lecture 6 - insurance Flashcards
how can risk exposure be quantified?
probability x magnitude x timing
what are the key strategic and public policy issues to do with risk?
do individuals/firms respond differently to risk?
how best/most cost effectively to plan and manage risk and uncertainty?
what is insurance?
financial contract that compensates for pre-specified severe loss event
can insurance be used for speculation?
no - it is a pure hedge.
how is insurance different to a gamble?
gamble = payment to accept risk, insurance payment to transfer risk.
must be an insurance interest in the thing being insured (e.g. for life insurance you have interest in your life, in a gamble on horses you don’t have an interest in the horse but in the outcome), this is absent in a gamble
must be degree of uncertainty regarding occurrence of the loss event (fortuity principle), gamble always involves a winner - even if not you.
what is the finance-insurance link?
Brennan (93) defined finance as pricing, allocation and trading of risks. likewise defines insurance as pricing, allocation and trading of risks.
finance and insurance therefore inextricably bound. insurance is important financial contracting device to mitigating agency incentive problems in firms.
what financial concepts derive from insurance?
moral hazard - insured people act recklessly because risk is transferred. can be managed through data from other insurers, contractually through things like no-claims bonuses to incentivize due care.
risk-sharing - e.g. syndication
risk-return - greater risk = greater price of insurance.
what can insurance in financial contracting mitigate?
agency cost of equity - protects undiversified shareholders for losses against insured assets
agency costs of debt - underinvestment problem
governance problems - directors and officers insurance protects against legal claims lodged by 3rd party or shareholders, mechanism for ensuring talented directors willing to take jobs
investment and liquidity risks
mitigates taxes - insurance premiums can be deducted against earnings, reducing liability
what are the 3 pillars of insurance?
contractual/legal
actuarial
financial
how important are insurance markets?
15% of global market capital is help by insurers/reinsurers
big in UK - in 2016, 325k people employed, 4th biggest in world.
insurance is all-pervasive - the most common risk management technique in public and private sectors
fundamental to strategic mgment in all industrial sectors
how does insurance help maximise shareholder wealth (i.e. +ve NPV investment)?
reducing earnings/cash flow volatility - markets don’t do well with volatility. insurance can even out potential risks/losses so can help mitigate this.
protecting cash resources so realising investment plans
reassuring stakeholders (inc mgrs) that interests in business are protected.
what specific strategic goals can be realised by insurance?
- 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.
- Improves governance – e.g., directors & officers (D&O) insurance protects shareholders & helps managers to take risk decisions
what are the limitations of insurance?
cost - economic good, must be judged on cost-benefit bases
over-insurance denudes not enhances firm value
insurance prices are not transparent between insurance providers
may encourage managerial entrenchment (agency costs), e.g. facilitating the easy life
stops mgrs taking risks and therefore earnings profits.
some things may not need insurance, e.g. natural hedges
adverse selection and moral hazard problems - need to be controlled by experience rating and contracts.
