Question

You are a financial specialist, the first one hired for a pool set up to offer insurance to construction companies in your city. The pool you work for takes in approximately $50 to $55 million dollars in premiums to provide workers compensation insurance for the members. In the past, the pool has hired a third party that has taken the money and invested it for the firm, making sure the money to pay claims is available, but at the same time making sure the money is not just sitting in a bank, but invested to provided additional capital to the pool. The contract with the third party administrator will expire in six months. The pool hired you to help them better understand the risks their financing activities represent. The leaders of the pool know that you have to invest the money to make money, and want the investments to be aggressive, but not too aggressive, so the pool will have money to pay claims in a bad year. They want to understand the balance between too passive and too aggressive an investment strategy.

Although you need to follow APA in your report, explain the information you’d pass on to the pool’s management. Explain what types of financial (speculative) risks their organization has. Explain to them countermeasures that can be taken to mitigate or eliminate these threats. Explain what you see as the top five threats that the pool faces from a financial risk management standpoint.

Answer 1

The firm should invest the surplus to generate the investment income. Suggested investment instruments are:

• Liquid funds
• Mutual funds
• Stock markets
• Bonds

Needless to say, each of the instruments specified above has its own share of risks. Collective risks the firm is exposed to are:

1. Interest rate risk
2. Inflation risk
3. Political stability
4. Capital market risks
5. Economic stability of the country
6. Foreign exchange risk
7. Regulatory risk

The best way to take care of these risks will be to:

• Build a diversified portfolio of the instruments talked about
  • Investments in liquid funds will allow the firm to take care of periodic claims and administrative expenses
• Hedging using derivatives

Top five threats:

• Loss in capital value: The investment value falls below the book value. This may be due to lack of stability in capital markets or interest rate
• Natural disasters or force majeure events leading to drastic increase in claims in a particular year: investments may have to be redeemed pre mature to take care of the excess claims.
• Political instability of any kind
• War
• Terrorism