In relation to insurance and insurance contracts, financial risk refers to the type of risk that affects a contract’s future cash flows arising from financial factors such as a change in a benchmark rate, market prices for investments/ assets/ commodities, as well as currency exchange rate, price indexes, credit rating, credit indexes, etc. Such risks are considered financial on the condition that any non-financial variables amongst the above factors is not specific to an insurance contract.
Financial risk, therefore, includes both financial and non-financial variables. However, non-financial variables are included in financial risk only if they are not specific to a party to the contract.
Examples of financial risk that arise from non-financial variables not specific to a party to the contract include exposures to an index of natural disasters in a certain region (which by definition is not a financial risk). However, this risk may affect the property owned by an party as it translates into be the risk of a possible future change in a non-financial variable specific to a party to the contract and would give risk to an insurance risk.
Financial risk, however, excludes non-financial variables that are specific to a party to the contract, such as the break-out of a fire or hurricane that wholly or partially destroys an asset of that party.
Furthermore, the risk of changes in the fair value of a non-financial asset is not a financial risk if the fair value reflects not only changes in market prices for such assets (a financial variable) but also a non-financial variable in relation to the condition of a non-financial asset held by a party to a contract. For example, if a guarantee of the residual value of a specific productive asset (e.g., machinery) exposes the guarantor to the risk of changes in the asset’s physical condition, in which case the risk involved is insurance risk, not financial risk.
