Risk Management
Hurricane Katrina: Landfall August 29,
2005
1
Fair Bet
• Cost Equals Expected Gain
• Cost = P * (Amount you Win)
• Example: Flipping a Coin
– Cost = $10
– P = .5
– Amount You Win = $20
2
Is This A Fair Bet?
• Flipping A Coin
– Cost = $50
– Amount You Win = $75
3
Risk Taking Behavior
• Risk-Averse
• Risk-Neutral
• Risk-Taker (Risk-Seeker, Risk-Lover)
4
Risk and Uncertainty
• Risk: A situation in which
several different
outcomes are possible.
• Uncertainty: The
perception that several
different outcomes are
possible.
5
Categorizing Risk
• Pure Risk v. Speculative Risk
• Diversifiable Risk v. Nondiversifiable Risk
• Fundamental Risks and Particular Risks
6
Pure Risks v. Speculative Risks
• Speculative Risks are Usually Chosen
– Stock Appreciation
– Manufacturing and Selling a Product
– Example: Furby
• Pure Risks are Usually a Byproduct
– Automobile Accident
– Sports Injury
7
Diversification
• Pooling Similar Risks
– INSURANCE
• Pooling Offsetting Risks
– A DIVERSIFIED PORTFOLIO
8
Why Reduce Uncertainty
• Individual
• Corporations
• Government
9
Why Manage Risk?
Individuals
• Reduce anxiety
• Planning
10
Why Manage Risks:
Corporation
(Nexus of Contracts)
owners
creditors
employees
Corporation
suppliers
government
customers
11
Early Historical Examples
of Risk Management
• Chinese Trading Boats
• Amish Rebuilding
12
Modern Risk Management
• Prior to 1950s: Insurance Purchaser
• Risk Managers
– Finance Dept., Freestanding, or
Human Resource Dept.
– Larger Companies
– Companies Facing Greater Risk
13
Risk Manager:
Minimize Adverse Consequences of Risk
•
•
•
•
•
Avoidance
Loss Control
Self-Insurance
Purchase Insurance
Anticipate Risk
14
The Decision to
Manufacture a Product
15
Product Development:
Motorcycle
• Investment: $1,000,000
• Profits if there is no Loss:
$150,000
• Possible Liability Losses:
– 1% Chance of $2,000,000
Loss
• Required Return on
Investment: 10%
16
Hiring an Employee
17
Hiring an Employee: Baseball
Player with Drug Addiction
• Salary: $200,000/year
• Financial Contribution to Club
– $300,000 if Says Clean
– $50,000 if Uses Drugs
– Chance of Staying Clean: 50%
18
Major Duties of Risk Managers
•
•
•
•
•
•
•
•
•
Buy Insurance
Identify Risk
Loss Prevention and Loss Control
Contract Review
Safety Training and Education
Govt. Compliance with Safety Issues
Risk Finance
Claims Mgmt. and Litigation Support
Employee Benefits
19
Risk Management Process
•
•
•
•
Mission Identification
Risk Identification
Risk Analysis
Consider Alternatives
– Risk Control
– Risk Finance
• Implement and Monitor
20
Mission Identification
• Goal of Organization
• Goal of Risk
Management Department
21
Organization Goals
• Corporation: Maximize Profits
• Non-Profit Organizations
– Religious Organization
– Hospitals
22
Organization Goals
• Charities
– Red Cross: The
American Red Cross, a
humanitarian organization
led by volunteers, . . . will
provide relief to victims of
disasters and help people
prevent, prepare for, and
respond to emergencies.
23
Post-Loss Objectives
•
•
•
•
•
Survival of the Organization
Continuity of Operations
Earnings Stability
Continued Growth
Social Responsibility
24
Pre-Loss Objectives
• Economy
• Reduction in Anxiety
–
–
–
–
–
Owners
Suppliers
Lenders
Customers
Govt. Agencies
• Meeting Externally Imposed Obligations
• Social Responsibility
25
Risk Management Process
Step 2
Risk Identification and Analysis
26
Risk Identification: Key Terms
•
•
•
•
Hazard
Risk Factor
Peril
Exposure
27
Difficulties with
Risk Identification
• New Laws
– Examples: Building Codes, Clean Air Act
• New Discoveries
– Examples: Black Lung, Second Hand Smoke
• Changing Societal Attitudes
– Example: Product Liability Laws, Cigarettes
28
New Laws and
Risk Identification
29
Sources of Risk
•
•
•
•
•
•
•
Physical Environment
Social Environment
Political Environment
Legal Environment
Operational Environment
Economic Environment
Cognitive Environment
30
Social Environment
and Disney Co.
