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FINA 3210 C/D Risk Management and Insurance Jason Yeh, ASA (Society of Actuaries), Ph. FINA 3210 C/D Risk Management and Insurance Jason Yeh, ASA (Society of Actuaries), Ph. D (UW-Madison) Associate Professor, Dept. of Finance, CUHK Tel: (852) 3943 -7653 Email: [email protected] msmail. cuhk. edu. hk

Spring 2018 Grading Ü Participation: 10% Ü Quizzes: 10% Ü Tests: 40% Ü Group Spring 2018 Grading Ü Participation: 10% Ü Quizzes: 10% Ü Tests: 40% Ü Group work for mini insurance cases 40% http: //www. iccb. org. hk/en_index. htm Page 2

Spring 2018 The Pulse of World Ü WTC tragedy triggers a dispute which is Spring 2018 The Pulse of World Ü WTC tragedy triggers a dispute which is byfar the most expensive… Ü TWO WTC Towers are down… Ü ONE Attack or TWO Attacks? Page 3

Spring 2018 One Occurrence or Two? A USD 3. 5 Billion Difference…… 瑞 士 Spring 2018 One Occurrence or Two? A USD 3. 5 Billion Difference…… 瑞 士 再 保 險(Swiss Re) 與 紐 約 世 貿 中 心 租 約 持 有 人 Mr. Silverstein 就 保 險 賠 償 發 生 爭 議,入稟 要求 紐 約 曼 哈 頓 聯 邦 地 區 法 院 澄 清。 Ü 世 貿 中 心 之 保 險 合 同 中,有 每 次 事 故 賠 償 上限 美 元 35 億 的 條 文,Swiss Re 認 為 兩 次 撞 機 實屬 單 一 事 件,只 可 作 一 次 保 險 索 償 看 待,故最 高 賠 償 額 為 35 億 美 元。 Ü Mr. Silverstein 認 為 兩 架 客 機 分 別 撞 上 世 貿 中 心南 北 大 樓 是 兩 次 個 別 事 件,故 保 險 公 司 應 分 別 賠 償 35 億 美 元。他 要 求 保 險 商 就「九一一」事 件 賠 償 70 億 美 元。 Ü Ü (1) The cause test relates events to their root cause, thereby minimizing the number of occurrences; (2) the effects test treats events separately and so increases the number occurrences; and (3) the unfortunate event test takes a middle line between the two. (“One Occurrence or Two: How the Courts Decide”, by Jeannine Chanes and Mary Daniels in Risk Management Magazine Vol. 49 No. 1, January 2002) Page 4

Spring 2018 Chapter 1: Risk & Its Treatment Ü Different Ü Chance Definitions of Spring 2018 Chapter 1: Risk & Its Treatment Ü Different Ü Chance Definitions of Risk of Loss, Peril and Hazard Ü Classification Ü Major Personal and Commercial Risks Ü Burden of Risk on Society Ü Techniques Ü Cost of Risk for Managing Risk of Risk and Value Maximization Page 5

Spring 2018 What Is Risk? Ü Expected loss – Riskier ==> greater frequency or Spring 2018 What Is Risk? Ü Expected loss – Riskier ==> greater frequency or severity of loss – Example: high risk of earthquake; “that driver is a poor risk”; “that building is an unacceptable risk”, etc. Ü Variability of loss (around expected value) – Riskier ==> more difficult to predict Page 6

Spring 2018 Different Definitions of Risk: uncertainty concerning the occurrence of a loss. Ü Spring 2018 Different Definitions of Risk: uncertainty concerning the occurrence of a loss. Ü Loss Exposure: Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs. Ü Ü Objective Risk vs. Subjective Risk – Objective risk is defined as the relative variation of actual loss from expected loss – It can be statistically calculated using a measure of dispersion, such as the standard deviation (or what? ) – declines as the number of exposure units increases – Subjective risk is defined as uncertainty based on a person’s mental condition or state of mind – Two persons in the same situation may have different perceptions of risk – High subjective risk often results in conservative behavior Page 7

