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Chapter 7

Chapter 7 BU353.docx

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Heather Graham

BU353 Chapter 7 – Risk Retention/Reduction Decisions Week 2 Firm Characteristics Affecting Risk Retention (Reduction) Decisions -Risk retention – the decision to accept the uncertainty associated with a particular risk exposure -Risk reduction – the decision to reduce uncertainty -The alternative to retention is to reduce risk using an insurance contract Benefits of Increased Retention 1. Savings on premium loadings 2. Reducing exposure to insurance market volatility 3. Reducing moral hazard 4. Avoiding high premiums that may accompany asymmetric information Savings on Premium Loadings -The ability to save on some of the admin expenses and profit loadings in insurance premiums, thus reducing the expected cash outflows for these loadings -Specific sources of savings include lower commissions to insurance brokers, savings in premium taxes -The savings on premium loadings depend on the insurer’s cost of providing these services relative to the firm’s own costs -Potential savings in profit loadings also can depend on the degree of competition in insurance markets Reducing Exposure to Insurance Market Volatility -Another motivation for some corporations to increase risk retention has been the desire to reduce their vulnerability to annual swings in insurance prices due to the effects of shocks to insurer capital on the supply of insurance and/or the insurance underwriting cycle Reducing Moral Hazard -When moral hazard is more of a potential problem, firms tend to retain more risk Avoiding High Premiums Caused by Asymmetric Information -The 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 claim costs Maintaining Use of Funds -A firm should view its opportunity cost of paying premiums as equal to its opportunity cost of capital for general investment decisions, which will exceed the risk-free rate of interest due to the presence of non-diversifiable risk, whereas insurers will discount expected claim costs at the risk-free rate -The appropriate discount rate for losses is the same for the firm and the insurer Costs of Increased Retention -Increased retention exposes the firm to greater risk, and increased risk can be costly -The greater risk from increased retention increases the probability of costly financial distress with associated adverse effects on lenders, employees, suppliers, and customers -Increased retention also may require the firm to raise costly external funds and forgo some profitable investment opportunities -The costs associated with increased retention will vary across firms depending on the nature of their ownership and operations Closely Held vs. Publicly Traded Firms with Widely Held Stock -The owners of closely held firms are not diversified, and because of that they have an incentive to retain less risk than publicly traded firms with widely held stock BU353 Chapter 7 – Risk Retention/Reduction Decisions Week 2 Firm Size and Correlation among Losses -Positive correlation among losses within a firm reduces the extent to which firms can diversify risk internally Investment Opportunities -Firms that are likely to have good investment opportunities will need funds to finance those investment opportunities -Firm that operate in growth industries and firms that require continual investment in research and development are likely to benefit from risk reduction Product Characteristics -When consumers expect future services from the provider of products and services, then the demand for those products and services will depend on consumers’ perceptions about the likelihood that the provider will be able to provide the future services Correlation of Losses with Other Cash Flows and with Investment Opportunities -Firms whose losses are positively correlated with other cash inflows will have a lower standard deviation of total cash flows and will tend to retain more risk – in these cases – firms have a natural hedge -A positive correlation between losses and the rate of return on new investment will reduce the ability of the firm to pursue profitable investments without raising external funds, thus increasing the demand for insurance Financial Leverage -Firms with higher financial leverage will have a higher likelihood of financial distress, holding the probability distribution of future asset values constant -Firms with higher leverage have higher fixed costs because they have a large interest payment to meet A Basic Guideline for Optimal Retention -Retain reasonably predictable losses and insure potentially large, disruptive losses -Potentially large losses that can case financial distress and interrupt planned investment can arise from a single event, or they can arise from a series of smaller events during a given period -For individu
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