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Chapter 2

Chapter 2 BU353.docx

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Wilfrid Laurier University
Heather Graham

BU353 Chapter 2 – Risk Management Decision Making Week 1 Risk Aversion and Demand for Insurance by Individuals Risk Aversion -A person is risk averse if when having to decide between two risky alternatives that have the same expected outcome, the person chooses the alternative that has less variability -People who are more risk averse will require a higher risk premium to induce them to accept risk -A person who is risk neutral cares only about expected wealth -Most people are risk averse -Risk averse people need to be compensated for taking on risk -The concept of utility, which is a measure of a person’s well-being associated with different amounts of wealth -Risk aversion implies that utility does not increase linearly with wealth; instead utility increases at a decreasing rate -The purchase of insurance involves giving up some wealth when no loss occurs and gaining wealth when a loss does occur -Due to risk aversion, most people are willing to pay insurance premiums in excess of their expected losses for insurance, that is, they are willing to pay a risk premium The Effects of Insurance on Wealth -By purchasing insurance, people increase their wealth if a loss occurs and reduce their wealth is a loss does not occur -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 -To receive additional money following a loss, a person must decrease wealth when a loss does not occur -Most people are willing to give up some money when a loss does not occur in order to receive additional money from the insurer after a financial loss Other Factors Affecting an Individual’s Demand for Insurance Premium Loading -The premium on an insurance policy equals expected claim costs plus what is referred to as a loading for administrative and capital costs -If the loading is zero, then purchasing insurance does not change a person’s expected wealth, because the premium equals the expected payments from the insurer -The premium loading is rarely zero because insurers must be compensated for their costs Income and Wealth -Income and wealth can influence a person’s demand for insurance for four reasons: -Having more wealth is associated with having more assets subject to loss -Some people do not have sufficient income to afford large amounts of insurance coverage -The degree of risk aversion may decline as a person’s wealth increases -Limited liability often induces people with little wealth to purchase relatively little insurance against liability risk Information -The demand for insurance will depend on the information that the individual has about the loss distribution -The insurer will price the policy based on its expectation of claim costs – if an individual has a lower estimate of expected claim costs than the insurer, the policy will appear to have a high loading, and the individual will demand less insurance BU353 Chapter 2 – Risk Management Decision Making Week 1 -Overestimation of expected claim costs compared to the insurer will induce the individual to purchase more coverage Other Sources of Indemnity -When deciding whether to purchase insurance, a person will consider whether there are other sources of payment (indemnity) Nonmonetary Losses -Ex. Suffering from physical injuries -The demand for insurance coverage against nonmonetary losses differs fundamentally from the demand for insurance against monetary losses -The demand for insurance against nonmonetary losses depends on different factors, such as whether the person values money more following a purely nonmonetary loss than without such a loss -Ex. The loss of a child does not cause a huge monetary loss (excluding funeral cost) but it does cause a huge nonmonetary loss -Most people are not willing to give up money when their child is alive to receive additional money if their child should die Business Risk Management and Demand for Insurance Shareholder Diversification -Insurance companies allow certain types of risk to be pooled Closely Held Businesses -If the owners of a business are not well diversified, business insurance purchases will reduce the owners’ risk -This reduction in risk is potentially an important benefit of business insurance Why Purchase Insurance when Shareholders are Diversified? -Business insurance purchases can: -Provide an efficient method of purchasing claims processing and loss control services -Reduce the expected cost of financing losses -Reduce the likelihood that the firm will have to raise costly external capital for new investment projects and thereby increase the likelihood that it will adopt good investment projects -Reduce the likelihood of financial distress and thereby improve the terms at which the firm will be able to contract with other claimants, such as employees, suppliers, lenders, and customers -Reduce expected tax payments Principles of Business Valuation -The objective of business risk management is to increase the value of the business to its owners Valuation Formula -To calculate firm value you must first estimate the firm’s expected cash flows and then discount the expected cash flows using the appropriate discount rate -The two fundamental determinants of value: 1. The level and timing of expected cash flows 2. The interest rate used to discount each cash flow Value = Sum (Expected net cash flow in year t) BU353 Chapter 2 – Risk Management Decision Making Week 1 t (1+r) r=appropriate discount rate -The appropriate discount rate is the rate of return an investor could expect to earn on an alternative investment with the same risk as the firm’s cash flows -The appropriate discount rate depends on the risk of the cash flows -The appropriate discount rate is called the opportunity cost of capital because it is the expected return an investor could have received has the person invested in a similar risk investment Components of the Opportunity Cost of Capital -The opportunity cost of capital has two basic components: -The return needed to compensate investors for the time value of money -The expected return needed to compensate investors for risk -The first component is usually called the risk-free rate of return -The second component is usually called the risk premium -Risk aversion suggests that as the cash flows become riskier, the risk premium increases Compensation for Risk -Investors can eliminate some risk, at virtually zero cost, by holding well-diversified portfolios -There are two types of risk: -Risk that can be eliminated by investors by holding diversified portfolios – diversifiable risk -Risk that cannot be eliminated by diversification – non-diversifiable risk -When holding a diversified portfolio, the good outcomes of some firms tend to offset the bad outcomes of other firms -Risk associated with general economic activity cannot be diversified away by investors -Non-diversifiable risk affects the opportunity cost of capital because investors require compensation for risk that they cannot diversify away on their own Risk Management and the Opportunity Cost of Capital -The discount rate equals the risk-free rate plus a risk premium -The risk-free rate is the rate of return on government bonds and cannot be influenced by firm decisions -If risk management decreases diversifiable risk only, the risk premium will be unaffected and so the opportunity cost of capital will be unaffected -Risk management activities only reduce a firm’s diversifiable risk -The types of risk that insurance companies tend to insure also are risks that the insurance company can largely diversify by selling insurance to many different policyholders -Non-diversifiable risk exists because there are unexpected events that affect the value of most firms -When a firm hedges non-diversifiable risk, it is shifting this risk to someone else who cannot eliminate it through diversification -The party who accepts non-diversifiable risk will require compensation for taking on this risk, and the cost of compensating the other party will decrease the firm’s cash flows -The amount that the firm must pay the other party for accepting the non-diversifiable risk would equal the amount by which the value of the firm would otherwise have increased from the lower discount rate -Risk management is unlikely to decrease th
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