Spring 2018 Chance of Loss Ü Chance of Loss: The probability that an event Spring 2018 Chance of Loss Ü Chance of Loss: The probability that an event will occur. Ü Objective Probability vs. Subjective Probability – Objective probability refers to the long-run relative frequency of an event assuming an infinite number of observations and no change in the underlying conditions – It can be determined by deductive or inductive reasoning – Subjective probability is the individual’s personal estimate of the chance of loss – A person’s perception of the chance of loss may differ from the objective probability Page 8

Spring 2018 Chance of Loss vs. Objective Risk Chance of loss is the probability Spring 2018 Chance of Loss vs. Objective Risk Chance of loss is the probability that an event that causes a loss will occur. Ü Objective risk is the relative variation of actual loss from expected loss Ü The chance of loss may be identical for two different groups, but objective risk may be quite different! City # homes Average # fires Range Chance of Fire Objective Risk Philadelphia 10, 000 100 75 – 125 1% 25% Los Angeles 10, 000 100 90 - 110 1% 10% Page 9

Spring 2018 Risk Identification: Key Terms Ü Peril: a potential cause of a loss, Spring 2018 Risk Identification: Key Terms Ü Peril: a potential cause of a loss, e. g. , fires, hurricanes, theft, heart attack, and etc. Ü Hazard: conditions that increase the probability or expected magnitude of a loss, e. g. , smoking when considering potential healthcare losses. Ü An insurance contract covers a policyholder for economic loss caused by a peril named in the policy Page 10

Spring 2018 Exposure, Peril, Hazard Ü Hazard – Physical hazard- physical condition that increases Spring 2018 Exposure, Peril, Hazard Ü Hazard – Physical hazard- physical condition that increases the chance or severity of loss – Moral hazard- dishonesty or characteristics of an insured individual that increase the chance or severity of loss – Morale (Attitudinal) Hazard- carelessness or indifferences to a loss because of the existence of insurance. Ü Example: Given the following scenario, state which is the hazard, the peril, and the exposure, respectively? A person recently moved from Beijing to Shenzhen and bought a home. A typhoon occurs and it destroys his home. Ü Example: True or False? A house of wood construction burns to the ground resulting in a complete loss. The fact that the construction was of wood is the peril involved in this loss. Page 11

Spring 2018 Categorizing Risk Ü Pure and speculative risk • Pure - there are Spring 2018 Categorizing Risk Ü Pure and speculative risk • Pure - there are only the possibilities of loss or no loss. • Speculative - both profit or loss are possible Ü Diversifiable Risk v. Nondiversifiable Risk – A diversifiable risk affects only individuals or small groups (car theft). It is also called nonsystematic or particular risk. – A nondiversifiable risk affects the entire economy or large numbers of persons or groups within the economy (hurricane). It is also called systematic risk or fundamental risk. – Government assistance may be necessary to insure nondiversifiable risks. Page 12

Spring 2018 Fundamental Risks. . . Page 13 Spring 2018 Fundamental Risks. . . Page 13

Spring 2018 Enterprise Risk • Enterprise risk encompasses all major risks faced by a Spring 2018 Enterprise Risk • Enterprise risk encompasses all major risks faced by a business firm, which include: pure risk, speculative risk, strategic risk, operational risk, and financial risk Ü Risk from the CFO’s Perspective Page 14

Spring 2018 Pure Risk: Characteristics and Expertise Needed Ü Characteristics – Large downside risk Spring 2018 Pure Risk: Characteristics and Expertise Needed Ü Characteristics – Large downside risk but NO (or low) upside return – Firm-specific – Controllable (to some degree) – Usually managed by insurance – Wealth losses to society Ü Expertise needed – Risk analysis – Safety management – Loss control – Insurance contracts Page 15

Spring 2018 Pure Risk versus Other Types of Risk – Generalizations: – Pure risk Spring 2018 Pure Risk versus Other Types of Risk – Generalizations: – Pure risk involves events that are firm-specific – Price risk affects many firms – Pure risk is managed by insurance – Price risk is managed by derivatives – Pure risk involves wealth losses to society – Price risk involves wealth redistributions in society – Nevertheless, use the same framework for management of pure risk and price risk Page 16

