ABSTRACT
This chapter considers two risk management techniques, namely transfer through insurance and retention through asset-liability management. Importantly these strategies differ sharply from avoidance and reduction as neither impact the probability of an unwanted event occurring; they merely allocate the financial loss involved. Insurance is a contractual arrangement whereby an annuity in the form of a stream of regular premium payments secures indemnity against a much larger, uncertain loss under specified conditions. Conventional capital markets theory argues that insurance does not add value because the same result can be achieved by firms or shareholders through diversification. Hedging is a type of diversification that matches separate exposures so that their values move in opposite directions. One approach is financial hedging using contracts that protect against loss in value due to market movements. Diversification to reduce risk always benefits shareholders when reduction in non-systematic risk is rewarded, or when it can be achieved at a cost that shareholders cannot match.
