BU353 Lecture Notes - Lecture 7: Public Company, Moral Hazard, Cash Flow
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.
publicly traded firms
- owners of closely held firms typically have a large investment in firm and have
an incentive to retain less risk (purchase more insurance)
b) Firm Size and
correlation among
losses
- if a firm has a large number of independent exposures, then the firm can
predict its average loss per exposure more accurately; positive correlation
among losses reduces the extent to which firms can diversify internally
c) Investments
- firms that finance investments are likely to reduce risk
d) Product
characteristic
- firs i idustries ulerale to osuers’ pereptios of akrupty retai
less risk and benefit more from risk reduction
e) Correlation of
losses with other
cash flows
- firms whose losses are positively correlated with other cash inflows will have a
lower standard deviation of total cash flows, and retain more risk
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
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
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.
