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Chapter 1-18 Textbook notes for BU 353.docx

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Wilfrid Laurier University
Richard Reiner

Chapter 1: Why Manage Risk Risk – any situation where there is uncertainty about what outcome will occur Risk is sometimes used in a specific sense to describe variability around the expected value and other times to reflect greater expected losses, due to either a higher probability of loss or a higher value of loss. 1) Personal Risks – the risks faced by individuals and families a) Earnings – potential fluctuation in a family’s earnings due to death, disability, aging, unemployment b) Medical Expense – health care costs c) Liability – auto, home, watercraft, personal actions d) Physical Asset – auto, home, boats, other (watercraft, electronics) e) Financial Asset – stocks, bonds f) Longevity – possibility that retired people will outlive their financial resources 2) Business Risks – possible reductions in business value from any source - unexpected changes in expected future cash flows are a major source of fluctuations in business value a) Hazard – pose a threat to life, health, property or the environment (also called pure risk) - ex. fire and property damage, windstorms, theft/crime/personal injury, business interruption, disease/disability, liability claims b) Financial – uncertainty over the magnitude of cash flows due to possible changes in prices, asset values, exchange rates, liquidity and credit risk - ex. Price, liquidity, credit, inflation/purchasing power, hedging/basis risk Price Risk – possible changes in output/input prices Output Price Risk – risk of changes in the prices a firm can demand for goods/services Input Price Risk – risk of changes in prices firm pays for labour and materials Three types of price risk are commodity price risk, exchange rate risk, and interest rate risk. Credit Risk – risk that a firm’s customers and the parties to which it has lent money will delay or fail to make promised payments (ex. Accounts receivables could be uncollectible) - this risk is particularly large for financial institutions that routinely make loans c) Operational – encompasses the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems; all risks stemming from business operations - traditionally managed informally by line managers; also addressed through audit and compliance functions d) Strategic – risks associated with an organization’s ability to achieve their business strategy - managed by directors and officers of an organization; entails identifying and analyzing the key risks to a company’s strategic plan Types of Losses from Hazard (Pure) Risks Direct Losses Indirect Losses - damage to assets - loss of normal profit (net cash flow) - injury/illness to employees - continuing and extra operating expense - liability claims and defence costs - higher cost of funds & foregone investment - bankruptcy costs The underlying causes of hazard risks are often subject to a significant degree of control by businesses. In comparison, while firms can take a variety of steps to reduce their exposure to price risk, the underlying causes of some important types of price changes are largely beyond the control of the firm. Businesses commonly reduce uncertainty and finance losses associated with hazard risk by purchasing contracts from insurance companies that specialize in evaluating and bearing such risks. Losses from hazard risk usually are not associated with offsetting gains for other parties. In contrast, losses to businesses that arise from other types of risk often are associated with gains to other parties. Insurance Deductible - The amount the insured is required and obligated to pay by the insurance policy. The deductible is chosen by the insured and is usually applied to coverage's such as comprehensive and collision. Generally the lower the deductible, the higher the insurance premium. Cost of Risk The cost of losses can be estimated ex ante (before the fact) and determined ex post (after the fact). Risk managers generally must rely on ex ante estimates of the cost of losses/risk for decision making. The cost of risk components (using the ex ante perspective) (1) expected losses - direct or indirect (2) the cost of loss control - increased precautions, reduced activity (3) the cost of loss financing - retention & self-insurance, insurance, hedging, other risk transfers (4) the cost of internal risk reduction - diversification, investments in information (5) the cost of any residual uncertainty that remains after the above have been implemented - effects on shareholders and other stakeholders Cost Tradeoffs (1) the expected cost of direct/indirect losses and loss control costs - increasing loss control costs should reduce expected losses (2) the cost of loss financing/internal risk reduction and the expected cost of indirect losses - as more is spent on loss financing/internal risk reduction, variability in cash flows decreases (3) the cost of loss financing/internal risk reduction and the cost of residual uncertainty - great cost control reduces residual uncertainty Risk Averse – when having to decide between two risky alternatives that have the same expected outcome, the person chooses the alternative that has less