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Risk Management and the Theory of the Firm
Author(s): J. David Cummins

Source: The Journal of Risk and Insurance, Vol. 43, No. 4 (Dec., 1976), pp. 587-609
Published by: American Risk and Insurance Association
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Risk Management and the Theory of the Firm

J. DAVID CUMMINS
ABSTRACT
This article integrates risk management decision variables into the
theory of the firm under risk and develops risk management decision
rules consistent with the firm's overall objectives. The theoretical construct chosen for extension to the risk management problem is the
capital asset pricing model. Utilizing this model, decision rules are
developed for optimal proportional retention, selection of aggregate
deductibles and choosing reserving policies. The results differ significantly from the expected value decision rules developed by previous researchers.The article concludes by examiningthe impact on the decision
rules of relaxing some of the key assumptionsof the model.
Recent years have witnessed significant progress in the application of
quantitative decision tools to the solution of risk management problems.
These developments have ranged from purely theoretical exercises to highly
particularized practical applications and have encompassed the entire
spectrum of quantitative methodology. For example, a model for the
selection of optimal deductibles has been developed and applied by Allen
and Duvall [1, 4]. Optimal insurance and loss prevention decisions have
been the subject of a paper by Shpilberg and de Neufville [16] which
employed a decision theoretic framework. A study which involved the
testing of alternative decision tools, such as utility theory and the worry
factor method, has been conducted by Neter and Williams [13] while
a computer simulation model of self insurance of workers' compensation
losses was developed by Mortimer [11]. The fitting of loss distributions to
facilitate the more precise estimation of future claim costs has been emphasized by Hartman and Siskin [9]. Finally, Head [8] has illustrated
how capital budgeting can be applied in the context of risk management
decision making.
These and numerous other studies have provided the basis for significant
improvements in risk management analysis. However, as is perhaps inevitable in a developing field, most of the articles have concentrated on
J. David Cummins is Assistant Professor of Insurance in the Wharton School, University of Pennsylvania. Professor Cummins is Research Director of the S. S. Huebner
Foundation and is a member of the Editorial Board of the Journal of Risk and Insurance.
He is the author of An Econometric Model of the Life Insurance Sector of the U.S.
Economy and co-authorof ConsumerAttitudes Toward Auto and Homeowners Insurance.
This paper was submitted for publication June, 1975. It was presented to the 1975
Risk Theory Seminar.
( 587)

588
The Journal of Risk and Insurance
local rather than global optimization.That is, the overall objectives of the
firm generally have been recognized only implicitly or peripherally in
the formulationof the risk managementdecision rules.' This approach is
potentially misleading, since rules which appear appropriatestrictly from
a risk management point of view may be suboptimal in the context of
the firm'sbroader goals. An appropriatecomplement to the existing risk
management literature thus would seem to be a general theory which
integrates risk managementinto the overall business setting. The purpose
of this article is to develop such a theoretical framework.
As microeconomictheory is a highly developed discipline, this paper
does not attempt to derive a totally new theoretical model. Rather, the
goal is to adapt existing models to incorporaterisk managementvariables
and parameters.Because of the nature of the risk management problem,
a theoretical model is required which views the firm in the context of
uncertainty.After considering a number of alternatives,the model chosen
for scrutiny in this paper is the capital asset pricing model developed
by finance theorists.2The applicability of this model was suggested to
the author by a recent paper by Schrammand Sherman [15]. That article
explored the idea that firms can manage the variabilityof their net income
streams by varying their advertising and research and development expenditures. The present paper focuses on the effect of the selection of
alternativerisk managementdevices on that variability.In this regard, the
capital asset pricing model is first utilized to derive some fundamental
optimization rules.
These rules are then expressed in terms of familiar risk management
variables. Because the model rests on a number of simplifying assumptions, the paper explores the realism of some of these assumptionsin the
risk managementcontext and the impact of their relaxationon the decision
rules. The paper concludes with a discussion of the potential for the empirical application of the model. The emphasis of this article is on theory
rather than on practical applications and the analysis is conducted at a
high level of abstraction. Hopefully, the theoretical results presented
eventually will provide guidelines for the development and testing of
practicalrisk managementdecision rules. However, much researchremains
before direct practical application is possible.
The Capital Asset Pricing Model
The capital asset pricing model as developed in the theory of finance is
a two period model in which the participantsare consumersand business
firms.At the beginning of Period 1, consumersare assumed to come to the
market with "quantitiesof resources-labor, which will be sold to some
firm, and portfolio assets, that is, shares of firms ... that must be allocated
to current consumption cl . . . and a portfolio investment whose market
1 This problem has been recognized in an earlier paper by Mehr and Forbes [10].
2This theory is discussed in numerous books and articles including Fama and Miller
[51 and Mossin [11].

Risk Management
589
value at the beginning of Period 2 determines the level of consumptions c2"

for that period. Consumers are assumed to be risk averse expected utility
maximizers and to behave as if the probability distributions of return on
their portfolios can be completely summarized in terms of two parameters, the expected value and some measure of the dispersion of the
returns.
The business firms in the market organize production activities which
are financed by selling shares in their Period 2 output values to consumers
The firms are assumed to operate according to the decision rule: maximize
Period I market value.4 The solution of the model involves the simultaneous
optimal allocation of funds by consumers between consumption cl and
investment and the maximization by firms of their Period 1 market values.
A number of assumptions are inherent in the capital asset pricing model:
1. Perfect capital markets. This assumption is similar to that found in the
conventional economic theory of perfect competition. Among its major
implications for the instant case are that no transactionscosts or taxes
exist, and that "no firm is large enough to affect the opportunity set
facing consumers."5
2. Consumerrisk aversion.
3. Symmetric stable distributions. Consumersare assumed to behave as if
distributions of returns on all portfolios are symmetric stable with the
same value of the characteristicexponent. This assumption permits the
summarizationof return distributionsby two parameters-the mean and
a measure of dispersion. For convenience, this analysis makes the added
assumption that the distributions are normal; i.e., that the measure of
dispersionis the variance.
4. Riskless borrowing and lending. The assumption is that consumers can
borrow and lend as much as they wish at a risk free rate of interest.
5. Homogeneous expectations. This assumption means that "all consumers
have the same set of portfolio opportunities. . . and all view the probability distributions of returns associated with the various available
portfoliosin the same way." 6
All five major assumptions are crucial to the model, but the last four
make the capital asset pricing model unique. The third assumption implies that consumers can summarize all distributions of return in terms
of the mean and a measure of the dispersion of those distributions. Combined with the second assumption, the use of two parameter distributions
permits the consumer to consider only those distributions which are mean,
variance efficient. Assumptions 4 and 5 further simplify the problem by
permitting all consumers first to view the efficient set in the same way
(assumption 5) and then (through assumption 4) to focus attention on
one common point on that frontier, the market portfolio. Thus, the assump3 Fama and Miller [5], p. 277.
4For a more complete discussion of the firm's objectives see Fama and Miller [5],
pp. 299-301. Schramm and Sherman [15] have shown that when risk is taken into
account, the value maximizationgoal may give rise to business behavior which manifests
itself as either growth or sales maximization.
5 Fama and Miller [51, p. 277.
i7i2A
D.
9287