Spring 2018 Major Types of Personal Risks Ü Risk of Life Ü Risk of Spring 2018 Major Types of Personal Risks Ü Risk of Life Ü Risk of Poor Health – Die too soon (premature) – Die too late (longevity risk) – INSIGHT 1. 1: Medical Bills Account for 40% of Bankruptcies Ü Risk of Property: direct and indirect Ü Liability Risk: resulting in property losses, physical injury, and/or pain & suffering of others Ü Financial Risk: stock; bonds; credit; liquidity Ü Unemployment Risk Page 17

Spring 2018 Major Types of Personal Risks Ü Property risks involve the possibility of Spring 2018 Major Types of Personal Risks Ü Property risks involve the possibility of losses associated with the destruction or theft of property: – Physical damage to home and personal property from fire, tornado, vandalism, or other causes Ü Direct loss vs. indirect loss – A direct loss is a financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a home – An indirect loss results indirectly from the occurrence of a direct physical damage or theft loss, such as the Page 18

Spring 2018 Major Types of Personal Risks Ü Liability risks involve the possibility of Spring 2018 Major Types of Personal Risks Ü Liability risks involve the possibility of being held liable for bodily injury or property damage to someone else – There is no maximum upper limit with respect to the amount of the loss – A lien can be placed on your income and financial assets – Defense costs can be enormous Ü INSIGHT 1. 2: Surgeons Leave Tools inside 1, 500 Patients a Year Ü In 2005, former outside directors of World. Com and Enron agreed to pay a total of $31 million out of their own pockets to settle securities class action lawsuits. (D&O insurance paid an additional $36 million to settle the World. Com suit, Page 19

Spring 2018 Major Types of Commercial Risks Ü Firms face a variety of pure Spring 2018 Major Types of Commercial Risks Ü Firms face a variety of pure risks that can have serious financial consequences if a loss occurs: – Property risks, such as damage to buildings, furniture and – – – office equipment Liability risks, such as suits for defective products, pollution of the environment, and sexual harassment Loss of business income, when the firm must shut down for some time after a physical damage loss Other risks to firms include crime exposures, human resource exposures, foreign loss exposures, intangible property exposures, and government exposures Page 20

Spring 2018 Property Risks Page 21 Spring 2018 Property Risks Page 21

Spring 2018 Burden of Risk on Society Ü Need for a Larger Emergency Fund Spring 2018 Burden of Risk on Society Ü Need for a Larger Emergency Fund – Put aside $25, 000 annually for damages (due to fire, windstorm, theft etc. ) to your home valued at $200, 000? Ü Loss of Needed Goods and Services – Some 250 companies once manufactured childhood vaccines, now just a few firms do. Ü Fear and Worry Page 22

Spring 2018 Methods of Handling Risk Avoidance Ü Loss Control Ü – – Ü Spring 2018 Methods of Handling Risk Avoidance Ü Loss Control Ü – – Ü Loss prevention (aims at reducing loss frequency) Loss reduction (aims at reducing loss severity) Retention – Active (desirable) is the deliberate choice to assume part or all of a loss exposure. – Passive (dangerous) often results from ignorance or inertia. Ü Noninsurance Transfers – Contracts (hold-harmless or indemnity clause) – Hedging – Incorporation (LLC) Ü Insurance Page 23

Spring 2018 Chapter 1 CASE APPLICATION Ü Ü Ü Ü Mike is a college Spring 2018 Chapter 1 CASE APPLICATION Ü Ü Ü Ü Mike is a college senior majoring in BBA. He owns a high-mileage 2000 Ford with current market value of $2, 500. The current replacement value of his personal property in a rented apartment totals $10, 000. He wears disposable contact lenses, which cost $300 for a six-month supply. He also has a waterbed in his rented apartment that has leaked water in the past. As avid runner, Mike run five miles daily in a nearby public park that has reputation of being extremely dangerous due to drug dealers. Mike’s parents both work to help him pay for his tuition. Page 24

Spring 2018 Mike’s Methods of Handling Risks Ü For each of the following risks Spring 2018 Mike’s Methods of Handling Risks Ü For each of the following risks and loss exposures, identify an appropriate RM technique that could have been used to deal with the exposure. • Physical damage to the 2000 Ford due to a collision with another motorist. Page 25