•
•
•
•
Euro-Disney
“Powder”
Domestic Partner Benefits
History Theme Park at Manassas
31
Example
• Workplace Injury
32
Categories of Exposures
• Property Exposures
– Direct: Immediate Result
– Indirect: Secondary Results
– Example: Robbery of a Store
• Liability Exposures
• Human Resource Exposures
33
Risk Identification Methods 1
•
•
•
•
•
Insurance Survey
Risk Analysis Questionnaires
Financial Statement Analysis
Flow Chart Method
Systems Safety Techniques
34
Risk Identification Methods 2
•
•
•
•
Interactions with External Resources
Interactions with other Departments
Past Losses
On-Site Inspections
35
Accident Causation
• Human Relations View
• Engineering View
36
Loss Analysis Ratios
• Severity = $Losses / # Losses
• Frequency = # Losses / # Exposures
• Expected Loss = $ Losses/ # Exposures
37
Ratios Example
• Data
– 1000 Restaurants
– 50 Fires
• Type 1 Fires: 20, $25,000
• Type 2 Fires: 30, $50,000
• Severity = [20($25,000) + 30($50,000)]/50 = $40,000
• Frequency = 50 / 1000 = .05
• Expected Loss = .05($40,000) = $2000
38
Concerns with
Measuring Severity
• Indirect Losses
– Ex: Store robbery
• Contagion
– Ex: Foot-and-Mouth Disease
• Snowball Effect
– Ex: Mad Cow Disease
39
Contagion Example: Bil Mar
40
Contagion Example: Listeria
• Chicago-based Sara Lee recalled hot dogs and deli meats
produced at its Bil Mar plant in Zeeland, Michigan, after the
CDC found listeria contamination in unopened packages of
the products.
• Affected brand names include Ball Park, Bil Mar, Sara Lee
Deli Meat and Sara Lee Home Roast.
• The states reporting listeria infections are Arizona,
Connecticut, Georgia, Indiana, Iowa, Kentucky, Maryland,
Massachusetts, Michigan, Minnesota, New York, Ohio,
Oregon, Pennsylvania, Tennessee, Vermont and West
Virginia.
41
Contagion Example: Listeria
• Tainted meat
– Killed 12 people
– Sickened 79 others in 16 states
• 241 workers fired or layed off
42
Loss Severity Measures
• Maximum Possible Loss
• Maximum Probable Loss
43
Example
Year
Flights
Crashes
2003
2004
2005
2006
2007
5,000
5,000
5,000
5,000
5,000
10
0
4
2
0
Losses
$2,000,000
0
$1,000,000
$500,000
0
44
Loss Statistics
n
 Oi pi
i1
freq mean = .2(.002)+.2(0)+.2(.0008)+.2(.0004)+.2(0)
Mean =
= .00064
sev mean = 10 (200,000)  6 (250,000)
16
16
= $218,750
E(L) = $140
45
Loss Statistics
S.D. =
Sev S.D. =
n
 pi ( O i  E V i ) 2
i1
(10)(200,000  218,750)2
16
( 6 )(250,000  218,750)2
16
= $26,791
46
Normal Distn Severity
Distance
1 S.D.
2 S.D.
Prob
68.2%
95%
$218,750
$191,959
$165,168
[
[
[
$245,541
$272,332
freq = .00064
sev = $272,332
E(L)95% = $174.29
47
Calculating the Mean and Std. Dev.