.590
tions lead to market equilibrium conditions in which individual utility

functions are not explicitly present.
Although capital market equilibrium in the foregoing model implies
a number of interesting relationships, the one selected for the analysis
of risk management decisions is the pricing equation for the Period 1
value of a firm:7
(1)
E(l)Rf
where
P - the equilibrium market value

of Pqriod 1 (in equilibrium,
- the market value
E(f)
M
P i
of the firm at the beginning
market value
portfolio;
Rf a the risk
a
of Period
2;
+ Rf)
-f
-'the market value at the beginning

portfolio
("market wealth");
PM
of the jth firm at the beginning

this quantity is maximized);
at the beginning
free borrowing-lending
of Period 2 of the market
of Period
rate;
1 of the market
and
coefficient
between the return
the correlation
firm and that on the market portfolio.
on the jth
The placement of a tilde over a symbol indicates that it represents a

random variable.
Accordingto the pricing equation, the Period 1 marketvalue of the firm
is the present value, computed at the risk free rate, of the firm'sexpected
value at Period 2 less the present value of a risk charge. The risk charge
is equal to the product of the marketprice of a unit of standarddeviation
(Sm), the correlationcoefficientof the firm'sreturnwith that of the market
and the standarddeviation of the firm'sPeriod 2 marketvalue. Of interest
is that the risk penalty of the jth finn varies directly with its correlation
coefficient with market return. That relationship exists because a stock
with a relatively low correlationwith market return is more valuable to
investors in terms of diversification.
Optimal Risk Management Decisions
General OptimizationRules
In most developments involving the capital asset pricing model, the
parameters of the distribution of returns of the individual firms remain
invariant. In order to apply the model in the risk managementcase, however, that assumption must be relaxed to permit the firm to vary within
7 Ibid., p. 296.

591
Risk Management
limits its mean and variance of return. In particular,the assumption that

the objective of the firmis to vary E(V) and a(V1) to maximizeits Period
1 value, P5. This procedureis an accurate abstractionof the risk management process as most decisions involving the use of deductibles and self
insurance hinge on the tradeoff between savings in the expected cost of
pure risk and the increased risk faced by the firm as a result of reductions
in its insurancecoverage.
For example, when a firmelects a larger deductible the usual motivation
is that its insurance premium is reduced by a larger amount than the
resultant increase in expected retained claims and settlement costs. In
return for this savings, however, the firm must be willing to accept a
higher degree of variabilityin its income stream as an unexpectedly large
number of losses could result in total loss costs substantiallyin excess of
the original premium. Intuitively, the anticipation is that the firm would
increase its deductible to the point at which the value of the premium
savings is offset precisely by the cost of the increased variability in the
income stream.
A noteworthy assumptionin this analysis is that the firm can obtain a
net savings by varying its degree of pure risk retention. Such a savings is
not necessarily available in the world of perfect markets and the assumption is equivalent to the introductionof a degree of imperfection in the
insurancemarket.Investigationsof the precise role of insurancein economic
equilibrium and the conditions under which the hypothesized savings
would be available are beyond the scope of this study but constitute intriguing avenues for future research.
This risk management process, under the assumption that savings
through risk retention are available, can be expressed in a more precise
mannerthrough the use of the capital asset pricing model. Thus, accepting
a larger deductible or adopting a self insurance program results in an
increase in both E(V') and O); I-e.,,
;D
>o
and
3D.L
>
where D standsfor the retentionof the insured

The optimization rule thus becomes:
Maximize: Equation (1) with respect to D.
In general terms, the first- and second-orderconditionsfor a maximumare
the following:
First-orderCondition
3D
nor
mjm a3D
3D
UD
)/(
aD
is

(2t
592
Second-order
Condition
a2p
921(
BD2
3D2
32a('
D
3D2
When written as (2)', the first order condition for a maximumcan be

given an interesting interpretation.Implied is that the firm should increase its risk retention to the point at which the marginal rate of substitution between return and risk is equal to the price placed by the
market on a unit of standard deviation multiplied by the correlationcoefficient between the firm and the market. Beyond that point, the firm
will not receive an increase in expected return adequate to compensate
for the additional risk.
Those familiar with the capital asset pricing model will recognize that
the derivation of expression (2) involves additional simplifying assumptions. In particular the assumption that the risk management decisions
of the individual firm have no impact either on the market price of risk,
S., or the correlationbetween the jth firm'sreturn and that of the market;
i.e., the assumptionis that aSm/JD and apjm/aDare equal to zero. Those
assumptions are not supportable in a strict mathematical sense as the
parameters of the firm are components of the market parameters.However, the former condition can be justified by noting that the model is
couched in terms of perfect competition. Thus, even though the firm's
risk-return characteristics are components of Sm, the number of firms
in the market is so large that any change on the part of one particular
firm has no measurableeffect on the market set.
The latter condition, apj/1D = 0, is considerablymore restrictive,but
its use in an approximatesense can be justifiedheuristicallyby recognizing
that most of the covariance between the returns of the various firms in
the marketarisesfrom the natureof their responseto economicfluctuations.
A change in retention, on the other hand, involves the assumption of
nsks generally uncorrelatedwith the business cycle and are approximately
independent across the set of all firms.8 Thus, additional pure risk assumption should affect the correlationwith marketreturnsonly minimally,
if at all.
A version of the first-ordercondition which permits pjmto vary with D,
while retaining the assumption that aD
(4):
aP
3D
aE(
aD
e
air
When aCov(tJ
acov(VI,
a
k)
0 , is presented as equation
" 0, j
3D
(V
OD
# k, equation (4) reduces to:
"A number of well-known real world phenomena are contrary to this assumption.
For example, disability income claim filings are negatively correlated with the business
cycle, while auto collision claims exhibit a positive correlation. However, in general,
a reasonable hypothesis is that pure risk occurrences demonstrate a lower degree of
interfirmcorrelation than returns from productive activities.