Spring 2018 Mike’s Methods of Handling Risks • Liability lawsuit against Mike arising out Spring 2018 Mike’s Methods of Handling Risks • Liability lawsuit against Mike arising out of the negligent operation of his car. • Total loss of personal property due to a fire in the kitchen of his rented apartment. Page 26

Spring 2018 Mike’s Methods of Handling Risks • Disappearance of one contact lens. • Spring 2018 Mike’s Methods of Handling Risks • Disappearance of one contact lens. • Waterbed leak that cause property damage to the apartment. Page 27

Spring 2018 Mike’s Methods of Handling Risks • Physical assault on Mike by gang Spring 2018 Mike’s Methods of Handling Risks • Physical assault on Mike by gang members who are dealing drugs in the park where he runs. • Loss of tuition assistance from Mike’s father who is killed by a drunk driver in an auto accident. Page 28

Spring 2018 Major Risk Management Methods Page 29 Spring 2018 Major Risk Management Methods Page 29

Spring 2018 Exercise: Loss Control Ü How to reduce the risk of injury to Spring 2018 Exercise: Loss Control Ü How to reduce the risk of injury to construction firm employees by the two major approaches of loss control? Ü Reduced level of risky activity – Taking on less hazardous projects – Reducing total number of projects Ü Increased precautions – Giving employees safety instruction – Making employees wear protective devices Page 30

Spring 2018 Risk Management is the decision making process by which adverse consequences of Spring 2018 Risk Management is the decision making process by which adverse consequences of risk are minimized. Page 31

Spring 2018 What Are the Adverse Consequences of Risk? Ü Expected Ü Cost cost Spring 2018 What Are the Adverse Consequences of Risk? Ü Expected Ü Cost cost of losses of risk control Ü Costs of risk financing Ü Cost of internal risk reduction Ü Costs of residual uncertainty Page 32

Spring 2018 Components of the Cost of Risk Page 33 Spring 2018 Components of the Cost of Risk Page 33

Spring 2018 Cost of Risk and Value Maximization: The Big Picture Ü Risk imposes Spring 2018 Cost of Risk and Value Maximization: The Big Picture Ü Risk imposes costs on businesses and individuals Ü Risk Management (e. g. , loss control and insurance) also are costly Ü Tradeoffs Ü Criteria must be made for Making Choices: Value Page 34

Spring 2018 Value Maximization and Minimizing the Cost of Risk Ü Firm value depends Spring 2018 Value Maximization and Minimizing the Cost of Risk Ü Firm value depends on net cash flows – Net cash flows = cash inflows - cash outflows – Important characteristics of net cash flows: – Expected magnitude – Timing – Variability (uncertainty) Ü Define – Cost of Risk = Value without risk - Value with risk Ü Then – Value with risk = Value without risk - Cost of risk – Maximizing value is equivalent to minimizing the cost of risk Page 35

Spring 2018 Example: Costs of Risk Component Ü Worker Injuries Cost of risk component Spring 2018 Example: Costs of Risk Component Ü Worker Injuries Cost of risk component Specific examples Ü Expected losses expected EC benefits; expected replacement costs; expected lost productivity Ü Loss Control Ü Loss Financing employee safety expenditures Loading on EC ins. premiums Ü Internal risk reduction information Ü Residual uncertainty investments in Page reduction in value due 36

Spring 2018 Cost of Risk Example Ü Value of firm in ideal world of Spring 2018 Cost of Risk Example Ü Value of firm in ideal world of no risk = $100, 000. Ü Issues to be examined: – What is value with risk of worker injuries? – What is relation between firm value and cost of risk? Page 37

Spring 2018 Cost of Risk Example Ü Business is faced with the following risk: Spring 2018 Cost of Risk Example Ü Business is faced with the following risk: Probability of worker injury = 1/10 Losses from a worker injury: medical expenses $10, 000 lost pay $50, 000 total $60, 000 Expected loss = $ Page 38

Spring 2018 Cost of Risk Example Ü Option 1: Do Nothing – Cost of Spring 2018 Cost of Risk Example Ü Option 1: Do Nothing – Cost of risk: Expected loss = Cost of residual uncertainty = $4, 000 (assumed) Cost of loss control = Cost of loss financing = Cost of internal risk reduction = – Total cost of risk = – Firm value = Page 39