variability - most people are risk averse Cost of Risk = Value without risk – Value with risk Minimizing the cost of risk for a non-profit organization with no shareholders may involve giving greater weight to certain factors than would be true for a for-profit firm. For example, a non-profit hospital might place greater emphasis on the adverse effects of large losses on its customers. Minimizing the total cost of risk for society produces an efficient level of risk. Efficiency requires that loss control, loss financing, and internal risk reduction be pursued until the marginal reduction in the expected cost of losses and residual uncertainty equals the marginal cost of these risk management methods. All social costs should be internalized by the business so that its private costs = social costs. If the private cost of risk (the cost to the business) differs from the social cost of risk (total cost to society), business value maximization generally will not minimize the total cost of risk to society. Chapter 2: Risk Management Decision Making Someone who is risk neutral cares only about expected wealth and would not require a risk premium to accept risk. Due to risk aversion, most people are willing to pay insurance premiums in excess of their expected losses for insurance; they are willing to pay a risk premium and most require additional compensation to induce them to accept risk. The increase in wealth if a loss occurs can be viewed as the benefit of insurance, and the reduction in wealth if a loss does not occur can be viewed as the cost of insurance. Individuals’ demand for insurance depends on (1) the premium loading, (2) a person’s income and wealth, (3) an individual’s information about expected losses relative to the insurer’s information, (4) the availability of other sources of indemnity, and (5) the nature of the losses (monetary/nonmonetary) Premium Loading Although risk-averse people generally desire insurance, the extent to which they will purchase insurance depends on the policy’s premium loading. The premium on an insurance policy = expected claim costs plus what is referred to as a loading for administrative and capital costs. If the loading = 0, then purchasing insurance does not change a person’s expected wealth. Unfortunately, the premium loading is rarely zero since insurers must be compensated for their costs. Nonmonetary Losses can take the form of pain & suffering from physical injuries and grief when a loved one dies. People generally do not purchase insurance against nonmonetary losses, and is provided implicitly by the court system when injured parties receive compensation. Valuation Formula A business’s value is defined as the PV of its expected net cash flows: Outcome Probability End-of-Year Cash Flow No Lawsuit 0.9 $100 Lawsuit 0.1 100 – 30 = $70 Expected cash flow = 0.9(100) + 0.1(70) = $97 Value = 97 / (1 + 0.135) = $85.46/share The appropriate discount rate is called the opportunity cost of capital since it is the expected return an investor could have received had the person invested in a similar risk investment. a) Risk-free Rate of Return – no risk associated b) Risk Premium – additional expected return due to taking on risks a) Diversifiable Risk – risk that can be eliminated by investors by holding diversified portfolios - does NOT affect the opportunity cost of capital b) Nondiversifiable Risk – risk that cannot be eliminated by diversification - increases the opportunity cost of capital Diversifiable risk is also called firm-specific risk, idiosyncratic risk, or nonsystematic risk since the risk that can be diversified away is the risk of events that are specific to a particular firm. Risk management is unlikely to decrease the opportunity cost of capital for firms with well-diversified shareholders because risk management activities generally decrease the type of risk (diversifiable risk) that shareholders can eliminate on their own by holding diversified portfolios. If risk management does decrease nondiversifiable risk and therefore the opportunity cost of capital, the cost of doing so is likely to negate the benefits of reducing the discount rate. Advantages of Purchasing Insurance 1. By bundling insurance coverage with claim processing and loss control services, a firm may be able to lower the costs of obtaining these services. 2. Insurance reduces the likelihood that the firm will have to raise new funds to finance losses or new investment projects. 3. Insurance reduces the likelihood that a firm will experience financial distress, which lowers expected bankruptcy costs. 