Risk Management
UP
DD
aE(V)
aa2tV()
DD
a0?mM)
593
CO?)
j
Readers concerned about the assumption that

=0 may wish to
9D
reformulate the subsequent analysis in terms of equation (4) or (5).
An importantobservationis that in a theoreticalsense the risk management decision affects the production characteristicsof the firm; i.e., it
alters the probability distributionof the firm'stotal earnings at Period 2.
Since the standard capital asset pricing model assumptionsare in effect,
once the risk management decision has been made, how the resulting
operations are financed is irrelevant; i.e., the mix of debt and equity
financinghas no impact on the market value of the firm.9Thus, whether
the insurance premium and/or the retained losses are paid for out of
equity or debt-generated financial resources is a matter of indifference
to the firm'sshareholders.
ProportionalRetention
In order to explore further the implications of expression (2) for risk
management decisions, to define E(V ) and Cov(VjVm) in terms of
more familiar risk management variables seems appropriate.Thus, one
can state that
v
where
:1
=t
'i
- C
21
(6)
v' Wnet income of the firm considering all revenues and all
expenses other than those associated with pure risk; and
C = the pure risk costs of the firm.
By focusing on the componentsof Cj, it is then possible to establish some

more precise decision rules.
In this section, the assumptionis that the firm can base its retention on
a quota share arrangementon "Originalterms."In that case,
(
,-(1 .-c)G2+ a(- + EJ)
where
G - the insurance premiumwhich the firm would be charged for

complete, first dollar coverage;
L - the firm's losses for the year;
the pureriskof the firmif all losses

Ej = the cost of administering
are retained;10
and
of the riskretainedby the firm.
a = the proportion
9 This is the familiar Modigliani-Miller Proposition I. For a proof of this result see
Fama and Miller [5], pp. 160-164.
"'In a more general formulation Ej would have fixed and variable components with
the latter being a function of Li. The simpler formulation is utilized here to reduce the
computational burden.

The Journalof Risk and Imurance
594
Based on this arrangement,

E&H) - E(01)
02(;t^:1
U2(Bt)
1 +
- a)G
32cU2C)
+ aE(L; ) +
2aCO"
]l
i'i.i;
(8)
(9)
Note that the insurance premium contributes nothing to the variance of

the finndsincome stream; iLe, by purchasing complete insurance coverage
the firm can transferits entire pure risk to the insurer.
The presence of the covariance term reflects the fact that losses due
to pure risks give rise to indirect as well as direct costs. For example, a
business interruption due to a fire could result in a decline in future
revenues if some customersfail to returnwhen the firmresumesoperations.
The subsequentanalysisassumesthat all costs of pure risk can be subsumed
under Lj and, therefore, that Cov(tLJ
0.
Based on that assumption and equations (2), (6) and (7), the first
order condition for a maximum in the proportional retention case is
the following:
Oa2(j )
Li
(G~j- E(L;j) - EJ) - szpjm=_
(10)
Solving for a, one obtains:

(G1a-
Ei~ 1
a(j
)s ~
)Smm
(11)
Verbally, ty is directly related to the marginal reduction in expected loss

costs arising from an additional dollar of retention (i.e., to GjE(tj)
- En). (Note that retention is not feasible if this term is e 0. Furthermore, if a exceeds 1 the analysis suggests that the firm-should become an
insurer.) The value of a also bears a direct relationshipto the ratio of the
standarddeviation of the firm'sincome stream, ?(Vj), and the variance of
its loss cost distribution.Thus, the more significantthe pure risk in terms
of the total risk of the firm, the less of it the firm should retain. Finally, a
is inversely related to the product of the market price of risk and the correlationcoefficient;i.e., for a given Sma firmwhose returnsare more highly
correlatedwith those of the market should have a lower retention.
Aggregate Deductibles and Self Insurance Reserves
The foregoing model should be relevant for a number of risk management situations. For example, if a is close to 1, the model implies that
complete self insurance is in order. Furthermore,applying the loss unit

595
Risk Managenwnt
concept and making the assumptionthat loss units are independent, the
decision rule could be applied separately to the various pure risks facing
the firm. For instance, the computation may give one answer for the
workers' compensation risk and another for that of products liability.
Nevertheless, many risk management situations exist to which (11) does
not apply. If a is substantially less than 1 but greater than zero, for
example, the results have little practical meaning as quota share arrangements are rarely effected between non-insurancefirms and insurers. The
more common arrangement,of course, is the use of a deductible; and,
consequently, the model now will be adapted to apply to the deductible
selection decision.
AggregateDeductible Selection.The firstcase consideredis that in which
the firm is faced with the choice of an optimal aggregate deductible; i.e.,
a deductible under a contract in which the insurer agrees to pay all
losses in excess of a total annual amount, D. The retention of the firm
under such an arrangementis:
L
D; and
if
,t
Ji i
if
*D
AD
CL2)
a5- the losses retained by the insured.
,where
The relevant parameterscan be developed as follows:

+ DfdF(j)
JtdP(i)
H(t-)
(13)
D
-
N2R)
J dFti
) + D2JdP(%)
(14)
E2(R)
ID
Differentiationwith respect to D then yields (after some simplification):