Spring 2018 Cost of Risk Example Ü Option 2: Loss Control – Spend $2, Spring 2018 Cost of Risk Example Ü Option 2: Loss Control – Spend $2, 000 to reduce probability of loss to 1/20 – Cost of risk: Expected loss = Cost of residual uncertainty = $3, 000 (assumed) Cost of loss control = Cost of loss financing = Cost of internal risk reduction = – Total cost of risk = – Firm value = Page 40

Spring 2018 Cost of Risk Example Ü Option 3: Additional Loss Control – Spend Spring 2018 Cost of Risk Example Ü Option 3: Additional Loss Control – Spend an additional $2, 000 to reduce probability of loss to 1/40 – Cost of risk: Expected loss = Cost of residual uncertainty = $2, 700 (assumed) Cost of loss control = Cost of loss financing = Cost of internal risk reduction = – Total cost of risk = – Firm value = Page 41

Spring 2018 Cost of Risk Example Ü Option 4: No loss control, but FULL Spring 2018 Cost of Risk Example Ü Option 4: No loss control, but FULL Insurance – Premium = $7, 500 w Loading = Premium - expected loss = $ – Cost of risk: Expected loss = Cost of residual uncertainty = $500 (assumed) Cost of loss control = Cost of loss financing = Cost of internal risk reduction = – Total cost of risk = – Firm value = Page 42

Spring 2018 Cost of Risk Example Ü Key Points: – Do NOT minimize risk, Spring 2018 Cost of Risk Example Ü Key Points: – Do NOT minimize risk, Minimize Cost of Risk – There are tradeoffs: w Increase insurance ==> » Pay loading » Decrease in residual uncertainty » May decrease loss control incentives (Moral Hazard) w Additional loss control ==> » Decreased expected losses » Increase loss control costs Page 43

Spring 2018 Cost Tradeoffs in Risk Management Ü Loss control costs vs. expected cost Spring 2018 Cost Tradeoffs in Risk Management Ü Loss control costs vs. expected cost of losses (direct and indirect) – Zero risk or zero probability of loss would be too costly Ü Cost of loss financing & internal risk reduction vs. expected cost of indirect losses – E. g. , more insurance increases loss financing costs, but might reduce the likelihood of bankruptcy and the likelihood of having to raise costly external capital (to pay Page 44

Spring 2018 Cost Tradeoffs in Risk Management Ü Cost of loss financing & internal Spring 2018 Cost Tradeoffs in Risk Management Ü Cost of loss financing & internal risk reduction vs. cost of residual uncertainty – E. g. , more insurance increases loss financing costs, but would reduce uncertainty in cash flows, which might (a) cause investors to place a higher value on the firm and/or (b) change the terms that risk averse employees will contract with the firm Page 45

Spring 2018 Risk Management & Societal Welfare Ü Minimizing the Cost of Risk is Spring 2018 Risk Management & Societal Welfare Ü Minimizing the Cost of Risk is an appropriate objective for – Nonprofit organizations – Individuals – Society Ü because it generally results in an efficient level of risk for society Ü efficiency ==> activities are pursued until the marginal costs exceed the marginal benefits Page 46

Spring 2018 Business Objectives and Other Claimants Ü Does maximizing shareholder wealth imply that Spring 2018 Business Objectives and Other Claimants Ü Does maximizing shareholder wealth imply that you ignore the effect of risk on employees, customers, etc. (ignoring regulation and legal liability)? Ü Not necessarily, because – informed employees, customers, etc will demand compensation for risk Ü Thus, risk management decisions that shareholder wealth generally also consider the effect of risk on other claimants Page 47

Spring 2018 Conflicts between Business & Societal Objectives Ü What if business cost of Spring 2018 Conflicts between Business & Societal Objectives Ü What if business cost of risk < societal cost of risk? – Possible scenarios: w workers are uninformed about injury risk w chance of being caught dumping waste is zero Ü Then, business might engage in excessively risky behavior (they may not consider the effects of risk on other claimants) Ü Thus, there is a potential role for regulation and legal liability Page 48