4. Insurance can reduce a firm’s expected tax payments Description Effect on Expected Cash Flows Pay loading on insurance premiums Decrease Decrease cost of services from insurers Increase - claims processing services - loss control services Decrease likelihood of having to raise new funds Increase - to pay for losses - to finance new projects Decreases likelihood of financial distress Increase - decreases expected bankruptcy costs - improves contractual terms with other claimants Reduce expected tax payments Increase - tax benefits of Insurance - ability to increase debt-related tax shields The key issue in services provided by insurers is whether bundling loss control and claims processing services with an insurer’s promise to pay claims is the least-cost way to purchasing the services demanded by the firm. For a given level of quality, if the firm can obtain these services at the lower cost through an insurance policy, then the firm would have an incentive to purchase insurance apart from any value obtained from the insurer’s promise to pay claims and regardless of how well diversified their shareholders are. Adjusted Net Present Value – the net present value minus the costs associated with financing the project Financial Distress – when it has difficulty meeting its obligations and therefore has a relatively high probability of bankruptcy Chapter 3: Risk Management Process ISO 31000 is emerging as the international standard for risk management. It was designed to help all organizations, whether private, public, or not-for-profit, better manage risk. It explicitly recognizes that all activities of an organization involve risk, both positive and negative. ISO 31000 Risk Management Process 1. Communication and consultation 2. Establishing the context 3. Risk assessment (including risk identification, risk analysis, and risk evaluation) 4. Risk treatment 5. Monitoring and review 1. Process begins with communication and consultation with both internal and external shareholders. Effective communication/consultation will help to ensure that both those responsible for implementing the risk management process and other stakeholders understand the basis on which decisions are being made. 2. Consideration of both the external and internal contexts in which the rest of the risk management process will take place. External factors that could impact risk include regulation, economic forces, climate and natural disasters. Internal factors include corporate culture, expertise, resources and financial strength. Goals and objectives must be defined. The measurement of risk is expressed as risk criteria. For example, a commonly used risk measure for financial risk is value at risk which is a measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the loss on the portfolio over the given time horizon exceeds this value is the given probability level. Ex. The VaR may be set so the max market loss on a portfolio will remain under 10M 99% of the time. Another important aspect to define is the organization’s risk appetite; the type and amount of risk the organization is willing to accept in pursuit of its objectives. 3. Risk Assessment includes the following activities: a) Risk identification - determining where, when, why and how events could prevent, degrade, delay or enhance the achievement of objectives b) Risk analysis - quantifying the likelihood and consequences of the risks, usually based on the controls in place to reduce risk c) Risk evaluation - comparing the existing level of risk to the risk criteria established in activity; if the existing level of risk is considered unacceptable, then risk treatment is necessary Book Value – the purchase price minus accounting depreciation Market Value – the value that the next-highest-valued user would pay for the property Firm-Specific Value – the value of the property to the current owner Replacement Cost New – the cost of replacing the damaged property with new property The frequency of loss measures the number of losses in a given period of time. If historical data exist on a large number of exposures, then the probability of a loss per exposure can be estimated by the number of losses divided by number of exposures. The severity of loss measures the magnitude of the consequences of each loss. One way to estimate expected severity is to use the average severity of loss per occurrence during a historical period. Risk Map – graphical representation of frequency and severity 4. Risk treatment options for risk that are acceptable or tolerable: a) taking or increasing risk in order to pursue an opportunity b) removing the risk source c) changing the likelihood d) changing the consequences e) sharing the risk with another party f) retaining the risk by informed decision Major methods of treating risk: (1) risk control a-d (2) risk financing e-f (1) Risk Control involves decisions to invest (or forgo investing) resources to reduce expected losses. Actions that reduce the expected cost of losses by reducing the frequency of losses and/or the severity (size) of losses that occur are known as loss control. Actions that primarily affect the frequency of losses are commonly called loss prevention methods. Actions that primarily influence the severity of losses that do occur are often called loss reduction methods. There are two general approaches to loss control: a) reducing the level of risky activity b) increasing precautions against loss for activities that are undertaken Risk Avoidance – completely eliminating exposure to losses by reducing the level of activity to zero (2) Risk Financing refers to decisions about how to pay for losses if they occur. Methods used to obtain funds to pay for or offset losses that occur are known as loss financing. There are four broad methods of financing losses a) retention – business or individual retains the obligation to pay for part or all of the losses b) insurance – the purchase of insurance contracts requiring insurer to provide funds to pay for losses c) hedging – forwards, futures, options and swaps are used extensively to manage various types of risk d) other contractual risk transfers – contracts that allow business to transfer risk to another party Chapter 4: Pooling Arrangements and Diversification of Risk Diversification of risk is one of the most important risk management concepts. Pooling Arrangement – parties pool their resources to pay evenly any accident costs that may occur Additional risk reduction can be obtained from pooling by adding additional people (or businesses) to the arrangement. Law of Large Numbers – as the number of participants increases, the average outcome is likely to get very close to the expected value The amount of risk that can be reduced through pooling arrangements increases as the number of participants increases. Central Limit Theorem – as the number of participants increases, the distribution of the average outcome becomes more symmetric and bell shaped Distribution costs – the substantial costs in marketing and in specifying the terms of agreement incurred in risk pooling arrangements (costs associated with adding participants to risk pools) Underwriting – the process of identifying (estimating) a potential participant’s expected loss Chapter 5: Insurability of Risk, Contractual Provisions, and Legal Doctrines Factors Limiting the Insurability of Risk a) Premium Loadings - administrative costs, capital costs b) Moral Hazard - arises because insurance changes a person’s incentive to take precautions c) Adverse Selection - arises when policyholders are better informed about expected claim costs than insurers a) Premium Loadings - as the loading increases, the quantity of coverage demanded is likely to decrease; any factor that increases administrative or capital costs will limit the amount of private market insurance coverage - items with low value and severity are more likely to be insured if they are bundled together with other exposures due to the fixed costs associated with underwriting and distributing an individual policy - when the probability of a loss is high, insurance is less likely to be provided, and expected claim costs are high which causes admin costs to be high as well - when losses are highly correlated across potential policyholders, the variance of the distribution of average losses will also be high - when insurers are uncertain about the true expected losses of insured, parameter uncertainty exists although this uncertainty always exists to a certain extent b) Moral Hazard - moral hazard arises once two conditions are met: a) expected losses must depend on the insured’s behaviour after having obtained insurance b) must be costly for the insurer to observe precautions by policyholders and measure their impact on expected claim costs A potential solution is to make the premium or coverage contingent on the insured’s behaviour during the policy period; ex. If a driver increases expected claim costs by driving fast, the premium could be increased immediately or coverage reduced -requires the insurer to closely monitor behaviour of the insured which is costly and sometimes impossible Major methods of reducing moral hazard: (1) experience rating - makes the premium charged contingent on the claims in prior periods (2) limiting coverage - uses deductibles and other provisions that require insured to bear part of the loss Both of the above provide incentives for insured to take precautions after policies are issued by placing some risk on the insured. Moral hazard implies that there is a tradeoff between risk shifting and incentives. c) Adverse Selection - situations where consumers have different expected losses but the insurer is unable to distinguish between the two types of consumers and charge them different premiums - if same price is offered to all consumers, higher risk individuals will buy more insurance and lower risk individuals will buy less insurance Deductible –eliminates coverage for relatively small losses - also reduces the costs of processing small claims that occur relatively frequently Ex. If James has a $250 deductible per occurrence, he will pay up to $250 of the loss each time his windshield is damaged; if the loss is less than $250, then he will pay the entire loss. If the loss is $1,000, James will pay $250 and the insurer will pay $750. A Coinsurance provision requires an insured to pay a specified proportion of the loss (ex. 20%). It provides less than full coverage while reducing moral hazard. Since the insured pays part of any loss with a coinsurance provision, the insured has a greater incentive to reduce losses. Insurance policies often limit the amount of coverage by placing an upper limit, known as a policy limit, on the amount that the insurer will pay for any loss. Ex. The insurer will pay up to $20k. A Pro Rata Clause specifies that each policy will pay a proportion of the loss based on the proportion of coverage provided. For example, if an insured has two property policies, one that provides 1M in limits and a second that provides 2M in limits, the first policy will pay 1/3 of any covered loss and the second will pay 2/3. Alternatively, the policy may include an excess clause which specifies that the insurer will pay only losses in excess of the coverage provided by another primary policy. Exclusions – exclude coverage for either specific causes of loss or for specific types of property - typically designed to eliminate coverage that is not needed by the typical buyer - ex. Life insurance exclusions for suicide within two years of policy purchase Two Types of Insurance Policies a) Indemnity Contracts - the amount paid = the value of the loss b) Valued Contracts - establishes the amount that the insurer pays at the time the contract is initiated without regard to the amount of the loss caused by the insured event Insurance-to-Value (Coinsurance) Clause – specifies the percentage of the property’s value that the insurer requires the insured to purchase to receive full reimbursement following a loss (normally 80%) Ex. Assume that David purchases insurance on his building with an 80% coinsurance clause. If David’s building is worth $2M, then David must purchase at least 1.6M to meet the requirement. If the policy limit is less than the coinsurance percentage times the value of the property at the time of a loss, then the insurer will reduce the reimbursement for losses using the following formula: Max. proportion of = ___________Amount of insurance purchased____________ loss paid by insurer Value of property at time of loss x coinsurance percentage Ex. If the policy limit is $150,000, the property’s value is $200,000, and the coinsurance percentage is 80%, then the maximum proportion of the loss paid by the insurer is: $150,000____ = 93.75% $200,000 x 0.8 The insurer will neither pay more than the amount of insurance purchased or more than the actual loss. Therefore, the amount paid by the insurer is the lesser of: (1) the maximum proportion of loss paid by the insurer (given by formula) times the actual loss (2) the amount of insurance coverage purchased (3) the actual loss The indemnity principle states that an insurance policy cannot pay more than the financial loss suffered. The loss is measured after it occurs and payment is limited to this amount. Insurable interest means that the policy-holder must suffer adverse financial consequences if the event that causes the insurance company to pay a claim occurs. Subrogation prevents an insured from recovering compensation from multiple sources. Insurance contracts require that both the policyholder and insurer disclose all relevant information with utmost good faith; must respond truthfully to questions that the insurer asks. Otherwise, it is known as misrepresentation. Information that the policyholder knows to be relevant to the decision to insure, but is not asked by the insurer, is considered concealment of relevant information. Insurance contracts are generally contracts of adhesion; the insurer has written and offered the contract to the policy holder for acceptance or rejection. When resolving contract disputes, courts generally interpret any ambiguous policy terms in favour with the insured. Doctrine of Reasonable Expectations – policies will be interpreted according to the expectations of a reasonable person who is not trained in the law Bad-Faith Suits – allege that insurers have acted in a manner inconsistent with what a reasonable policyholder would have expected and therefore have failed to act in good faith Chapter 6: Loss Control Numerous activities reduce expected losses by reducing the frequency of losses (loss prevention). An extreme example of loss prevention is to avoid completely the activity that potentially gives rise to the loss (loss avoidance). Activities that reduce expected losses by decreasing the size of the loss conditional on a loss occurring are called loss reduction; they can occur before or after a loss. Pre-loss activities occur before a loss; they decrease the magnitude of a loss if one occurs. Post-loss activities occur subsequent to an event that causes a loss. An important type of pre-loss reduction activity is disaster response or catastrophe planning. Segregation of Exposure Units – when a firm diversifies risk by segregating loss exposures into smaller exposure units; reduces the variance of direct losses and the maximum probable direct loss Optimal loss control decisions required that loss control expenditures be made up to the point that the marginal benefits no longer exceed the marginal costs. Directing resources towards safety measures that are the most cost-effective saves lives and reduces the total cost of risk. Loss control decisions often need to assess the value of human life. The net present value often is written as the PV of net cash flows minus the initial cash outflow for the investment. Incremental expected cash flow example (fencing project) This Year Year 1 Year 2 Year 3 Capital investment (150,000) Reduction in theft 55,000 55,000 55,000 losses Reduction in 15,000 15,000 15,000 security Depreciation 50,000 50,000 50,000 Earnings before 20,000 20,000 20,000 interest & taxes Taxes (34%) 6,800 6,800 6,800 After-tax earnings 13,200 13,200 13,200 Cash flow 50,000 50,000 50,000 adjustments: Add depreciation Expected net cash 63,200 63,200 63,200 flow PV of cash flow (150,000) 57,454 52,231 47,483 (10% discount rate) NPV = $7,169 Chapter 7: Risk Retention/Reduction Decisions Risk Retention refers to the decision to accept the uncertainty associated with a particular risk exposure. Risk Reduction refers to the decision