Number of Fires
Probability
0
10
30
50
60
.10
.20
.40
.20
.10
mean =
.10(0)+.20(10)+.40(30)+.20(50)+.10(60) = 30
S.D. =
sq. root [.10(0-30)(0-30) +.20(10-30)(10-30) +.40(30-30)(30-30)
+.20(50-30)(50-30) +.10(60-30)(60-30)] = 18.43
48
Important Distributions
• Loss Frequency Distribution
• Loss Severity Distribution
• Total Loss Distribution
49
Loss Frequency Distn
Taxi Accidents N = 2000
Ot
0/2000
10/2000
30/2000
50/2000
60/2000
Pt
.10
.20
.40
.20
.10
n
E(Ot )   ptOt  AvgFreq.
t 1
 0(.10) .005(.20) .015(.40)
.025(.20) .03(.10)
.015
.015(2000) = 30 Accidents
50
Loss Severity Distn
N = 100
Sevt
$1,000
$2,000
$10,000
$50,000
Pi
.80
.05
.10
.05
n
E(Sev )   (Sev )( pt )
i i1
i
 $1,000(.80) $2,000(.05) $10,000(.10) $50,000(.05)
 $4,400
51
Drawbacks to Use
of Historical Data
• CHANGE in Process
• Insufficient Data
52
Importance of Timing
of Losses
• Time Value of Money
• Cash Flow Considerations
53
Loss Triangles
• Predict When Losses Will Occur
• Predict Total Losses
• Highlight Trends
54
Loss Triangle
Product Liability Suits
Loss Year
Year
of
Experience
(ex. Year of
Sales)
2003
2004
2005
2006
2007
2003
12
2004
16
16
2008 = 15 x 1.337 = 20
2009 = 20 x 1.246 = 25
2005
20
21
9
2006
22
26
12
8
2007
22
29
15
11
15
2010 = 25 x 1.1075 = 28
2011 = 28 x 1 = 28
55
Development Factors
Development Period
Year
of
Experience
2003
2004
2005
2006
y+1
1.33
1.3125
1.33
1.375
y+2
1.25
1.238
1.25
y+3
1.10
1.115
y+4
1.00
MEAN
1.337
1.246
1.1075
1.000
Examples
2003, y+1 = 16/12 = 1.33
2003, y+2 = 20/16 = 1.25
56
Loss Development:
2007 Sales Year
2007: 15 Losses
2008:
2009:
2010:
2011:
15 x 1.337
20 x 1.246
25 x 1.107
28 x 1.000
= 20
= 25
= 28
= 28
57
Present Value Calculation
Determining Losses from 2003 Sales
Claim
Made
in Year
2003
2004
2005
2006
2007
2008
2009
Losses
2003
Sales
i%
6%
6%
6%
6%
6%
6%
6%
Total
Cost/Claim PV in 2003 # Losses Losses
$10,000
$12,000
$14,000
$15,000
$18,000
$20,000
$24,000
$10,000
$11,321
$12,460
$12,594
$14,258
12
4
4
2
0
$120,000
$45,284
$49,840
$25,188
0
$240,312
58
Homework Problems
• A) Determine the Number of Fully Developed
Losses for 2004, 2005, and 2006.
• B) What is the PV of Losses Arising from
2005 Sales as of 2005?
59
Shapes of Different Distributions
• Medical Expenditures
• Church Fires
• Parking Tickets
60
Normal Distribution
• Bell Shaped
• Two Parameters
• Easy to Use
61
Property Losses
• Property Exposed to Loss
• Peril
• Financial Consequences
62
Property Exposed to Loss
[ Real Property
[ Personal Property
[ Non-owned Property
63
Non-owned Property
•
•
•
•
•
•
•
Bailed Property
Leased Property
Property on Consignment
Employee’s Property
Property under Lien
Agency Relationships
Contingent Property
64
Perils
• Commonly Insured
• Government Insured
• Uninsurable
65
Commonly Insured Perils 1
•
•
•
•
•
•
Fire
Lightning
Windstorm
Hail
Explosion
Smoke
66
Commonly Insured Perils 2
•
•
•
•
•
•
•
•
•
•
Aircraft & Vehicle Damage
Riot
Vandalism (Malicious Mischief)
Falling Objects
Weight of Snow, Ice, or Sleet
Water Damage
Glass Breakage
Sprinkler Leakage
Perils of Transportation
Crime Perils
67
Difficult to Insure Perils
• Earth Movement
• Floods
• Nuclear Reaction
68
Why Are Some Perils
Uninsurable?
