Investment Risk Insurance
A financial institution, such as a bank, a hedge fund or an insurance company, that engages in trading activities may need to hedge--or protect--against financial risks such as market or credit risks. A company's top leadership must implement adequate loss-prevention strategies to limit operational and financial losses, including internal reviews and risk insurance policies.
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Investment Risk Defined
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Investment risk is the risk of loss that may arise from unfavorable market trends and could relate to market or credit risk. Market risk is the risk of loss originating from adverse security price variations. For example, if a bank buys a stock at $10 today and it's valued at $8 after three days, the $2 decrease is a market loss. Credit risk is the loss that may arise from a business partner's default due to bankruptcy or temporary financial problems.
Investment Risk Insurance Defined
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Investment risk insurance is a type of policy that protects an investor's assets up to a pre-determined amount. This insurance is very critical for an investor who engages in credit transactions with a business partner, because the risk of default may be higher than market risk. To illustrate, consider a bank that lends $10 million to a retail store and immediately buys a risk policy at 90 percent. If the store files for bankruptcy after nine or 10 months, the bank may collect $9 million from the insurance company.
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Types
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Types of investment risk insurance policies vary, depending on the company size, industry and business partners. An insurer may increase or decrease premiums based on partners' risk profiles and credit histories. For instance, an insurance company may agree to cover a bond investment transaction up to 90 percent, whereas it may set coverage percentage at 80 percent in another transaction. The 10 percent difference may be due to less creditworthy business partners being present in the latter transaction than in the former.
Significance
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Investment risk insurance is an important part of a corporation's risk hedging strategy because it prevents operating losses and thus increases net profits. For example, assume a bank engages in a lending transaction with two business partners and advances $100 million to each partner. The bank then purchases risk coverage at 90 percent for one transaction and 95 percent for another. After three years, both partners file for bankruptcy. The bank collects a total of $185 million ($90 million plus $95 million) from the insurance company and loses only $15 million instead of $200 million if it had not purchased coverage.
International Investment Risk Insurance
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A multinational company that engages in financial transactions with foreign partners or trades on global securities exchanges may also purchase investment risk coverage. International coverage contracts are similar to domestic ones, with the exception being that they often may include local provisions that are linked to national regulations. As a practical matter, an insurance company may increase risk-coverage premiums based on the transaction size, credit profiles of business partners and the country's economic standing.
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References
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