ID
- F(D)
2[ 1 - F (D)]1[D -
3D
y~gj
Substituting these expressionsinto equation (2), the first-ordercondition

for a maximum,one obtains:
[1 - F(D)][D
3G
Oi)+
Sp

(17)
596
The left side of equation (17) is derived by recalling equation (6) and
noting that Cj in this case is equal to the insurancepremiumplus the losses
and administrativeexpenses retained under the aggregate deductible plan.
Althoughtheoreticallythe optimal deductible can be obtained by solving
expression (17) for D, a generalized explicit solution to the equation cannot easily be derived. Nevertheless, this version of the optimizationcondition suggests two important observations about the use of aggregate
deductibles. First, an increase in the aggregate deductible always increases
the variance of retained losses; i.e., aa2(i)/laD > o.
be verified, under the assumption that
This relationship can

D
> o and that i
>.
o, by
noting that
D
U(R
Jdh)
(t
+ D UPt
D
H(t
<
) + DfdF(?)
0
Thus , D
E(?~R) > 0 and,
D.
D
from (16),
aa2CR)/aD
>
0.
Second, it should be evident that a necessary (although not sufficient)

condition for the adoption of an aggregate deductible is that the left side
of equation (17) must be positive for some value of D. That term, of
course, represents the net marginal expected savings in loss costs arising
from the use of a deductible; i.e., the marginalpremiumreduction aGJ/aD
less the marginal increase in the expected retention, 1 - F(D). If the
expected increase in retained losses always is greater than the premium
reduction, the firm has no incentive to adopt a deductible. Likewise, if
the term is zero; i.e., if the premium is actuariallyfair at the margin, the
firmshould not adopt the deductible because it would be accepting a larger
variance with no offsetting increase in expected return. The condition is
not sufficientbecause a positive expected reduction in loss costs must be
large enough to offset the resulting increase in the variance, with the requisite relationshipbetween the two effects determinedby the parameters
of the capital asset pricing model.
The Optimal Level of Reserves. Another interesting case involves the
choice of an optimal buffer or reserve fund to accompanya retention program. In order to focus exclusively on this decision, the analysis is initially
conducted under the assumption that an optimal aggregate deductible
already has been selected and that, given that deductible, the firm wishes
to establish an optimal size reserve fund. The case in which the optimal
deductible and reserve fund are established simultaneouslyis considered
subsequently.

597
Risk Management
To solve the buffer fund problem it is useful to redefine Vj as follows:

t
A
Bj AdR RC) -
Gj (1 + Rj)
-Bj) Rj
(D -B;
Bj <
Rj
(18)
<D
>
Two additional variables have been introduced:

Rj = the rate of return on shares of firm j; and
Bj = the buffer or reserve fund for loss costs associated with pure risks.
Equation (18) is equivalentto that utilized to derive
the optimaldeductible
OV
#-%
(LJ-Bj)Rj, Bj < L < D
with the exceptionof 2 terms,Bj(Rj-Rf
) and{#
(D-Bj)Rj,
LiND
which are designed to represent the effect of reserves on the net revenues
of the firm. The former term appears in the equation with a negative
sign and represents the opportunity cost of holding reserve funds; i.e.,
if the firm maintainsreserves of Bj*, it sacrificesearnings of RjBj*, which
could be earned if those funds were invested in its production processes,
but earns instead the lower amount RfBj*, which represents the earnings
on the reserve fund invested in relatively liquid, risk free assets. The latter
term, on the other hand, represents the firm's sacrifice in earnings if
losses exceed the buffer fund. In that instance, the equation implies that
the firm loses its earnings for the entire year on funds paid out as losses.1'
That aspect of the equation constitutes a built-in penalty for failure
to maintain adequate reserves. That is the case because the equation
suggests that losses paid from reserve funds are paid at the end of the
year while loss payments in excess of reserve funds are made at the beginning of the year. To understand this point, note that for losses greater
than the reserves, lost interest is equal to Ri times the excess while the
buffer fund is assumed to earn interest at the risk free rate for the full
year. If losses less than the buffer fund were paid prior to the end of the
year, the firm could not be credited with the entire amount, BjRf. A more
nearly realistic version of the model might utilize the following cost element for the buffer fund case:
-
-(Bj - Lj) (Rf/ 2) , L'j <iB

- Band - Rf/2)
(Lj - B )(RJ/2),
B < Lj < D
>D
(D - B )(Rj/2),
"The losspayments
themselves
arereflected
in L1.

598
This expressionmakes the alternativeassumptionthat losses are paid, on

the average, midway through the year. Although such an expression is
more realistic than the one included in equation (18), the latter formulation has been utilized in the analysis. That decision was based on two
principal considerations. First, the desire to compare the results of the
present model with those obtained by Duvall and Allen [4], whose formulation is consistent with equation (18) and second, the difficultyof fully reflecting the consequencesto the firmof uninsuredlosses differentfrom those
expected, due to the abstract nature of the two period capital market
model. The assumption inherent in equation (18) helps to remove this
limitation as it exacts a more significant penalty for losses 'in excess of
reserves than the alternative expression.1 For the reader reluctant to
accept this assumption,the optimality conditions can easily be derived by
performing the appropriate computations under the alternative formulation. These results differmi detail but not in substancefrom those presented
below.
Before proceeding with the computations,it seems appropriateto reiterate that the optimization is carried out under the assumptionthat Rj
and D are fixed; i.e., the optimal buffer fund will be derived conditional
on those two variables. Taking expected values and differentiatingequation (18) with respect to Bj, one obtains (after some simplification):
0 )
3B
(j-
Rf) + RjEl - (Bj)J
(19)
This result is equivalent to that obtained by Duvall and Allen [4, p. 501]
if one assumes no taxes. As explained in their article, (Rj -Rf) represents
the opportunity cost to the firm of increasing reserves by $1, while the
latter term is the expected savings of the firm as a result of the additional
dollar of reserves.
To obtain the variance contributionof the buffer fund, note that when
Rj and D are fixed, the firstthree terms of equation (18) do not contribute
to the variance of Va. Differentiationwith respect to Bj of the variance
contributionof the last two terms yields
392B
Although these com-
putations are straightforward,they are cumbersome; and, accordingly,

are presented in an Appendix, which is available from the author. In the
Appendix it also is demonstratedthat aac2(Vj)/aBj < 0 for 0 < B, D
that, for a fixed deductible, the firm can reduce its variance through the
use of a reserve fund.
An intuitive rationale for this variance reduction is that earnings become more predictable as a result of the earmarkingof funds for the
12Thepenaltyprobably
whichan unexpected
dueto theliquidityproblems
Is realistic
lss couldpresent.