• Against Public Policy
• Under the Control of the Insured
– Ex. Suicide
• Probability of Loss is Too High
• Simultaneous Destruction
69
Generally Uninsurable Perils
• War, Terrorism, Rebellion, and Insurrection
• Intentional Losses
• Fading, Rust, Dry Rot, Settling
• Production, Marketing, and Political Risks
70
Financial Consequences
•
•
•
•
•
•
•
•
•
•
Reduction in Value
Debris Removal
Business Interruption
Contingent Business Interruption
Loss of Rental Income
Loss of Rental Value
Loss of Leasehold Interest
Inability to Reconstruct Records
Loss of Use Value in Improvements and Betterments
Demolition Costs and Increased Cost of Reconstruction
71
Valuation of a Loss
• Market Value
• Replacement Cost
• Actual Cash Value
– (Replacement Cost - Depreciation)
• Present Value of the Asset’s Contribution
72
Actual Cash Value
Calculation: Building
• Purchase
– Date: January 1, 1987
– Price: $1,000,000
– Expected Lifetime: 40 years
• Fire
– Date: January 1, 2007
– Replacement Cost: $2,000,000
73
Actual Cash Value
Calculation: Building
• ACV = Replacement Cost - Depreciation
–As of the Time of Loss
• ACV = $1,000,000 = $2,000,000 - $1,000,000
74
Present Value of the Asset’s Contribution
75
Liability Loss
• Expenditure of TIME
and MONEY
• Investigate, Negotiate,
Defense, Payment
76
Property Losses v.
Liability Losses
• Parties Involved
• Measurement of Exposure
• Changing Environment
• Tail
77
Types of Legal Liability
• Criminal
– Agent
– Punishments
– Insurance
• Civil
– Private Duties
– Common Law, Statutes, Contracts
78
TORT
• Wrongful Act or Omission
• Independent of Contract
• Legal Remedy: DAMAGES ($$$)
79
Types of TORTS
• Intentional Torts
• Negligence
• Strict Liability
80
Intentional TORTS
• Legally Protected Right
• Intentional Interference
– Voluntary
– Damages Reasonably Foreseen
– No Valid Defense
81
Intentional Torts: Defamation
• Types
– Libel
– Slander
• Plaintiff Must Show
– False, Injurious Statement
– Publication
– Damages
82
Defenses
• Truth
• Privilege
– Absolute
– Qualified
•
•
•
•
•
No Malice
Not Known False
No Intent to Injure
Fair, if by news media
Covered Body
83
Intentional Torts:
Invasion of the Right of Privacy
• Examples
– Release Confidential Information
– Hidden Microphones
• Public Figures v. Private Figures
84
Intentional Torts:
Assault and Battery
• Assault
• Battery
• Defenses
–
–
–
–
–
Consent
Self-Defense
Defense of Property
Defense of Others
Allowed Discipline
85
The “Preppy Killer”: Consent??
'Preppie killer' headed back to prison on drug rap
NEW YORK (AP) -- New York's so-called "preppie killer" is headed back to prison.
Robert Chambers already served 15 years behind bars for strangling a woman in
Central Park during what he said was rough sex.
He pleaded guilty Monday to selling drugs. The Manhattan district attorney's office says
Chambers is promised 19 years and four months in prison when he is sentenced on
September 2.
Chambers and his girlfriend were charged with dealing cocaine out of their Manhattan
apartment in 2007.
Chambers pleaded guilty in 1988 to manslaughter in the death of 18-year-old Jennifer Levin
two years earlier.
Stories portrayed him as a handsome, privileged, prep school youth gone bad.
He was released from prison in 2003.
