BU353 Lecture Notes - Lecture 2: Risk Premium, Cash Flow, Risk Aversion
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.
Idiiduals’ dead for isurae depeds o the preiu loadig, a perso’s ioe ad
ealth, a idiidual’s iforatio aout epeted losses relatie to the isurer’s iforation,
(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
depeds o the poli’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
purhasig isurae does ot hage a perso’s epeted ealth. Ufortuately, 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 usiess’s alue is defied as the PV of its epeted et ash flos:
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
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Document Summary
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. Although risk-averse people generally desire insurance, the extent to which they will purchase insurance depe(cid:374)ds o(cid:374) the poli(cid:272)(cid:455)"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 pur(cid:272)hasi(cid:374)g i(cid:374)sura(cid:374)(cid:272)e does (cid:374)ot (cid:272)ha(cid:374)ge a perso(cid:374)"s e(cid:454)pe(cid:272)ted (cid:449)ealth.
