Insurance and Risk Finance 640

1
Insurance and RiskFinance 640

• Class 17
• November 22, 2004

2
Review of the Effects of Insurance on Expected
Cash Flows

• Description Effect on Expected Cash Flows
• Pay loading Decrease
• Decrease cost of obtaining services Increase
• Decrease likelihood of having to raise
• new funds Increase
• Decrease likelihood of financial
  distress Increase
• Decrease expected tax payments Increase
• (examined in Ch. 10)
  

3
The Basic Valuation Model

• Valuation Model
• Value PV(expected cash flows)
• Value
• where r opportunity cost of capital
• Key Issues
• How does risk management affect
• Expected Cash Flows?
• Opportunity cost of capital ?

4
Does Insurance Affect the Cost of Capital?

• Insurance generally reduces diversifiable risk
• gt Insurance generally will not affect the
  opportunity cost of capital

5
Risk Retention/Reduction Decisions

• Benefits of increased retention
• Save on premium loadings and transaction costs
• Reduce exposure to insurance market volatility
• Demand for insurance by individual firms is often
  inelastic in the short run (comparatively
  unresponsive to price changes)
• Arranging alternative financing, accumulating
  internal funds or forming a captive takes time.
• Even though the major purpose of insurance is to
  reduce uncertainty in cash flows, the volatility
  of insurance prices exposes a firm to
  uncertainty.

6
Benefits of Increased Retention(cont.)

• Reduce moral hazard
• Insurance contractual provisions, such as
  deductibles and coinsurance, are designed to
  reduce moral hazard.
• However, when moral hazard is more of a potential
  problem, these provisions mat not be totally
  effective.
• Therefore, firms will often retain more risk to
  better manage moral hazard.
• Avoid high premiums caused by asymmetric
  information
• Avoid implicit taxes due to insurance price
  regulation
• Which arise from higher premiums needed to
  subsidize residual markets

7
Factors Affecting Costs of Increased Retention

• Ownership structure
• Closely held versus publicly traded firms with
  widely held stock
• Owners of closely held firms have an incentive to
  retain less risk
• Managers who own large amount of stock will also
  be motivated to purchase more insurance
• Firm size
• Larger firms tend to have a large number of
  exposures
• Can capitalize on the law of large numbers, if
  the losses are independent.
• Result can be a reduction in the variability of
  the average expected loss, thereby emulating a
  major benefit of insurance
• Larger firms also generally produce larger
  internal cash flows
• Or, they are able to raise external capital more
  economically than smaller firms
• This position them to finance losses internally
  rather than through insurance

8
Factors Affecting Costs of Increased Retention

• Correlation of Losses
• However, positive correlation among losses can
  reduce the extent to which the firm can diversify
  internally
• Positive correlation increases the demand for
  insurance
• Investment opportunities
• Firms with good investment opportunities need
  internal funds to finance those projects
• These firms will more likely reduce risk through
  insurance so as not to be forced to miss
  attractive opportunities
• Examples
• Firms in growth industries
• Firms that required continual investment in
  research and development

9
Factors Affecting Costs of Increased Retention

• Product characteristics
• Firms providing a product, which may require
  future service or involves the promise to perform
  in the future, tend to purchase more insurance
  than other firms
• Consumers, perceptions about the firms
  probability of bankruptcy affect their purchase
  decision regarding such products
• Examples of products subject to this
  consideration
• Consumer durables
• Automobiles
• Electronic equipment
• Financial services
• Insurance
• Banking

10
Factors Affecting Costs of Increased Retention

• Correlation of losses with other cash flows
• Positive correlation of losses with cash flow
  provides a natural hedge.
• When losses tend to be high, other cash flows are
  also high
• This reduces the risk of financial distress and
  the need for external funds
• Example of positive correlation
• Firm having more workplace injuries during times
  of peak demand for its products

11
Factors Affecting Costs of Increased Retention

• Correlation of losses with investment
  opportunities
• Hedging example of negative correlation
• Firms in oil industry
• Decline in oil prices reduces the return on new
  investment in exploration
• Following an oil price decline, oil firms tend to
  invest less money in exploration.
• They also have less need to hedge the risk of
  lower prices
• Financial leverage
• Firms with higher debt to equity ratio have a
  higher likelihood of financial distress
• Because of this, firms with higher leverage place
  a value on risk reduction and tend to purchase
  more insurance

12
Concept Check 1, P. 488

• Other factors held constant, which type of firm
  would be more likely to fully retain
  (self-insure) its workers compensation losses?
• A firm with an individual who owns 50 of the
  stock versus a firm in which no shareholder owns
  more than 1.
• A trucking firm with 5,000 drivers versus a
  manufacturing firm with 5,000 workers in a single
  plant.
• A firm with operating profits positively
  correlated with claims costs versus a firm with
  operating costs uncorrelated with claims costs.
• A firm with a large amount of debt in its capital
  structure versus a firm with no debt.

