing. TIF subsidies are geared toward real estate development in
targeted areas. Depending on the state, the subsidies can be as large as 20% to 30% of the
cost of the project. Better yet, you may even be able to borrow against this subsidized value. If
your own community does not offer a TIF program, look at communities that do. You may end
up a little farther from your home or office, but it could be worth your while.
2. Internal Revenue Service. No, the IRS does not lend money. But it does allow you to deduct
expenses. If you are paying a heap in taxes, evaluate whether you can use your profits to
expand your business–and reduce your tax bill.