599
Risk Management
payment of unexpectedly large retained losses. This function of the

reserve fund becomes readily apparent when one thinks of a real-world
case in which a firm can cushion the impact on reported earnings of an
uninsured loss by drawing down its reserve fund. This increased stability
in earnings might be expected to give rise to a correspondingstabilization
in the price of the firm'sstock.
As one might anticipate, however, the use of a reserve fund generally
involves some sacrifice of expected return by the firm. This anticipation
is the case as (19), although positive for small Bj, is a monotonicallydecreasing function of that variable and can be expected to be negative for
a buffer fund of any substantial size. The implications of this result for
the selection of an optimal buffer fund can be given more precise form by
setting up the maximizationcondition [from (2) and (19)]:
Rf -
aa2(v )fas
=
RF(B)
SmPjm
mjin
(20)
2a(Vj)
Since au2(Vj)/aBj < 0, it is clear that if [Rf - RjF(B,)] is positive fox

all Bj -? D, the buffer fund should be set equal to the deductible. In that
case the use of the buffer fund would both increase expected return and
decrease the variance over the entire range of possible values of B,. In
view of the fact that [Rt - RjF(Bj)] may become negative for B, < D,
however, it seems appropriateto examine the most likely outcomes under
that condition. These are illustrated in Figures la and lb.
Rf
E (Vj)
Rf
iB
]
8
optimum
optimum
~~~I
[cr21t'1
~~~~~~~~f
Figure
E'(VY)
'a
Figure
lb
SELECTION OF AN OPTIMUM RESERVE FUND

FOR A PREDETERMINED DEDUCTIBLE
*V
In the figures, the curve E'(Vj), which represents [Rf - RjF(Bj)], is

equal to Rf when Bj =0, and then gradually declines, crossing the B,
axis for B, < D. The other curve f[Cr2'(V,) , which represents
aa2(0
SMP
)/aB
2a

