Fall 2008 Version Professor Dan C Jones FINA

Fall 2008 Version Professor Dan C. Jones FINA 4355

Risk Management and Insurance: Perspectives in a Global Economy 2. Risk Perceptions and Reactions Professor Dan C. Jones FINA 4355

Study Points Decision-making under uncertainty: Individuals Businesses Society Economic Theories 3

Individual Decision-making under Uncertainty

The Case John Received an inheritance of $10, 000 from an uncle Unsure of what to do with the money for investment purpose Decision-making theories Expected value (function) Expected utility (function) Risk-averse expected utility (function) 5

Risk Decisions and the Expected Value 6

Risk Decisions and the Expected Value 7

Risk Decisions and the Expected Value The expected value (EV) of a set of n possible outcomes equals the sum of these outcomes, each outcome (xi) weighted by the probability of its occurrence (pi): 8

Risky Decisions and the Expected Utility Rule The St. Petersburg Paradox 9

Risk-Averse Utility Function A utility function for the risk-averse person exhibits two characteristics: Increasing wealth leads to increasing levels of satisfaction. The marginal utility of wealth decreases as wealth increases. The law of diminishing marginal utility as shown Figure 2. 1 Risk-averse individuals will select the option with the highest expected utility. 10

Risk-Averse Utility Function (Figure 2. 1) 11

Risk-Averse Utility Function 12

Case Maria Owns a home worth $150, 000 in the Philippines Has $50, 000 in a savings account The earthquake Probability of 10% in any given year An earthquake will totally destroy her house XYZ Insurance Company Fully indemnifies insureds for earthquake-related losses Charges a premium equaling the expected value of the loss 13

Expected Utility with Insurance – Maria Actuarially fair premium Premium equaling the expected value of the loss 14

Expected Utility with Insurance – Maria Should Maria buy the insurance policy? 15

Insurance Demand Lifetime Utility Maximization

Insurance Demand Lifetime Utility Maximization 17

Theories of Consumption Life cycle hypothesis Figure 2. 4 The typical individual’s income: Low in the beginning and end stages of life High during the middle stage of life The individual maintains a constant or increasing level of consumption. Consumption theories and insurance “Risk-averse” individuals increase their expected lifetime utility by the purchase of: Life insurance to provide payments on death and Annuities to provide payments during retirement 18

Life Cycle of Consumption and Saving (Figure 2. 4) 19

Economic Theories of Consumption

Prospect Theory: Loss Aversion and the Value Function Kahneman and Tversky Each of us has a personal value function that reflects our degree of satisfaction derived from gains and losses from some reference point. The reference point is each individual’s point of comparison or standard against which risky decisions are contrasted. This point is not static and can vary for the same individual depending on how the choices are framed or presented to the individual. The Kahneman–Tversky value function Concave in gains, as with a utility function, but convex in losses Figure 2. 5 21

Illustrative Prospect Theory Value Function (Figure 2. 5) 22

Probability Weighting Function (Figure 2. 6) 23

Other Anomalies Decision regret We feel far worse about having made bad choices than we do about our failures to have made smart choices. Mental accounting We tend to separate a whole into components. Endowment effect The tendency to set a higher price to sell that which we already own than what we would be willing to pay to purchase the identical item if we did not own it. 24

Business Decision-making under Uncertainty

Types of Business Sole proprietorship Partnership General partners Limited partners Corporation Limited liability of its owners Easy transfer of ownership Continuity of existence Closely held corporations 26

Sole Proprietorship and Partnership Reactions to Risk Sole Proprietorship Being indistinguishable from the individual who owns it, the sole proprietorship’s risk perception and behavior logically is that of its owner. Partnership Its risk perception and behavior reflect some combination of the owners’ degrees of risk aversion. An exception can occur If the partnership interest is held by many partners, has a ready market or is a small portion of the partners’ overall investment portfolio, or If the partners have a sound understanding of how the value of their partnership interest changes with changes in the value of other investments 27

Corporate Reactions to Risk The goal of the firm and owner risk profiles By assembling their own portfolio of financial assets, owners can determine their own consumption and risk profiles. They want managers simply to maximize net present values, acting as risk-neutral agents for the owners and undertaking every project whose net present value is positive, irrespective of its risk. Risk-neutral utility function Increasing wealth leads to increasing levels of satisfaction. The marginal utility of wealth is constant as wealth increases. Figure 2. 7 28

Risk-Neutral Utility Function (Figure 2. 7) 29

Why Do Corporations Manage Risks? Managerial self-interest Principal-agent problems Corporate taxation Refer also to Chapter 19 (the Economic Foundations of Insurance) Cost of financial distress Bankruptcy risk and cost vs. the cost of insurance Capital market imperfections High transaction costs associated with external finance Imperfect information about firm riskiness by those who might provide the external finance The high cost of financial distress 30

Societal Decision-making under Uncertainty

Economic Efficiency as a Social Goal Just as individuals seek to maximize their welfare (i. e. , their individual utilities), so do societies want to maximize their welfare. Because of differences in individual preferences, there is no such thing as a societal utility function. Economics offers an alternative. Efficient allocation of resources Individuals and businesses should undertake risk management (and all other) actions so long as the marginal benefit is greater than the marginal cost. Economists measure benefits based on the concept of “willingness to pay. ” 32