86
Intentional Torts:
Assorted Others
• False Arrest and Wrongful
Detention
• Malicious Prosecution
• Trespass
• Conversion
• Nuisance
87
Intentional Torts:
Assorted Others Continued
• Wrongful Interference with a
Business Relationship
– Copyright Infringement
– Deception
• Bad Faith
– Delaying Payment of Claims
– Refusing to Pay Claims
88
Negligence
• Acts of Omission
• Acts of Commission
89
Elements of a Negligent Act
• Legal Duty
• Breach
• Damages
• Proximate Cause
90
Damages
• Compensatory Damages
– Special Damages
– General Damages
• Punitive Damages
91
Defenses to Negligence
•
•
•
•
•
Contributory Negligence
Comparative Negligence
Assumption of Risk
Statute of Limitations
Immunities
– Sovereign
– Charitable Institutions
– Public Officials
92
Strict Liability Torts
• Abnormally Dangerous
Instrumentalities
• Ultrahazardous Activities
• Dangerously Defective Products
• Workers Compensation Statutes
• Disability Benefit Statutes
• Aviation Law
• Dram Shop Laws
• Contractual Assumptions
93
Goals of the Tort System
• Compensate
• Deter
94
Tort Reform Proposals
• Modify Joint and Several Liability
• Caps on Non-Economic Damages
• Caps on Punitive Damages
95
The Work Relationship
• Employer
– Sets Hours
– Defines and Supervises Work
• Employee
– Sacrifices Time for Income
– Is Told How to Work
– Method of Payment Not Important to
Status
• Independent Contractor
– Not an Employee
– Controls Methods of Work
96
Workplace Injuries
• Common Law:
Negligence
• Statutory Law:
Workers
Compensation
97
America’s Most Dangerous Jobs in 2004
Rank
Occupation
Death rate/100,000
Total deaths
1
Logging workers
92.4
85
2
Aircraft pilots
92.4
109
3
Fishers and fishing workers
86.4
38
4
Structural iron and steel workers
47.0
31
5
Refuse and recyclable material collectors
43.2
35
6
Farmers and ranchers
37.5
307
7
Roofers
34.9
94
8
Electrical power line installers/repairers
30.0
36
9
Driver/sales workers and truck drivers
27.6
905
10
Taxi drivers and chauffeurs
24.2
67
98
Some Exceptions to
Workers Compensation
• Small Firms
• Farm Workers
• Domestic Workers
99
Employers’ Common
Law Duties
• Safe Place to Work
• Adequate Number of Competent
Fellow Employees
• Provide Safe Tools and
Equipment
• Warn of Inherent Dangers
• Make and Enforce Safety Rules
100
Workers Compensation
• Accident
• Arising Out of and In the
Course of Employment
• Only Bodily Injury
101
Workers Compensation
Benefits
• Lost Wages
• Medical Care
• Body Part Payments
• Death Benefits
102
Exceptions to WC as Sole Remedy for
Workplace Injury
•
•
•
•
Assault by the Employer
Retaliatory Discharge of the Employee
Dual Capacity Doctrine
Suits by 3rd Parties
– Ex. Loss of Consortium
– Ex. Consequential Injuries
• Property Damage
103
Human Resource Exposures
• Loss of Personnel
• Cost of Employee Benefits
104
Employee Benefits
• Attract Workers
• Retain Workers
• Retire Workers
• Encourage Productivity
105
Loss of Personnel
• Premature Death
• Disability/Poor Health
• Resign
106
Premature Death
Losses that Result
• Loss of Human Life Value
• End of Life Expenses
• Emotional Grief of Survivors
107
Premature Death
Risk Management Strategies
• Loss Prevention:
– Medical Care
– Good Health
• Life Insurance: Many are Underinsured
• Pension Plan
• Earnings of Surviving Spouse
108
Estimating Human Life Value
Example: Worker 3 years from Retirement
Year
Output
Pay
2004
2005
2006
50000
49000
48000
40000
38000
36000
TOTAL
Surplus PV(8%)
10000
11000
12000
10000
10185
10288
30473
109
Calculating Loss of
Human Life Value
Worker dies at age 61 after being paid.
At the time of death 3 working years remained.