to reduce uncertainty. Benefits of Increased Retention (1) savings on premium loadings - ability to save on some of the administrative expense and profit loadings in insurance premiums, thus reducing the expected cash outflows for these loadings (2) reducing exposure to insurance market volatility - reducing vulnerability to annual savings in insurance prices due to the effects of shocks to insurer capital on the supply of insurance and/or the insurance underwriting cycle (3) reducing moral hazard - deductibles and other copayments reduce moral hazards; without these provisions, expected claim costs would be higher and therefore so would insurance premiums - consequently, when moral hazard is more of a problem, firms tend to retain more risk (4) avoiding high premiums that may accompany asymmetric information - inability of insurers to estimate claim costs precisely for all potential buyers causes some buyers to face prices that are relatively high compared to their true, unobservable expected claim costs - these buyers have an incentive to retain more risk as opposed to higher risk buyers Costs of Increased Retention - the greater risk from increased retention increases the probability of costly financial distress with associated adverse effects on lenders, employees, suppliers, and customers, which causes them to contract with the firm at less favorable terms - may require the firm to raise costly external funds and forgo profitable investment opportunities - may reduce expected tax shields and sacrifice advantages to insurance bundling Several characteristics impact the cost of retention: Characteristic Impact a) Closely held vs. - owners of closely held firms typically have a large investment in firm and have publicly traded firms an incentive to retain less risk (purchase more insurance) b) Firm Size and - if a firm has a large number of independent exposures, then the firm can correlation among predict its average loss per exposure more accurately; positive correlation losses among losses reduces the extent to which firms can diversify internally c) Investments - firms that finance investments are likely to reduce risk d) Product - firms in industries vulnerable to consumers’ perceptions of bankruptcy retain characteristic less risk and benefit more from risk reduction e) Correlation of - firms whose losses are positively correlated with other cash inflows will have a losses with other lower standard deviation of total cash flows, and retain more risk cash flows f) Financial leverage - firms with higher debt-to-equity ratios will have a higher likelihood of financial distress; higher leverage = higher fixed costs from interest For individual firms, application of the guideline that firms should retain predictable losses but insure potentially large, unpredictable, and disruptive losses depends on the magnitude of the benefits and costs of increased retention. The discounted cash flow analysis can be used to evaluate a variety of risk management decisions. If the net present value is positive, the firm can increase their value. Personal Risk Retention Decisions: Choosing a Deductible Individuals purchase insurance for many potential losses, including property damage to their automobile, home, and other personal assets. Due to the high frequency of lower severity losses, it is not cost-effective to purchase insurance for small losses. Insurance with a deductible addresses this problem by having policyholders retain losses that are costly to insure due to high frequency. Choosing a higher deductible means the insured is purchasing less insurance and therefore the premium is lower. An insured can save money by choosing a higher deductible, but at some point the savings do not outweigh the expected cost of a higher retention. Aggregated or Disaggregated Risk Management Should firms take a disaggregated or micro approach and hedge (insure) each individual risk exposure separately? Or should firms hedge (insure) some aggregate or macro measure of performance, such as earnings, which depends on each separate risk exposure, as well as the relationships between the various risk exposures? Traditionally, risk management has taken a disaggregated approach but there are many arguments suggesting that an aggregated focus is more effective. A disaggregated approach can increase transaction costs since there are fixed costs associated with this process; using a single contract that covers multiple sources of risk can reduce these fixed costs. Bundled Policy – a policy that bundles multiple exposures - once a firm’s aggregate retention level was reached, any additional loss would be covered, reducing the insured’s incentive to control additional losses once the retention level was reached; to mitigate this moral hazard problem, per occurrence deductibles for each type of loss exposure would likely be included in any bundled policy - a disadvantage is that the parties need to have an understanding of all of the risk exposures and their correlations; transaction costs of doing analysis may rise relative to those for separate contracts Conclusion Several of the reasons for reducing risk imply that a firm should focus its risk reduction activities on an aggregate financial variable, s
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