Independent risk is the danger associated with investing in a particular instrument or division of a company. Investors can address this risk by diversifying their portfolios or registering different departments of a company as separate legal units.
Independent risk describes the danger associated with investing in a particular instrument or investing in a particular division of a company. A typical investment portfolio contains a wide range of instruments, in which case investors are exposed to a great deal of risk and potential reward. By contrast, an independent risk is one that can be easily distinguished from these other types of risk.
When an investor only invests in one type of stock, his or her total investment return depends on the performance of that collateral. If the company that issued the stock performs well, then the stock will grow in value, but if the company goes insolvent, the stock may lose its value. Therefore, such an investor is exposed to independent risk because that individual’s entire investment could be lost due to the underperformance of a single asset. In addition, someone who invests in a wide range of securities is also exposed to independent risk if that person holds each type of instrument in a separate brokerage account. In such situations, the investor would not lose everything if an asset fell in value, but each portfolio account would expose the investor to a different independent risk, since each account would only have one type of collateral.
Like private investors, large corporations, including investment firms, are exposed to independent risks. A flood insurance division of a major financial company is exposed to the risk that large numbers of hurricanes or coastal flooding could cost the company a significant amount of money in terms of policy payouts. The auto and health insurance divisions of the same company would not expose the company to this same risk because these types of policies do not provide the insured with payments related to water damage.
Many investors try to address independent risk by expanding portfolios to include other types of securities and assets. An insurance company cannot completely eliminate the risk associated with flooding by selling other types of policies, but a business that sells life, health, and auto insurance policies is less likely to have financial trouble after a major storm than a business that only sells flood insurance. From a structural point of view, some companies register different departments of the company as separate legal units to protect the entity from risks associated with a division of the company or a type of asset. If all of a company’s holdings operate as a single structure, then the company’s creditors and investors may attempt to seek damages if the failure of one division of the company causes those groups and individuals to lose money. When a company registers its various business units as separate legal entities, creditors and investors cannot try to offset losses by reclaiming assets owned by one of the other units of the company.
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