Economic Efficiency as a Social Goal Two problems Even if it’s efficient, is it fair? Society may not necessarily prefer a Pareto efficient allocation of its resources Even if it’s fair, is it efficient? Market prices do not always equal opportunity costs. 33

Imperfections in Markets – Market Failures Some goods or services may be unavailable or available only in some suboptimal way. Four general classes of problems Market power Externalities Free rider problems Information problems These classes of problems are discussed throughout the book. 34

Market Power The ability of one or a few sellers or buyers to influence the price of a product or service Causes Governmentally created barriers to entry Economies of scale Product differentiation/price discrimination 35

Market Power – Governmentally Created Barrier Market power arises when a market has entry or exit barriers and few sellers. Monopoly Oligopoly National tax regimes can lead to the creation of market power. In financial services, national licensing requirements technically are entry barriers, although they may be justified on consumer protection grounds. 36

Market Power – Economies of Scale Economies of scale exist when a firm’s output increases at a rate faster than attendant increases in its production costs. Minimum efficient scale (MES) at which long-run average costs are at a minimum; further growth yields no additional efficiencies If efficiency increases over an industry’s entire relevant output range, the MES is so large relative to market size that only one firm can operate efficiently—a so-called natural monopoly case. A monopolist or oligopolist unable to exercise market power if the market is contestable 37

Market Power – Product/Price Differentiation Product differentiation When a large number of firms produce similar but not identical products, they are engaged in monopolistic competition which gives the firms an element of monopoly power (i. e. , the ability to influence price). Price discrimination Firms offering identical products at different prices to different groups of customers Predatory pricing also known as dumping Lowering prices to unprofitable levels to weaken or eliminate competition with the idea of raising prices after competitors are driven from the market 38

Externalities Benefits or costs that occur when a firm’s production or an individual’s consumption has direct and uncompensated effects on others Positive externalities Negative externalities Societal risk management is particularly concerned about negative externalities. 39

Externalities – Nature The purely competitive economic model does not accommodate externalities easily, because the market prices of goods and services that carry externalities fail to reflect their true (opportunity) costs. Here lies the problem with allowing competitive markets to deal freely with goods and services that carry externalities. With negative externalities too much of the good or service produced or consumed the price becoming too low too little effort and resources devoted to correct/reduce the externality. With positive externalities too little of the good or service produced the price becoming too high too little effort devoted to enhancing the externality. 40

Externalities – The Importance of Property Rights Negative externalities (e. g. , pollution) can persist in competitive markets because the persons adversely affected by the negative spillovers have poorly defined, dispersed or no property rights. Too often, property rights are not well established or they are widely dispersed, thus precluding meaningful actions by private citizens against the polluter. 41

Free Rider Problems Some collectively consumed goods and services that are desired by the public—called public goods—carry extensive positive externalities. Examples are: Public education Lighthouse Police and fire protection services When such goods and services are available to others at low or zero cost, they can cause a free rider problem. Left to itself, a competitive market is unlikely to provide as much of public goods as society really wants. 42

Information Problems Information problems occur when buyers (or sellers) lack sufficient information to make an informed purchase (or sales) decision. Markets that suffer such information asymmetries often are regulated if the goods or services involved are important elements of our lives or the economy. 43

Information Problems – Asymmetric Information The problems arise when one party to a transaction has relevant information that the other does not have. A Lemons problem when the buyer knows less than the seller about the seller’s products A principal-agent (or agency) problem when the buyer of services knows less about its agent’s actions than does the agent An adverse selection problem when the seller knows less than the buyer about the buyer’s situation Moral hazard is the propensity of individuals to alter their behavior when risk is transferred to a third party. 44

Information Problems – Asymmetric Information Tradeoffs are inevitable between The additional expenses incurred to become better informed and The additional costs inherent in making decisions with less information 45

Information Problems – Non-existent Information Neither the buyer nor the seller has complete information because desired information simply does not exist. This uncertainty leads them to take ameliorating actions intended to reduce their risk exposure. These offsetting actions require the expenditure of additional resources, thus decreasing overall benefits to society. 46

Information Problems – Non-existent Information These situations can be addressed through actions such as diversification and creation by governments of various “safety nets” for its citizens One of the premises for social insurance programs is that individuals will not or cannot fully arrange for their own financial security So government must force them to do so. 47

Discussion Questions

Discussion Questions 1 & 2 “If individuals were not risk averse, insurance would not exist. ” Do you agree with this statement? “If individuals were not risk averse, risk management would not exist. ” Do you agree with this statement? 49

Discussion Question 3 Why would we ordinarily expect corporations whose shares were widely held to be risk neutral? 50

Discussion Question 4 Even corporations whose shares are widely held often seem to be risk averse. Offer some sound economic reasons for such corporate behavior. Offer some practical reasons for such corporate behavior. 51

Discussion Question 5 Justify the following statement: “If externalities did not exist, society would have no worry about pollution. ” 52

Discussion Question 6 “If a market is operating with reasonable efficiency, government should leave it alone. ” Under what circumstances would you (a) agree and (b) disagree with this contention? 53