600
is below the Bj axis for all Bj >0 and : D and is drawn with a minimum
for some Bj < D. As demonstratedin the Appendix available from the
author, the curve is unambiguouslynegative, but the U-shape portrayed
by the figures is only one possible outcome. It is possible for the curve
to be monotonically decreasing; but if so, outcomes similar to those
illustratedin Figures la and lb still would representthe only alternatives.
In Figure la, the value of the variance reduction resulting from the
use of the buffer fund always is greater in absolute value than E'(Vj).
In that case, the optimal solution would be at Bj = D. Figure lb illustrates
the more likely outcome; i.e., the two curves intersect yielding an optimal
reserve fund less than the deductible. In both cases, however, the optimal
buffer fund occurs when E'(MV) < 0. This finding indicates that expected
value decision making would result in a buffer fund of suboptimal size
as in that case the fund is chosen where E(VJ,) = .ys
Simultaneous Selection of Deductibles and Reserves. The preceding
analysis has developed optimizationconditionsfor an aggregate deductible
in the absence of a bufferfund and for a bufferfund given a predetermined
deductible. While those decision rules were useful in focusing attention
on the individual variables, theoretical precision requires that a more
general result be obtained which will permit the simultaneousselection of
optimal values for the decision variables,D and B,. To facilitate the analysis, it is helpful to express the problem as follows:
Maximize: Equation (1), with Vj given by (18)
Subject to: Bj ! D
Forming the Lagrangian,Z = P, - k(Bj - D), and taking partial derivatives, the necessary conditions for a maximumare obtained:
az
aZ
aD
DE (V
1
'
)fa
/aD
a (
S Q.
a
X 0
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~Jaa2c
i~)
1 + Rf 'D
9z
3Bj
3E(R
2a(
mjm
(B
aa2(~ i )/aB
Smf) 2M
X > 0;
B.
)
~~~~2a(~
- I) < 0;
) -
X *
A(B1 - D) - 0
(21)
(22)
(23)
Because the constraintis an inequality,the conditionsare obtained according to the Kuhn-Tuckerrules.

The term aE(V) is given by equation (19) and aa2(V)/9Bj is presented in the Appendix available from the author. However, the corresponding partial derivatives with respect to D are different from those
implied by equations (15) and (16) because those expressions did not
explicitly recognize Rj and because they were developed under the as2 Se Duval and Allen (41 p. 501.

601
Risk Managenent
sumption that no reserve fund would be used. With the introductionof

those factors, it can be shown that:
DFE(v)
an
and
G
a
(1 + R
_ a~:
-Z(9
2(1
- F(D)I(I
+ Rj)t1
(24
+ R)
dF(L)
F(D)]{jL
0
+ BjRF (j )
+ jL(1
+ Ri)dF(i)
B;
(1 + R; )DF-(D)}
(25)
Under the assumptionthat JdF(Ly * o and that the probability mass of

0
the distributionover the range 0 "I

it is easy to show that aa2()/9D
>
< Dis not all concentratedat Lj = D,

0.
Furthernore, when BA=O, expres-
sion (25) is equivalent to (16) with the explicit recognition of Ra. With
the introduction of a reserve fund,
aa2(t
)/aD
declines, and this decline
is uninterruptedfor O<B, e?D. That result can be verified by noting that

aZ;2(@)/aDBa - -2(1 + Rj)[1
- F(D)]RJF(B)
< O.
Thus, ceteris paribus the
use of a reserve fund permits the firm to adopt a larger deductible than
otherwise would be the case.
To obtain the optimal values for Bj and D, one would have to solve
equations (21) through (23) according to the Kuhn-Tuckermethod. Although a generalized explicit solution to this problem cannot easily be
derived, an interesting interpretationof equations (21) and (22) can be
obtained by eliminating A and rearrangingthe resulting equation to yield:
BE(B )
aD
aE&Y)
+
BB
s p
2a (
aa2(B )
aa2(' )
aD
)B
This equation implies that the total effect of the deductible program (i.e.,
the deductible itself and the reserve fund) on expected earnings must
be proportional to the impact of that program on the variation in the
firm's income stream. The proportionalityfactor varies directly with the
market price of risk and the correlation coefficient of the firm's returns
with those of the market and inversely with the standard deviation of
the firm's expected earnings. Thus, as in the proportionalretention case,
a more risky firm could be expected to opt for a higher degree of retention
than one with a more predictable distributionof returns.

602

Impact of Selected Assumptions
The preceding analysis of risk management decisions in the context of

the capital asset pricing model has been conducted subject to a number
of simplifying assumptions. Many of these are no more restrictive in the
risk management case than for other types of microeconomic analysis and
have not been analyzed further in this article on the ground that such
a discussion more properly belongs in an article on the capital asset pricing
model itself. However, two of the assumptions are particularly limiting in
the risk management case, and the purpose of this section is to determine
the effect of their relaxation on the risk management decision rules. The
two assumptions are: (1) that there are no taxes and (2) that the return
distributions are symmetric stable.
Taxes and Risk ManagementDecisions

The assumption about taxation is restrictive in the risk management
case because of the rules regarding taxation of casualty losses, insurance
premiums, and contributions to self insurance reserves. Although the tax
law in this area is complex, for theoretical purposes it is generally correct
to assume that the first two items are deductible while the third is not.
In other words, the tax law contains an apparent bias in favor of insurance
and against self insurance.
The tax rules can be incorporated into the model by dividing Bj in
equation (18) by (1 - t) where t is the corporate income tax rate. This
operation indicates that, when taxes are present, Bj/(1 - t) dollars (before
taxes) rather than Bj dollars are needed to set up a buffer fund of size
Be. Carrying out the optimization with that modification for the most
general case discussed above yields a decision rule equivalent to equation
(26) with terms analogous to equations (24), (25), 19, and V2(Jv) . As one
would expect, it can be shown that the introduction of taxes results both
in a smaller buffer fund and a lower deductible than in the no-tax case;
i.e., the tax law does appear to be biased in favor of insurance.
Decision Rules with Non-SymmetricDistributions

The significance of the symmetry assumption derives from the fact that
many loss distributions are known to be positively skewed.14 However,
this does not necessarily invalidate the results obtained above utilizing
the capital market model. That is the case as the model is based on
distributions of total return, which have generally been shown to be
symmetrical.15 Apparently, the risk management aspects of the typical
firm's operations combine with its other activities in such a way that the
total distribution retains the symmetry property. This observation, in
fact, is what the central limit theorem would lead one to expect for a
14
See, for example, the results obtained by Hartman and Siskin [9].
15 Fama and Miller [51, p. 260.

Risk Management
603
large firm with many (approximately) independent activities. Another

factor which may limit the impact of the skewness problem is that the
risk inherent in the large loss tails of loss distributionsusually is transferred by the firm to an insurancecompany.Thus, althoughthe distribution
of retained losses is not precisely symmetrical,most of the skewness effect
is no longer present. As a consequence of these factors, the foregoing
decision rules probably constitute a satisfactoryapproximationto the more
precise theoretical results which would be obtained if higher moments
of the loss distributions were considered.
In spite of the foregoing considerations,optimizationrules are developed
below which recognize the fact that loss distributionsare not symmetrical.
These rules are presented for two major reasons. First, it is possible that
for some firms the insurance capacity crisis, the general trend toward self
insurance,and the changing economic and legal environment will cause
risk management decisions to play an increasingly important role in the
determinationof net income. Thus, distributionsof returnsfor those firms
may in the future acquire a more pronounceddegree of (negative) skewness. An industry in which such a trend may be present is the drug industry, which is beset by burgeoning products liability problems. The
second reason for the development of a more general set of decision rules
is to provide an indication of the nature of the precise optimumconditions
in the risk managementcase. This precision is desired on the ground that
one should fall back on the central limit theorem only as a last resort and
that even then it would be helpful to know the extent to which meanvariance analysis leads to a departure from the exact result.
When the symmetry assumption is removed, the effect on the capital
asset pricing model is significant. If one is no longer willing to assume
symmetry,one can no longer summarize distributionsof return in terms
of their means and variances (assuming, of course, that utility functions
depend on more than the first two moments of the return distributions).
Thus, mean-varianceefficiencyceases to be a useful concept, the advantage
derived from the assumption of risk free borrowing and lending is lost,
and utility functions must be introduced explicitly into the optimization
problem.
Unfortunately,the introduction of utility functions gives rise to other
fundamental issues. For example, not immediately apparent is whose
utility function should be introduced. Consistency with the capital asset
pricing model requires that the function be that of an investor, but more
than one investor generally holds shares in a firm and interpersonalutility
comparisons usually are not acceptable.
Recent developments in the theory of finance may offer a possible solution to this dilemma. Friend and Blume [7] have shown that the relative
risk aversion coefficient of an individual investor can be approximatedby
the following function: 16
16 See Friend and Blume [7], p. 10. Risk aversion coefficients are discussed in Arrow
(2] and Pratt [141.

604
11+1
Ck
where
C - the harmonic mean of the Ck, and

ek - a disturbance
term with zero mean.
In other words, a reasonableassumptionis that in terms of expected values

a constant relative risk aversion coefficient for the entire securities market can be developed. Thus, to utilize a utility function for the entire
market in lieu of one or a series of individual investors'utility functions
may be acceptable.'7 This procedure is equivalent to assuming that the
market, through the actions of a large number of individual investors,
arrives at a ranking of probability distributionsof return on risky assets
which possesses the properties required by the axioms underlying utility
theory.
The use of a marketutility function would retain a key advantageof the
more restrictiveform of the capital asset pricing model; i.e., decision rules
could be developed and applied without constructing individual or corporate utility functions. As the use of the marketindex involves a number
of complex problems, however, that development has been consigned
to a future research project. This paper follows instead the more conventional approach of adopting the utility function of the firm'smanagers
as the appropriate index.
When the model is couched in termsof utility analysis,the basic optimization rule becomes:
Maximize:
where
EMU(O)]
t-
U(-)
he Period
- the utility
of Period
F(')
fU(j)dF(j)
(28)
2 value
of the firm;
function
1; and
of Period
- the distribution
function
2 value
at the beginning
of Period 2 value of the firm.
Expression (28) indicates that the objective of the firm is to maximize

the expected Period 1 utility of its Period 2 marketvalue. This objective is
analogous to the capital market model objective of maximizationof the
risk adjusted expected Period 1 value of the firm. One should recognize
that the discountingprocess is now implicit in the utility function although
that operation generally will be ignored in the examples presented below.
To utilize expression (28) to derive risk management decision rules, the
first step is to substitute equation (6) or equation (18) for Va. Then
the first order conditionsfor a maximumare obtained by setting the appropriate derivatives equal to zero. As the risk managementmaximizationis
"IThe foregoingconclusionis that of the authorand not of Friendand Blume.

Risk Management
605
conditional on the other stochastic variables which affect the firm and
because those variables have been assumed to be independent of total
losses, the expected value operationcan be carried out with respect to the
marginal distributionof total losses rather than the complete distribution
of Vs. For the simplest case, proportionalretention,the general rule would
be:
..L...
)(G- -L
f
-U'(V
act
ij
- E )d(L )
(29)
iJ
where Vj is defined by equations (6) and (7). By solving that equation

for a one would obtain the optimal level of proportionalretention.
For the aggregate deductible-bufferfund version of the model, the optimization problem is:
Maximize: EEU(J)
Subject
(30)
BJ < D
to:
~~~D
By
where
E[U(Y:)]
) +
RJ(Yi)dH(?
+ JU(V3J)dF(tJ);
I)
- G (1 + R;) - BJ(RJ - Rf) -
V2:m V1J
V3
fU(V2j)dF(j)
to
(i
- B
)Rj;
J;
and
+ Ad - D - (D - BJ)RJ.
The maximizationwould be carried out according to the Kuhn-Tucker