Age
62
63
64
Total
Earnings
Taxes
$40,000
$40,000
$40,000
$16,000
$16,000
$16,000
Self
Family
PV(8%)
$10,000 $14,000
$10,000 $14,000
$10,000 $14,000
$14,000
$12,963
$12,003
$38,966
110
Disability Problem
• Disability is comparatively frequent
• Disability can be extremely costly
• Most lost income due to disability is not
replaced
• Disability insurance is confusing
– Multiple definitions of disability
• Disability insurance is subject to moral hazard
– Malingering
111
Risk of a 90+ Day Disability v. Death
During Working Years
Age
22
62
P(Disability)/P(Death)
7.5
2
112
Risk Control
•
•
•
•
•
Avoidance
Prevention
Reduction
Information Management
Some Risk Transfers
113
Risk Avoidance
• Proactive Avoidance
• Abandonment
114
Drawbacks to Avoidance
• Lost Benefits of Risk
• Perhaps not Possible
$ Government Imposed Risks
$ Nature of the Risk
• May Result in Worse Risks
115
Important Forms
of Loss Reduction




Salvage
Subrogation
Litigation Management
Catastrophe (or Contingency)
Plans
 Duplication
 Separation
116
Information Management
as Loss Control
•
•
•
•
Customers: Enhanced Sales
Creditors: Lower Debt Cost
Suppliers: Better Relationships
Owners: Greater Market Value
117
Risk Transfer
• Property or Activity Transferred
• Contractually Pass the Liability
“Exculpatory Contracts”
118
Government and
Risk Control
• Public Interest
• Efficiency
119
Risk Financing:
General Methods
• Retention
• Transfer
120
Risk Financing: Timing
• Contemporaneous
• Prospective
• Retrospective
121
Approaches to Retention
 Passive or Unplanned
 Active or Planned
122
Retention: Funding Arrangements
• No Advance Funding
• Liability or Earmarked Accounts
• Earmarked Asset Accounts
• Captive Insurer
123
Types of Transfers
• Insurance
• Noninsurance Transfers
• Hedging
124
Elements of Insurance
• Contract
• Premium
• Conditional Benefits
• Pooling of Resources
125
Insurance Transaction
• Buyer Side of the Market
– Risk Managers
– Brokers
– Consultants
• Supplier Side of the Market
– Insurance Company
• Underwriters, Claims Adjusters, Agent, Actuaries
– Agent
126
Noninsurance Transfers
• Do Not Satisfy Conditions to be
Insurance
• Provide External Funding
127
Hedging
• Taking an Offsetting Risk
• Not Possible for Many Types of Risks
128
129
130
131
Hedging Example
January 1: Arrange to sell chairs for $5.00
Raw materials today cost $2.50/chair
June 1:
Build chairs
July 1:
Deliver chairs
132
Hedging Example
Risk:
Cost of raw materials
Options:
1. Sell chairs on a cost + basis
2. Buy and hold raw materials
3. Buy and have seller hold raw
materials
4. Use a hedge
133
“Futures” Contract
Owner of contract on Termination Date Receives the lumber
Price of contract depends on
a) Cost of lumber today
b) Risk Premium
Origination Date: September 1
Termination Date: August 31.
134
Hedging Contract
January 1:
June 1:
Buy Hedging Contract
Hedging Contract = $2.50 + x
Lumber = $2.50
Risk Premium = x
Buy Lumber & Sell Futures Contract
Lumber = $2.50 + y
Futures Contract = $2.50 + (x - z) + y
Change in lumber cost = y
Depreciation of risk premium = z
Total Cost
= ($2.50 + x) + ($2.50 + y)
- ($2.50 + (x - z) + y)
= $2.50 + z
135
Hedging Contract
Numerical Example
Origination Date: September 1
Termination Date: August 31.
Original Risk Loading: 0.60
x = .40
x decreases .05 per month
z = .05(5) = .25
Total Cost = $2.50 + .25 = $2.75
136
Hedging Instruments for Financial Risks
137
Hedging Volatility
• Volatility is a measure of risk
• Some sources of volatility can be hedged
– Interest Rate
– Exchange Rate
– Commodity Price
138
Interest Rate Volatility
• Debt is a key component of a firm’s capital structure
• Interest rate hedges can stabilize borrowing costs
• Some tools: forwards, futures, swaps, options
139
Exchange Rate Volatility
• International businesses are exposed to exchange rate risk
• Tools for managing exchange rate risk
– forwards
– futures
– swaps
140
Commodity Price Volatility
• Costs of materials can be volatile:
– Pricing becomes problematic
– Sales demand becomes harder to predict
• Hedging allows for:
– Better production decisions
– Reduced volatility in cash flows
• Available tools (depending on the type of commodity):
–
–
–
–
Forwards
Futures
Swaps
Options
