Why does it make sense for a company to purchase insurance or to hedge its risks?

A company should do whatever strategy that will minimize its risk at the lowest cost. If a company hedges its risks through the stock market or by options, it will constantly have to rebalance its portfolio daily. Each time they do this they would pay transaction costs. Most of the time you hedge to prevent against price increases in the market. Not all of hedging is preventable by means of the stock market. Depending on what you are hedging against then it may be necessary to buy some type of insurance. For example if you want to protect yourself from a fire loss then you would buy fire insurance, because there are no financial instruments that will protect you from a fire loss.

If hedging reduces diversifiable risk, then hedging will not reduce the opportunity cost of capital. Hedging and insurance reduce systematic risk (nondiversifiable risk) will reduce the opportunity cost of capital.

When a company purchases insurance they pay a premium, which consists of the expected loss that the insurer calculates plus some loading. Since the company already expects to lose the calculated expected loss there is no need for the company to pay for the additional cost of loading. However through the purchase the company buys the insurer’s services that may save the company time, money, and aggravation. Insurance benefits you the most when you actually do have a really big loss.