Published on April 18, 2008
Chapter 22: Chapter 22 Risk Retention/ Reduction Decisions Risk Retention/Reduction Decisions: Risk Retention/Reduction Decisions Benefits of increased retention Save on premium loadings and transaction costs Reduce exposure to insurance market volatility Reduce moral hazard Avoid high premiums caused by asymmetric info Avoid implicit taxes due to insurance price regulation Risk Retention/Reduction Decisions: Risk Retention/Reduction Decisions Factors affecting the costs of increased retention Ownership structure Firm size Correlation of losses Investment opportunities Product characteristics Correlation of losses with other cash flows Correlation of losses with investment opportunities Financial leverage Basic Guideline for Retention: Basic Guideline for Retention Retain reasonably predictable loss exposures and reduce risk of potentially large, disruptive loss exposures Not always applicable – e.g., British Petroleum case Evidence on Risk Reduction Decisions: Evidence on Risk Reduction Decisions Evidence on insurance companies use of reinsurance Smaller insurers use more reinsurance Insurers with undiversified owners use more reinsurance Evidence on use of derivatives by industrial firms: Larger firms are more likely to use derivatives (due to fixed costs of hedging) Firms with greater R&D expenditures are more likely to use derivatives (Merck example) Evidence on Risk Reduction Decisions: Evidence on Risk Reduction Decisions Evidence on gold mining companies hedging of gold price risk Firms with high managerial stock ownership are more likely to hedge Evidence on oil & gas producers Firms are more likely to hedge as financial leverage increases What Should be Hedged?: What Should be Hedged? What should a firm focus on when making risk reduction decisions? Some alternatives choices: Aggregated approach (hedge some aggregate measure of firm performance) Example: hedge earnings or cash flows or firm value Disaggregated approach (hedge individual risk exposures separately) Example: hedge property losses, workers’ comp losses, liability losses, losses from interest rate movements, and losses from commodity price movements. What does the Theory Say to Hedge?: What does the Theory Say to Hedge? Disaggregated vs. Aggregated Approach: Disaggregated vs. Aggregated Approach Even if a firm wants to hedge some aggregate performance measure (e.g., earnings), it can do so by hedging all the individual sources of risk that influence earnings. What are the advantages & disadvantages of such a disaggregated approach? Consider transaction costs Consider moral hazard Transaction Costs : Transaction Costs Aggregated approach Bundle multiple risk exposures into one contract Disaggregated approach hedge each exposure with a separate contract 1st point: if there are fixed costs per contract, then disaggregated approach might be more costly 2nd point: disaggregated approach will result in unnecessary coverage, which increases costs that are proportional to the amount of coverage 3rd point: dissagregated approach is more complex, which can make it more costly to supply Unnecessary Coverage Argument: Unnecessary Coverage Argument Illustrate unnecessary coverage with disaggregated approach with an example Two exposures: Property Loss Liability Loss Firm does not want total loss to exceed $40 million Option 1: Purchase coverage on each loss with a deductible of $20 million Option 2: Purchase coverage on total loss with a deductible of $40 million Unnecessary Coverage Argument: Unnecessary Coverage Argument Unnecessary Coverage Argument: Unnecessary Coverage Argument Option 1 provides coverage that is not needed. Since transaction costs (loadings) are proportional to coverage, Option 1 might be more costly than Option 2. Complexity Problem: Complexity Problem Pricing a policy that covers multiple sources of risk is more complex It requires expertise in a variety of fields It requires knowledge of correlation across loss exposures It requires modeling skills Implications Administrative costs might be higher There will be fewer suppliers and less competition (potentially higher costs) Moral Hazard Problem: Moral Hazard Problem Once one loss triggers coverage, incentive to reduce losses from other sources is reduced Implication: Even policies that cover multiple sources of risk will have per occurrence deductibles and per occurrence limits Slide16: 1. Which of the following is not a potential benefit to a firm from increasing retention? savings on premium loadings increased moral hazard avoiding implicit taxes that arise from insurance price regulation reduced exposure to insurance market volatility Answer: b Type: K Slide17: Which one of the following firms is more likely to use retention? closely held firm publicly traded and widely held firm a firm with a high level of financial leverage a small firm Answer: b Type: K Slide18: A disaggregated risk management approach will generally result in lower transactions costs higher transactions cost lower expected losses higher expected losses Answer: b Type: K Slide19: Which one of the following is an example of an aggregated approach to risk management? hedging exchange rate risk hedging interest rate risk purchasing a high level of liability insurance developing a (derivative) contract to stabilize fluctuations on total revenue Answer: d Type: A Slide20: The underwriting cycle affects the retention/reduction decision because the retention/reduction decision is often part of a long-term business plan a firm usually wants to correctly alternate between retention and reduction as the underwriting cycle dictates purchasing insurance in soft market will stabilize cash flows The underwriting cycle has little effect on the retention/reduction decision. Answer: a Type: A Slide21: Residual markets regulation can create an incentive to self-insure when residual premiums are higher than those in the voluntary market because firms who self-insure do not participate in residual market financing because self-insured firms are subsidized by the residual markets whenever residual markets provide coverage for compulsory coverages Answer: b Type: K Slide22: A basic guideline for the retain/insure decision is ‘Insure those exposures that… have reasonably predictable losses.’ (This makes for stable premiums.) can potentially result in large, disruptive losses have high frequency and high severity are measurable Answer: b Type: K Slide23: Firms concerned with their probability of insolvency will tend to retain more risks so as to keep use of funds otherwise spent on premiums retain more risks to avoid increasing their debt financing insure more risks in order to decrease their reliance on debt financing insure more risk to stabilize their cash flows Answer: d Type: A Slide24: Optimal retention for many firms involves the retention of predictable losses and buying insurance against large, potentially disruptive losses. Slide25: Reducing exposure to insurance market volatility is a benefit of retaining a risk exposure.