141
Reducing Risk Exposure
• Hedging will not normally reduce risk completely
– Typically, only price risk can be hedged  not quantity risk
– Reducing risk completely causes loss of potential upside
• Timing
– Short-run exposure can be managed in a variety of ways
– Long-run exposure almost impossible to hedge
142
Forward Contracts
• A contract between parties
– Agreement today on the price of the asset on the delivery date
– Delivery and payment is specified for a future date
• Forward contracts are legally binding on both parties
• Positions
– Long:
– Short:
Agrees to buy the asset on the future date
Agrees to sell the asset on the future date
• Key points
– Negotiated contract
– No exchange of cash initially
– Usually limited to large, creditworthy corporations
143
Payoffs on Forward Contracts
144
Hedging with Forwards
• Forward contracts can virtually eliminate price risk
• New risk created: Credit risk of the counterparty
• Forward contracts are primarily used to hedge exchange
rate risk
145
Futures Contracts
• Futures traded on organized securities exchanges
• Upfront cash payment: MARGIN
– Small relative to the value of the contract
– “Marked-to-market” on a daily basis
• Clearinghouse guarantees contract performance
• Clearinghouse and margin requirements virtually
eliminate credit risk
146
Hedging with Futures
• Futures contracts are standardized
– Allows for trading
– Exact hedging may be difficult or impossible
• Credit risk is virtually nonexistent
• Futures contracts are available on
–
–
–
–
physical assets
debt contracts
Currencies
equities
147
Swaps
• A long-term agreement between two parties
• Can be viewed as a series of forward contracts
• Generally limited to large creditworthy institutions or
companies
148
Option Contracts
•
The right, but not the obligation, to buy (sell) an asset for a set price on or before a
specified date
–
–
–
–
•
Call – right to buy the asset
Put – right to sell the asset
Exercise or strike price –specified price
Expiration date – specified date
Buyer has the right to exercise the option; the seller is obligated
– Call – option writer is obligated to sell the asset if the option is exercised
– Put – option writer is obligated to buy the asset if the option is exercised
•
Options allow a firm to hedge downside risk, but still participate in upside
potential
•
Pay a premium for this benefit
149
Buy a call with E = $40
Sell a Call E = $40
70
0
60
-10 0
50
-20
40
Payoff
Payoff
Payoff Profiles: Calls
30
20
20
40
60
80 100
-30
-40
-50
10
-60
0
0
20
40
60
Stock Price
80 100
-70
Stock Price
150
Payoff Profiles: Puts
45
40
35
30
25
20
15
10
5
0
Sell a Put E = $40
0
-5 0
-10
20
40
60
80 100
-15
Payoff
Payoff
Buy a put with E = $40
-20
-25
-30
-35
-40
0
20
40
60
Stock Price
80 100
-45
Stock Price
151
Retention vs. Transfer
•
•
•
•
•
•
•
•
Ability to Bear the Loss
Cost and Effectiveness of a Transfer
Degree of Control over the Risk
Insurance Loading Fees
Additional Insurer Services
Insurance as a Signal
Opportunity Costs
Taxes
152
Risk Financing Methods
• Guaranteed Cost Insurance
• Experience-Rated Insurance
• Retrospective Rating
153
Guaranteed Cost Insurance
 Underwriting
 Premium Depends on Classification Group
 Premium = (A)* (PURE PREMIUM) + B
154
Pure Premium
# cars = 10,000
# losses = 250
$ losses = $4.5 million
Pure Premium = frequency x severity
Frequency = 250 / 10,000 = 2.5%
Severity = $4.5 million / 250 = $18,000
Pure Premium = 2.5% (18,000) = $450
A = 1.4 B = $50
1.4 (450) + 50 = $680
155
Underwriting Considerations
•
•
•
•
•
•
Adverse Selection
Misclassification
Control
Civil Rights
Costs of Classification
Social Policy
156
What’s Fair and Why
Health Insurance Underwriting Factors
•
•
•
•
•
•
•
Cigarette Smoking
Obesity
Age
Prior history of heart disease
Genetic Predisposition to Stomach Cancer
Gender
Race
157
State Underwriting Restrictions: Health
Insurance
• CALIFORNIA:
Blindness, Gender, Marital Status, DES
• N. DAKOTA:
Blindness, Gender, Race
• WISCONSIN:
Blindness, Gender, Physical Impairment
158
How Insurance Works
An Example
Assume an individual has a 1% probability of getting
cancer and incurring medical expenses of
$200,000.
How much would you charge to bear this risk?
