Introduction
As a newbie investor, it gets quite confusing and overwhelming when you have a look at investments or options for financing. It can be navigating or traversing through every commodity of a financial nature that can rip you off your element of logical thinking.
Between stocks, shares, investment bonds, debt bonds, real-estate products, or structured notes, it becomes quite hard for you to evaluate the pros and cons of every financial instrument vis-a-vis its working mechanism.
When you further deep dive into the conceptual part of understanding, it is obvious that insurance and hedging are risk management strategies. However, they differ in their purpose, mechanism, and applications.
On this parlance, let us understand the key points of differences covering Insurance Vs Hedging. Helping you get started here:
Defining the purpose between Insurance and Hedging
Insurance is primarily designed as a calamity-protecting commodity that helps individuals and businesses bounce back from unexpected or unforeseen circumstances like accidents, illnesses, and property damages indeed.
Whereas, with respect to hedging, this is an investment-based strategy that helps investors manage their price fluctuations on income-earning securities or high-paying shares. Therefore, one can reduce or offset pricing fluctuations across investments and commodities against volatile market conditions.
Risk Transfer Vs Risk Mitigation
Insurance is mainly a risk-transferring strategy wherein the risk factor of the investor is transferred from the investor to the insurance service provider. In other words, the element of risk is transferred from the policyholder to the insurer. This happens in exchange for a premium amount that is paid out by the insured to the insurer.
Whereas in the case of hedging, this is more of an investment strategy that involves offsetting the position of financial derivations. These include equity shares or income-earning securities that have a call or put options embedded in them. This is specifically done to mitigate the level of risks the investor has in a volatile market condition.
In a nutshell, insurance is more of a risk-transferring financial strategy while hedging is more of a risk mitigation investment strategy.
Nature of Coverage including examples between insurance and hedging
Insurance is a domain that covers specific or predefined risks that are predominantly associated with health, property, or liability.
For instance, you can avail of a comprehensive health insurance policy that takes care of your medical bills or daycare pharma invoices in a streamlined manner. Plus, you can avail of a direct cashless hospitalization with leading healthcare centers wherein the insurance service provider settles the bills or claims directly to the hospital vendors. Similarly, you can look for property insurance that takes care of the home repairs or refurbishment expenses you may have to pay millions of dollars for. Homeowners can heave a sigh of relief by remitting affordable premiums on a home and refurbishment property insurance and the yearly bills are covered by insurance service providers.
Whereas, in the case of hedging you look at it as a risk mitigating option to save your financial derivatives comprising shares and commodities against the volatility of market conditions. For instance, you might take a pre-emptive decision to buy 500 shares of Coco Cola wherein the cost of every share is $25 each. When the shares of Coke touch $50, you would want to sell them. Here, you earn double the profits on your initial investment over a very short span of time. This can be a Future Hedging operation wherein you buy shares anticipating a hike in the future.
Similarly, you might want to buy 2-year bonds over 5-year bonds as the interest rates might be better over 2-year bonds as compared to the 5-year bonds. This is a hedging operative wherein you anticipate better interest rates to buy or sell your bonds later in the marketplace.
Determining the cost structure
Insurance operates via remittance of regular premium payments by insurance policyholders to insurance service providers. The premiums are usually fixed payments of money and are not recoverable in case no claims are made by policyholders in lieu of the same.
Whereas, in the case of hedging, it is the price variances you anticipate over Future Calls or Put options that are pre-designed on financial derivatives comprising, equities, shares, securities, or commodities. Here, the members do not pay any amount of money but anticipate or forecast future buys or sells based on the nature of volatility that particular derivative suffers or enjoys in the market.
Determining the time horizon period between the two
Insurance usually has a more spread-over or long-term coverage to help you source different insurance plans and pay premiums towards the same.
For instance, a health insurance premium or a car insurance premium needs to be levied every year or so. You also have insurance coverage plans ranging from 5 to 25 years. Therefore, these are risk management products that are more suitable over long-term time horizons.
Whereas, with respect to hedging, this is a risk mitigation technique that is more applicable over short-term or tenor-based investments. This is done in response to a specific set of events or market conditions. A hedge usually varies for days and can go on for months.
Determining the level of market focus
For an insurance domain, this is a risk-managing investment that is primarily meant for individual consumers and business entities as a matter of fact. In other words, business owners and retail investors take up insurance policies to mitigate losses arising from illnesses, and damage to properties, or automobiles.
Whereas, with respect to hedging, the market focus lies on wealth managers or investment houses that perform a host of hedging operations on the investment portfolios of their clients and stakeholders. This is a risk mitigation process that is primarily done by financial conglomerates and investment banking houses to offset or mitigate losses arising from stocks, trades, and cryptocurrencies.
Regulation
Insurance is a domain that is highly regulated by Govt authorities to protect the interests of investment holders and policy subscribers to a greater extent. By enhancing govt-aided protocols of facilitation, one can ensure fairness with claim procedures, ensure the solvency of the insurance service providers, and above all lead to a better degree of policyholder protection.
Whereas, with respect to hedging practices, investment houses and bankers perform risk mitigation procedures to offset or mitigate capital-based losses on behalf of their investor clients. The monitoring is done by the console or the investment firm and there isn’t any form of Governmental or authority-based intervention with respect to hedging.
How does Insurance and Financial planning go hand-in-hand- Insights Explained
Insurance and Financial planning go hand in hand. Let us have a run-down of pointers with respect to the same.
Helping you get started here:
Plan for your financial emergencies or contingencies well in advance
When you take up a health insurance policy, you can foresee the medical emergencies or contingencies you and your family members could face way down the line. Or, when you go for fire damage coverage for the godowns or inventory sheds inside your factory outlets, you anticipate or foresee inventory damage due to fire outbreaks and thereby claim a coverage plan in lieu of the same.
Therefore, when you take up insurance policies that foresee financial emergencies or contingencies for the future, this is also a kind of financial planning that is done by you in advance.
Helping you chart out your financial goals in a systematic manner indeed
By taking the right type of insurance policies, you chart out the financial goals or your objectives in a streamlined and systematic manner.
For instance, when you take an education policy, you can make a claim in lieu of your son’s or daughter’s future education expenses in terms of tuition fees that fall in line for the entire semester or two. Similarly, by taking a home refurbishment insurance policy, you can file for your claim amounts as and when you want to renovate the rooms of your home, repaint your entire house, or replace ceiling walls that creak down.
This way, by choosing the right insurance policies, you chart out your financial goals into short-term, mid-term, and long-term tangibles.
Provide a sense of freedom or relief from financial emergencies or contingencies
When you opt for the right type of insurance policy, you get an overall sense of relief and freedom from the stress of medical emergencies, fire outbreaks, or property damages. As you can claim for a claim as and when the insured emergencies arise, you can stay back stress-free and relaxed.
The Bottom Line
Insurance and Hedging are risk management components of an investment or financial portfolio although their way of operations and lean-in mechanisms differ vividly. What are your thoughts on this? Do let us know in the comments below!
Frequently Asked Questions or FAQs
Define a futures contract.
Answer: A futures contract is a contract wherein you foresee an exposure of an asset that might accelerate or ply due to volatile market conditions. Here, you purchase financial derivatives with the call or put that are future options so that you typically mitigate your losses or gains in the equity markets out there. In a nutshell, you bet a course of action here. Here, you discuss the view on what can occur between say a currency vis-a-vis its counterpart share or derivative or how you might lose if you take an opposite course of action.
