Insurance 811: Insurance

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Insurance 811 Insurance

• Neil Doherty

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We showed that hedging can eliminating costs of
risk. Now compare hedging with other post-loss
financing strategies

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An Illustration of Hedging

• The following is relevant and summarized
  financial data for NEW DRUGS
• Productive capital, replacement cost 10 billion
  yields expected EBIT of 2 billion per year
• Current Debt is 5 billion _at_ 7 (treat as
  perpetuity) thus annual interest is 350m
• Shares outstanding 300 m. - Current cost of
  equity 11
• Tax rate 34
• New Drugs has a RD program and a history of
  successful innovation. Investors estimate the
  value of future investment opportunities as
  equivalent of 15 per share (note that we could
  have presented this as a growth opportunity
  i.e., net earnings are expected to grow at an
  annual rate of x). To avail itself of these
  investment opportunities, the firm must be able
  to raise and commit new capital. Using crowding
  out reasoning, it is estimated that some of
  these opportunities may be lost if there are
  large uninsured losses and the premium investors
  are willing to pay may fall below 15 per share.

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VALUE OF NEW DRUGS WITHOUT LOSS

• Without thinking about the possible loss, the
  firm is valued as shown. Note that
• Note the leverage of the firm
• WITH FUTURE GROWTH D/E 5/14.4 0.345
• WITHOUT FUTURE GROWTH D/E 5/9.9 0.505
• We now look at how ACTUAL losses will affect value

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New Drugs Insurance Strategy

• Work Backwards backwards induction
• If event destroyed assets, would New Drugs wish
  to reinvest (is there a post-loss investment
  opportunity?)
• If so, should it be funded with post-loss funding
  (here debt) or pre-loss funding (insurance)
• First look at post-loss investment decisions
• Then anticipate potential losses and compare
• Insurance
• Planned use of post-loss debt (or equity) if loss
  occurs
• Winner is the option with the highest share price
  NOW

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NEW DRUGSValuation After Three Loss Scenarios

• The three scenarios differ in two dimensions.
  Losses of different relative size are examined
  and these will be compared with and without
  reinvestment. The three scenarios are
• (1) A fire destroys 100 million of productive
  assets (1 of the total 10 billion assets
  value).
• The assets are replaced and financed with debt
  at 8.
• Cost of equity increases to 11.03 because of
  increased leverage
• (2) Fire destroys 1 billion of productive assets
  (10 of productive assets).
• Replaced and financed with debt at 8.
• Cost of equity increases to 11.5 because of
  increased leverage
• (3) Fire destroys 1 billion of productive assets
  (10 of productive assets).
• Destroyed assets are not replaced - result
  loss of 10 of EBIT.
• Cost of equity increases to 11.5 because of
  increased leverage

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LOSS OF 100 M ASSET ASSET REPLACED FUNDED W/
DEBT

• ASSUMPTIONS
• If asset replaced, EBIT restores to pre-loss
  level. No permanent business interruption.
• Asset can be replaced with 100 m debt at 8
  interest
• Resulting leverage increases cost of equity to
  11.03
• Increase in leverage with intensify agency
  problems in future. How will this affect future
  growth opportunities? Assume no material effect
  i.e. still worth 15 per share

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LOSS OF 1,000 m ASSET ASSET REPLACED FUNDED W/
DEBT

• ASSUMPTIONS
• If asset replaced, EBIT restores to pre-loss
  level. No permanent business interruption. This
  assumption is SHAKY with such a big loss.
• Asset can be replaced with 1,000 m debt at 8
  interest
• Resulting leverage increases cost of equity to
  11.5
• Increase in leverage with intensify agency
  problems in future. This might materially affect
  future growth opportunities

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LOSS OF 1,000 m ASSET ASSET NOT REPLACED

• ASSUMPTIONS
• Lost asset represented 10 of capital. Assume 10
  of EBIT is also. In general need not be
  proportional
• Leverage increases because of loss of equity with
  existing debt. Cost of equity increases to 11.03
• Increase in leverage with intensify agency
  problems in future. This might materially affect
  future growth opportunities

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Which post-loss strategy?

• If 1 bn loss arises, better to replace. Note
  investment of 1 bn increases EBIT by 0.2 bn per
  year (20 pretax ROR) plus any change in growth
  premium.
• Compare this with cost of capital
• Given that replacement of destroyed asset is
  efficient consider how it will be funded
• Insurance
• Post-loss debt
• Other (not in this example)
• Look at decision to buy insurance for the coming
  year. Not concerned with insurance for subsequent
  years. That is later decision

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Pre-loss financing-Insurance

• Expected loss of assets E(L) 50 million per
  year
• Insurance premium 60 m (note 20 markup on
  expected loss)
• 60 (1 - .34) 39.6 after tax
• OR Losses can be funded with post loss debt at 8
  interest.
• Will New Drugs have higher share price NOW if
• a. it buys insurance
• b. plans to fund losses as they occur with
  post-loss debt
• Note that we are deciding now insuring against
  this years loss. We are not deciding on
  insurance for future years.

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TABLE 3. INSURANCE VERSUS POSTLOSS DEBT FINANCING