conditions with the solution of the resulting equations giving optimal
values for Bj and D.
In order to provide an illustration of the nature of the decision rules
generated by the utility model, the maximizationproblem is solved below
for the proportional retention case under the assumptions that losses
follow a gamma distribution and that the utility function of the firm is
exponential. The use of an exponential utility function implies that the
firm's absolute risk aversion coefficient is constant and that its relative
risk aversion is increasing. These properties mean that the firm would
have the same tendency to insure a potential source of loss of a given size
regardless of its wealth and that if the magnitude of the insurable loss
and the firm'swealth increased proportionallyit would be more likely to
insure after than before the increase. While one may quarrel with the

The Journalof Riskand Insurance
606
reasonablenessof these properties, it is importantto recall that risk management decisions have only a marginalimpact on the wealth of the firm.
Thus, for a given firm at a particulartime, constant absolute risk aversion
probably does not constitute a serious departurefrom reality while relative
risk aversion properties are not especially relevant. If one is unwilling to
accept this reasoning,however, other functions are available which possess
more acceptable properties.'8
With gamma distributed losses and exponentialutility, the proportional
retention problem becomes:
Maximize:
y (C
E[U()]
- Cej)
(r?)r.eL
ie
(31)
where
the absolute risk aversion parameter,and

A, r = parametersof the gamma distributionof losses.
r--
The integration easily is accomplished by recognizing that the first term

inside the integral integrates to C while the second can be written as
-Ce--v multiplied by the moment generatingfunction of the gammadistribution, where V
Vt
(lc)G1
and the parameter of the mo-
cEj
ment generatingfunction is ya. Thus, one can write:

E[U(6'j
)J
C - Ce Y(V)(l
Differentiationwith respect to
BE1U( )]
|- .-Cey(v.
- Xa)-r
A)
yields:
) (-Y) G
-Bej(V)(.r(l
(32)
E)
(3:3)
Y;frl(
The optimal solution for a then becomes:

C1=
a y(;
Y
(34)
This condition indicates that the level of retention varies inversely

with the degree of risk aversion displayed by the firm, a result which is
both reasonable and consistent with intuitive expectations. Not so intuitively apparent is the reason that a varies inversely with (Gj - Ej). The
rationale for this relationship becomes clearer when one recalls that
retention is feasible only when Gj > E ( Lj) + Ej. Thus, the relationship
between Gj and Ej is reflectiveof the relative significanceof the stochastic
and non-stochastic portions of the total cost of the retention program.
18 For example, the log utility
function exhibits constant relative and decreasing
absolute risk aversion. See Pratt [14].

Risk Management
607
Consequently,if Ej increases relative to the total, one can say in an intuitive sense that the riskiness of the retention program declines and that a
can be set at a higher level.
Empirical Comsiderations
The preceding analysis has integrated risk management variables into
the theory of capital market equilibrium. The resulting decision rules
indicate that the firm must consider more than expected values when
developing its program for dealing with pure risk. As a theoretical construct, the model should be useful in focusing attention on the relationships between expected costs, risk, and other parametersinvolved in risk
retentionprograms. However, there appearsto be reason to doubt its practical applicability.
One problem is the abstract nature of the model and the number of
simplifying assumptions employed. Thus, the decision rules may be too
simplistic and may ignore too much relevant information for real-world
application.A second problem is that, due to the magnitude of the market
parameters and other variables appearing in the model, most of the
decision rules may reduce for practical purposes to expected value criteria.
An interesting possibility for future researchwould be to test this contention through the use of real-worlddata. However, even if practical application is not feasible, many of the foregoing relationshipsstill can be useful
for organizingand analyzing risk managementdata. Furthermore,the construction and use of utility functions appears to offer significantpotential
for practical applications.
Summary and Conclusions
In this article the capital asset pricing model of the theory of finance
has been adapted and applied to the development of risk management
decision rules. The fundamental concept underlying the analysis is that
when considering a retention program, a firm must recognize not only
the savings in expected loss costs but also the increase in risk accompanying such a program. The model reveals that the firm should increase its
retention to the point at which the marginal rate of substitutionbetween
expected return and risk is equal to the market price of risk multiplied
by the correlationcoefficient between the firm'sreturns and those of the
market. This rule was applied more specifically for the cases of proportional retention and of aggregate deductible selection. The latter problem
was solved both with and without the use of a reserve fund.
The optimization rules reveal that the degree of proportionalretention
is inversely related to the ratio of the varianceof the firm'sloss distribution
and its standard deviation of total return. When an aggregate deductible
is adopted, the use of a reserve fund results in a decrease in the variance
attributable to the deductible. The recognition of this negative variance
contributionimplies that the optimal reserve fund should be chosen where

608
< 0,
suggesting that expected value decision making leads to
2,j
a reserve fund of suboptimal size.