159
How Insurance Works
Central Limit Theorem
Mean = True Mean
Law of Large Numbers
Increase sample size by N
 New Mean = Old Mean x N
 New S.D. = Old S.D. x Sq. Root of N
160
HOW INSURANCE WORKS
AN ILLUSTRATIVE EXAMPLE
Sample Size = 1,000
Mean = 10
S.D. = 2
Loss per claim = $200,000
4
6
8
10
12
14
S.D. Prob.
1
68.27
2
95.45
3
99.73
16
161
HOW INSURANCE WORKS
AN ILLUSTRATIVE EXAMPLE
For 99.73% survival prob. insurer will charge:
16 x $200,000 = $3,200
1,000
Increase sample size to 100,000 (100x)
Mean # of Losses = 10 x 100 = 1,000
S.D. = 2 x sqroot (100) = 20
Now for 99.73% survival prob. insurer will
charge: 1060 x $200,000 = $2,120
100,000
162
Requirements of an
Insurable Risk
1.
2.
3.
4.
5.
Large Number of Homogenous Exposure Units
Accidental
Determinable and Measurable
No Simultaneous Destruction
Probability Calculable and Not Too High
 suicide, space shuttle, mental illness, war,
 early flight and computers, terminally ill
163
Social and Economic
Value of Insurance
•
•
•
•
•
•
Stability
Indemnification
Reduction in Reserve Funds
Insurers’ Ability to Invest
Satisfies Financial Requirements
Specialization in Loss Prevention
164
Social Costs of Insurance
• Insurers’ Operating Costs
• Moral Hazard
• Exaggeration of Losses
165
Cheating with Insurance
• Insurer
–
–
–
–
Failure to Honor the Contract
Misleading Contracts
False Advertising
Inappropriate Sales
• Insured
– Fraud
166
Controlling Cheating
• Litigation
• Regulation
167
Litigation
Requirements of an Insurable Contract
• Offer and Acceptance
• Consideration
• Competent Parties
• Legal Purpose
168
Litigation
Legal Principles: Indemnity
• Valuation
– Property: ACV
– Liability: Actual Damages
• Apparent Exceptions
– Valued Policies
– Replacement Cost Insurance
– Life Insurance
169
Actual Cash Value Example
ACV = Replacement Cost – Depreciation
1/1/04: Buy Machine for $3,000, 10 year life
1/1/06: Fire Destroys Machine; New Machine
Costs $10,000
ACV = $10,000 - $2,000 = $8,000
170
Litigation
Principle of Insurable Interest
• Property and Liability: Time of Loss
– Ownership
– Potential Legal Liability
– Secured Creditors
• Life Insurance: Time of Policy Purchase
– Close Ties: Love, Blood, Marriage
– Pecuniary Interest
171
Litigation
Principle of Subrogation
• Prevents Double Indemnification
• Holds Down Insurance Costs
172
Litigation
Principle of Utmost Good Faith
• Representations
• Concealment
• Warranty
Is It Material?
173
Why Is Insurance Regulated?
• Advance Payment of Premiums
• Complexity of Transaction
174
Types of Regulation
•
•
•
•
•
Licensing
Solvency
Rate Approval
Agents’ Activities
Insurance Contracts
175
Insolvency: Major Reasons
•
•
•
•
•
•
Bad Management
Poor Underwriting
Inadequate Reserves
Bad Investing
Inattentive to Loss Prevention
Competitive Pressures
176
Danger of Insolvency
• Most Insurers are Very Solid
• 100+ Years
– 71 Life Insurers
– 200 Property and Liability Insurers
• Guaranty Funds
• Buyout of Failing Firms
177
Premium Regulation
• Adequate
• Fair
• Reasonable
178
Methods of Rate Regulation
• Prior Approval
• File and Use
• Open Competition
179
Advantages of Open Competition
•
•
•
•
Flexibility
Increased Availability of Insurance
Avoid Political Fights
Frees Time of Regulators
180
Disadvantages of
Open Competition
• Price Gouging (?)
• Risk of Insolvency (?)
• Fair (?)
181
Regulation of Agents’ Activities
• Licensing
• Prohibited Acts
– Twisting
– Rebating
182
Causes of Insurance
Market Failure
• Adverse Selection
• Individuals Underestimate
the Loss Potential
• Insurance Costs Too Much
• Pooling Not Possible
• Insurers Can Not Estimate
the Loss Potential
183
THE END
184