Insurance + Reading

Question 1

What is Risk

Answer 1

• Broadly – a threat (e.g. to strategic goals)
• Indicates volatility in expected outcomes
• Risk exposure can be measured (Probability x financial magnitude x timing)
• Actuarial science has helped in risk measurement
• Uncertainty cannot be measured – the “unknown unknowns” present the greatest challenges

Some key strategic & public policy issues are:
- Do individuals/firms respond differently to risks?
- How best (cost effectively) to plan/manage risk & uncertainty?

Question 2

What is Insurance?

Answer 2

• A financial contract that compensates for a pre-specified severe loss event
• Insurance thus a pure hedge – cannot (unlike derivatives) be used for speculation. (Derivatives can use for speculating and heding)

Insurance is not gambling as:
- must be an insurable interest in the thing (e.g., life or property) being insured; this is absent in a gamble
- must be a degree of uncertainty regarding the occurrence of the loss event (fortuity principle); a gamble always involves a winner
- Gamble payment to accept risk; insurance payment to transfer risk

Question 3

Finance-Insurance Link

Answer 3

• Prof Michael Brennan (UCLA) defined finance and insurance as the pricing, allocation & trading of risks.
• Finance & insurance are thus inextricably bound
• Insurance is an important financial contracting device for mitigating agency incentive problems in firms.
• (Re)insurance has an important intermediary function in financial markets (viz. (re)insurers are underwriting & investment entities)

Many concepts in finance derive from insurance e.g.,
- adverse selection
- moral hazard (condition of an insured person acting carelessly as the consequences will fall onto the insurance company. Insurance company can handle that using data (e.g. claims records, contracting mechanism, no claims bonus
- risk-sharing (e.g., syndicates)
- risk-return (e.g., CAPM)

Question 4

Insurance in Financial Contracting

Answer 4

Mitigates…
- agency cost of equity (e.g., protects undiversified (family) shareholders for losses)
- agency cost of debt (e.g., underinvestment problem)
- governance problems (e.g protects directors from third party therefore they are willing to take up jobs)
- investment & liquidity risks (e.g., crowding out problem - if a disaster happens then the company resources may have to be redirected, however, insurance can protect the assets)
- taxes (e.g., deductibility)

i.e. Risks do not stay constant and need continual revision to ensure risks are still appropriate

Question 5

Essentials of Insurance

Answer 5

3 pillars of insurance (risk management) are:
1. Contractual (legal)
2. Financial
3. Actuarial

Is it legal? What’s the risk? Will it make money?

Question 6

Importance of Insurance Markets

Answer 6

• At macro-level insurance is one of the 3 pillars of a capitalist economy & society especially in China (the others being banking & financial markets)
• Insurance is big business – 15% of global market capital held by insurers/reinsurer: big in UK – In 2016, 325k people employed; 4th biggest in world (after US, Japan & China); API = £225billion; investments £2 trillion (25% UK net worth); adds ~ £50 billion pa to UK gross value added (Source ABI, 2018)
• Insurance is fundamental to economic development policy & growth in emerging markets (e.g., micro-insurance)
• Insurance is all-pervasive - the most common risk management technique in the public & private sectors
• Insurance is fundamental to strategic management in all industrial sectors – the oil & gas industry

Question 7

Strategic Role of Insurance

Answer 7

Froot, Scharfstein & Stein (HBR, 1994) state the key goal of business is to have sufficient cash at the time you need it to invest in positive NPV projects.

If the overarching corporate strategic mission is to maximise shareholder wealth (+ve NPV investment) how does insurance achieve this?
- reducing earnings/cash flow volatility
- protecting cash resources so realising investment plans
- reassuring stakeholders (including managers)

Specific strategic goals realised by insurance include:
- Lowering the cost of equity & increasing share values, particularly in undiversified (e.g., family) firms
- Reducing cost of debt/increasing debt capacity by protecting collateral & alleviating risks of financial distress/bankruptcy
- Producing ‘tax shield’ benefits (tax management technique, important as tax is second most expensive in the business after employment cost) – e.g., through deductibility of premiums against earnings
- Protects liquidity & ensures investment plans can be realised ex-post a major loss
- Improves governance – e.g., directors & officers (D&O) insurance protects shareholders & helps managers to take risk decisions

Question 8

Limitations of Insurance

Answer 8

> Cost – insurance is an economic good so must be judged on a cost-benefit basis
Over-insurance reduce not enhances firm value
Insurance prices are not transparent between insurance companies (reflect underwriting policy)
May encourage managerial entrenchment (agency costs) – e.g., facilitating ‘the easy life’
Some things may not need insuring – e.g., ‘natural hedges’
Adverse selection & moral hazard problems – need to be controlled by experience rating & contract