Chapter 9

Risk Aversion and Risk Management by Individuals and Corporations

McGraw-Hill/Irwin
Copyright 2004 by the McGraw-Hill Companies, Inc. All rights reserved.

Demand for Insurance by Individuals

Why do individuals take actions to reduce risk?

Simple answer: they are risk averse

Risk aversion ==> prefer certain outcome to an uncertain outcome with the same expected value
Examine risk aversion in more detail

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The Effects of Insurance on Wealth

Begin by examining the effects of insurance on a persons wealth Example:

Wealth without insurance = $80,000 or $100,000 with equal probability
i.e., there is a 0.5 chance of a $20,000 loss for a person with $100,000

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The Effects of Insurance on Wealth

Wealth with no insurance
Wealth
$80,000 $100,000

Wealth with $10,000 of coverage for a premium of $5,000?

Wealth

$80,000

$100,000

Wealth with $20,000 of coverage for a premium of $10,000

Wealth
$80,000
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$100,000
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The Effects of Insurance on Wealth

Important Point:
Insurance reduces wealth if a loss does not occur Insurance increases wealth if a loss does occur

Useful perspective when thinking about insurance purchases:

do I want to give up some wealth when a loss does not occur so that I will receive additional wealth when a loss does occur?

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Risk Aversion
A risk averse person prefers a certain amount of wealth to a risky situation with the same expected wealth
Example:
Would you accept a 50-50 chance of winning $1,000 or losing $1,000? The gamble does not change a persons expected wealth, but it makes the persons wealth uncertain A risk-averse person therefore would choose not to accept the gamble
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Risk Aversion
By not accepting the gamble, you are saying that the possible loss of $1,000 hurts more than the possible gain of $1,000 benefits you This is the essence of risk aversion:
A loss of $X hurts more than a gain of $X benefits you The loss hurts more than the gain benefits you because money means more to you when you have less of it

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Risk Aversion
A risk averse person would require compensation (called a risk premium) before accepting the gamble in this example
change the odds (e.g., 60% chance of winning) change the payoffs (e.g., win $1,400, lose $1,000) The additional expected wealth ($200) needed to induce a risk averse person to accept the gamble is the premium required to compensate the person for the risk

A risk neutral person would not require a risk premium to accept this gamble; a risk neutral person only cares about expected wealth
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Risk Aversion

A risk averse person would be willing to pay more than the expected loss to reduce risk Example:
2% chance of losing $10,000 Expected loss = $200 A risk averse person would pay more than $200 to eliminate the risk

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Risk Aversion

Most people behave as if they are risk aversion

they pay positive loadings for insurance they require additional expected return to invest in riskier securities

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Factors Affecting the Demand for Insurance

Premium Loadings As loading increases, quantity of insurance purchased generally falls Income and Wealth
More wealth is usually associated with more assets to lose and therefore more insurance coverage Limited resources may prevent people from purchasing insurance Degree of risk aversion may decline as wealth increases Limited liability may cause poor people to buy less liability insurance coverage
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Factors Affecting the Demand for Insurance

Information
Individuals perception of loading Underestimate the true risk ==> buy less insurance Overestimate the true risk ==> buy more insurance

Other Sources of Indemnity

If others (e.g., society or family) will pay uninsured loss, buy less coverage

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Factors Affecting the Demand for Insurance

Nonmonetary Losses
Examples:
pain and suffering loss of heirloom loss of consortium

Demand for insurance against nonmonetary losses differs from demand for insurance against monetary losses

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Factors Affecting the Demand for Insurance

Why do people buy insurance against monetary losses?

because insurance gives them money when it means the most to them, i.e., when they have less of it (following a loss) This logic does not necessarily apply to nonmonetary losses

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Factors Affecting the Demand for Insurance

Money does not necessarily mean more following a nonmonetary loss; indeed, the opposite could hold
Example: loss of child Many people would prefer to have more money when the child is alive than when the child is dead

Thus, many people would not demand insurance against nonmonetary losses even if there were no premium loading

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Business Risk Management

Main Points:
Shareholder diversification reduces risk Shareholder diversification potentially substitutes for corporate risk management
Why should corporations reduce risk when shareholders are diversified?

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Why Do Corporations Manage Risk?

Some businesses are closely held

owners are not diversified

Insurers provide services at lower costs than they can be purchased elsewhere
loss control claims processing

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Why Do Corporations Manage Risk?

Insurance might be the lowest cost method of financing losses Alternative methods of paying losses
insurance internal funds raise new funds For firms without sufficient internal funds, insurance premium loading can be lower than the expected cost of raising new funds following a loss
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Why Do Corporations Manage Risk?

Insurance might reduce expected financing costs for new investment projects Paying losses from internal funds increases the likelihood that new funds will have to be raised to finance new investment projects Cost of raising new funds
lowers value of new projects may pass up some good projects

Purchase insurance to avoid these scenarios

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Why Do Corporations Manage Risk?

Reduce the likelihood of financial distress

Bankruptcy is costly to shareholders (must pay accountants, lawyers, etc) Reducing risk reduces likelihood of incurring these direct bankruptcy costs

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Why Do Corporations Manage Risk?

Reduce the likelihood of financial distress Bankruptcy is costly to other claimants (e.g., employees, lenders, suppliers, customers) These claimants require compensation for this risk (e.g., higher wages, higher lending rates) Shareholders can reduce costs by lowering likelihood of bankruptcy

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Why Do Corporations Manage Risk?

Reducing risk lowers expected tax payments for several reasons:

discussed in greater detail in Chapter 21

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