The decision rules based on the capital asset pricing model can be
rendered more realistic by introducing taxation and by recognizing that
loss distributions are rarely symmetrical. When taxes are introduced, it
can be demonstrated that the optimal solution implies lower values for
both the aggregate deductible and the reserve fund. The relaxation of
the symmetry assumption necessitates the adoption of utility functions.
Although the capital asset pricing model decision rules probably have
limited empirical applicability, utility analysis represents a potentially
fruitful alternative for those who wish to avoid exclusive reliance on expected values in practical situations.
REFERENCES
1. Allen, Tom C. and Duvall, RichardM. A Theoreticaland PracticalApproach
to Risk Management. New York: American Society of Insurance Management, 1971.
2. Arrow, Kenneth J. Essays On the Theory of Risk Bearing. Chicago: Markham Publishing Company, 1971.
3. Borch, Karl. The Mathematical Theory of Insurance. Lexington, Mass.:
Lexington Books, D. C. Heath and Company, 1974.
4. Duvall, Richard M. and Allen Tom C. "Least Cost Deductible Decisions."
Journalof Risk and Insurance40, no. 4 (December 1973): 497-507.
5. Fama, Eugene F. and Miller, Merton H. The Theory of Finance. Hinsdale,
Ill.: Dryden Press, 1972.
6. Feller, William. An Introductionto ProbabilityTheory and Its Applications.
Vol. 2. 2nd ed. New York:JohnWiley & Sons, 1971.
7. Friend, Irwin and Blume, Marshall E. "The Demand for Risky Assets."
Working Paper No. 1-74a. Philadelphia: Rodney L. White Center for
Financial Research, Wharton School,, University of Pennsylvania, 1974.
8. Head, George L. "A Capital Budgeting Approach to Risk Management
Decisions." Paper presented at the AmericanRisk and InsuranceAssociation
Annual Meeting, White Sulphur Springs, West Virginia, August 27, 1974.
9. Hartman, Gerald R. and Siskin, Bernard R. "Actuarial Analysis of 'A'
Corporation's Losses: 1943-1969." Unpublished research paper, Temple
University, 1974.
10. Mehr, Robert I. and Forbes, Stephens W. "The Risk ManagementDecision
in the Total Business Setting." Journal of Risk and Insurance 40, no. 3
(September 1973): 389-401.
11. Mortimer, Thomas J. "A Stochastic Computer Simulation Model to Assist
in the Evaluation of Various Risk Financing Methods for Workmen'sCompensation Insurance."M. S. Thesis, University of Pennsylvania, 1974.
12. Mossin, Jan. Theory of Financial Markets.Englewood Cliffs, N.J.; PrenticeHall, 1973.
13. Neter, John and Williams C. Arthur,Jr. "Acceptabilityof Three Normative
Methods in Insurance Decision Making."Journalof Risk and Insurance38,
no. 3 (September 1971): 385-408.

Risk Management
609
14. Pratt, John W. "RiskAversionIn the Small and In the Large."Econometrica

32, no. 1 (January 1964): 122-136.
15. Schramm, Richard and Sherman, Roger. "ProfitRisk Management and the
Theory of the Firm." Southern Economic Journal40, no. 3 (January1974):
353-363.
16. Shpilberg, David and de Neufville, Richard. "Use of Decision Analaysis
for Optimizing Choice of Fire Protection and Insurance."Journal of Risk
and Insurance42, no. 1 (March 1975): 133-149.
17. Tsiang, S. C. "The Rationale of the Mean-StandardDeviation Analysis,
Skewness Preference, and the Demand for Money," American Economic
Review 62, no. 3 (June 1972): 354-371.


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Risk Management and the Theory of the Firm

Author(s): J. David Cummins

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Risk Management and the Theory of the Firm

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The Journal of Risk and Insurance

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value at the beginning of Period 2 determines the level of consumptions c2"

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The Journal of Risk and Insurance

tions lead to market equilibrium conditions in which individual utility

P - the equilibrium market value

of the firm at the beginning

-'the market value at the beginning

of the jth firm at the beginning

of Period 2 of the market

The placement of a tilde over a symbol indicates that it represents a

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limits its mean and variance of return. In particular,the assumption that

where D standsfor the retentionof the insured

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The Journal of Risk and Insurance

When written as (2)', the first order condition for a maximumcan be

# k, equation (4) reduces to:

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Readers concerned about the assumption that

By focusing on the componentsof Cj, it is then possible to establish some

G - the insurance premiumwhich the firm would be charged for

the pureriskof the firmif all losses

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The Journalof Risk and Imurance

Based on this arrangement,

Note that the insurance premium contributes nothing to the variance of

(G~j- E(L;j) - EJ) - szpjm=_

Solving for a, one obtains:

Verbally, ty is directly related to the marginal reduction in expected loss

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a5- the losses retained by the insured.

The relevant parameterscan be developed as follows:

Differentiationwith respect to D then yields (after some simplification):

Substituting these expressionsinto equation (2), the first-ordercondition

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The Journal of Risk and Insurance

be verified, under the assumption that

This relationship can

> o and that i

E(?~R) > 0 and,

Second, it should be evident that a necessary (although not sufficient)

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To solve the buffer fund problem it is useful to redefine Vj as follows:

Two additional variables have been introduced:

with the exceptionof 2 terms,Bj(Rj-Rf

-(Bj - Lj) (Rf/ 2) , L'j <iB

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The Journal of Risk and Insurance

This expressionmakes the alternativeassumptionthat losses are paid, on

Rf) + RjEl - (Bj)J

Although these com-

putations are straightforward,they are cumbersome; and, accordingly,

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payment of unexpectedly large retained losses. This function of the

Since au2(Vj)/aBj < 0, it is clear that if [Rf - RjF(B,)] is positive fox