13
Evidence on Risk Reduction Decisions

• Evidence on insurance companies use of
  reinsurance
• Smaller insurers use more reinsurance
• Insurers with undiversified owners use more
  reinsurance
• Evidence on use of derivatives by industrial
  firms
• Larger firms are more likely to use derivatives
• (due to fixed costs of hedging)
• Firms with greater RD expenditures are more
  likely to use derivatives (Merck example)

14
Basic Guideline for Retention

• Retain reasonably predictable loss exposures and
  reduce risk of potentially large, disruptive loss
  exposures
• Not always applicable e.g., British Petroleum
  case

15
Evidence on Risk Reduction Decisions

• Evidence on gold mining companies hedging of gold
  price risk
• Firms with high managerial stock ownership are
  more likely to hedge
• Evidence on oil gas producers
• Firms are more likely to hedge as financial
  leverage increases

16
What Should be Hedged?

• What should a firm focus on when making risk
  reduction decisions?
• Some alternatives choices
• Aggregated approach (hedge some aggregate measure
  of firm performance)
• Example hedge earnings or cash flows or firm
  value
• Disaggregated approach (hedge individual risk
  exposures separately)
• Example hedge property losses, workers comp
  losses, liability losses, losses from interest
  rate movements, and losses from commodity price
  movements.

17
What does the Theory Say to Hedge?
18
Disaggregated vs. Aggregated Approach

• Even if a firm wants to hedge some aggregate
  performance measure (e.g., earnings), it can do
  so by hedging all the individual sources of risk
  that influence earnings.
• What are the advantages disadvantages of such a
  disaggregated approach?
• Consider transaction costs
• Consider moral hazard

19
Transaction Costs

• Aggregated approach ? Bundle multiple risk
  exposures into one contract
• Disaggregated approach ? hedge each exposure with
  a separate contract
• 1st point if there are fixed costs per contract,
  then disaggregated approach might be more costly
• 2nd point disaggregated approach will result in
  unnecessary coverage, which increases costs that
  are proportional to the amount of coverage
• 3rd point dissagregated approach is more
  complex, which can make it more costly to supply

20
Unnecessary Coverage Argument

• Illustrate unnecessary coverage with
  disaggregated approach with an example
• Two exposures Property Loss
• Liability Loss
• Firm does not want total loss to exceed 40
  million
• Option 1 Purchase coverage on each loss with a
• deductible of 20 million
• Option 2 Purchase coverage on total loss with a
• deductible of 40 million

21
Unnecessary Coverage (cont.)

• Liability Loss
• 50 million with a probability of 0.02
• 25 million with a probability of 0.04
• 0 with a probability of 0.94 million
• Property loss
• 50 million with a probability of 0.02
• 25 million with a probability of 0.04
• 0 with a probability of 0.94 million

22
Option 1

• Purchase coverage on each loss with a deductible
  of 20 million
• Expected claim cost on each policy would be
• (50 million 20 million) x 0.02 (25 million
  20 million) x 0.04
• 30 million x 0.02 5 million x 0.04 800,000
  on each policy
• Total expected claims costs for 2 policies 1.6
  million
• Loading 20 320,000
• Total premium 1,920,000

23
Option 1 With Separate Policies , Insurer pays
all losses in excess of 20 million for each
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Option 2

• Purchase one policy that would pay aggregate (sum
  of property and liability) losses in excess of
  40 million
• Expected claim cost for the bundled policy
• .472 million
• See following chart
• Loading 20 x .472 million
• 94,400
• Versus 320,000 for 2 separate policies
• Total premium 566,400
• Versus 1,920,000 for two polices

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Option 2 With Bundled Policy , Insurer pays
aggregate losses in excess of 40 million
26
Unnecessary Coverage Argument
27
Unnecessary Coverage Argument

• Option 1 provides coverage that is not needed.
• Since transaction costs (loadings) are
  proportional to coverage, Option 1 might be more
  costly than Option 2.

28
Complexity Problem

• Pricing a policy that covers multiple sources of
  risk is more complex
• It requires expertise in a variety of fields
• It requires knowledge of correlation across loss
  exposures
• It requires modeling skills
• Implications
• Administrative costs might be higher
• There will be fewer suppliers and less
  competition (potentially higher costs)

29
Moral Hazard Problem

• Once one loss triggers coverage, incentive to
  reduce losses from other sources is reduced
• Implication
• Even policies that cover multiple sources of risk
  will have per occurrence deductibles and per
  occurrence limits

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Chapter 23

• Commercial Insurance Contracts

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Major Types of Commercial Insurance

• First-party coverage for property damage and loss
  of income
• Liability and related coverage for injury to
  third-parties
• Multiple peril contracts (cover property and
  liability exposures in a single contract)
• Surety bonds and financial guarantees
• Performance guarantees
• Surety / guarantor has recourse against principal

32
Comparison of Insurance and Surety Bonds

• Two parties to an insurance contract.
• The insurer expects to pay losses. The premium
  reflects the loss that will be paid.
• The insurer normally does not have the right to
  recover a loss payment from the insured.
• Insurance is designed to cover losses that
  ideally are outside of the insureds control

• There are three parties to a surety bond.
• Principal the party that owes the performance
• Obligee the party to which performance is owed
• Surety
• The Surety theoretically expects no losses to
  occur.
• The premium is viewed as a service fee,
• By which the suretys credit is substituted for
  that of the principal
• The Surety has the legal right to recover a loss
  payment from the defaulting principal.
• The Surety guarantees the principals character,
  honesty, integrity and ability to perform. These
  qualities are within the insureds control

33
U.S. Premiums by Line of Business
34
Policy Standardization

• Insurance Services Office (ISO)
• National Council on Compensation Insurance (NCCI)
• Standard forms are designed to meet the basic
  needs of a broad class of buyers
• Enabled by McCarran Ferguson Act
• Customization through endorsements or
  Manuscript policies
• Standardization facilitates price and service
  comparisons

35
Designing / Negotiating Programs

• Major criteria used to choose among competiting
  proposals
• Present value of expected cost
• Premium Payments
• Timing of the payments
• Possibility of dividends
• Risk Variation in firms costs due to impact of
• Deductibles
• Self-Insured Retentions
• Limits
• Price sensitive adjustments

36
Major Criteria (cont.)

• Availability and scope of specialized coverages
  and endorsements
• Quality of loss control, claims settlement, other
  services
• Any prior experience with the insurer
• Insurers reputation and financial strength

37
Deductibles / Self-Insured Retentions

• Deductibles
• Per occurrence
• Aggregate
• Stop loss provisions
• Self-insured retentions (SIRs)
• With large deductible policies, insurer pays
  for the entire loss (up to the policy limit, if
  any) and bills insurer for the amount of
  deductible
• SIRs insurer only pays amount of loss above the
  deductible

38
A Simple Exposure Diagram
39
Exposure with Aggregate Deductible
40
Limits, Primary, and Excess Coverage

• Policy limits
• Per occurrence
• Annual aggregate
• Primary insurance
• Pays for losses above any SIR up to its limit
• Primary insurers provide defense for liability
  coverage
• Excess policies pay if losses exceed primary
  limits
• Layering of primary and excess policies

41
3m Coverage Above 1m SIR
42
Exposure with Two Coverage Layers
43
Umbrella Liability Coverage

• Special type of excess coverage
• Distinctive features
• Covers losses above primary limits for more than
  one type of insurance
• E.g., auto liability
• Workers compensation
• Some umbrella policies cover losses above a
  specified retention level that are not covered by
  any primary insurance

44
Umbrella Coverage Example

• Lilly Inc. purchases the following set of
  policies
• Auto liability policy providing 1 million excess
  coverage above a 100,000 self insured retention
  (SIR).
• Products liability policy providing 10 million
  excess coverage above a 1 million SIR.
• Umbrella policy providing 20 million of
  coverage, excess of liability limits on the other
  two policies

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Umbrella Coverage Example (cont.)

• Two losses occur during the coverage period
• Auto liability loss 10.1 million
• Products liability loss 15 million

46
Umbrella Coverage Example (cont.)
Loss Paid by (In millions)
47
Coverage Chart Example
48
Property Insurance

• Often sold as part of ISO Commercial Package
  Policy (CPP)
• CPP allows insured to choose one or more of the
  following coverages
• Commercial property income
• Commercial general liability
• Auto
• Crime
• Boiler machinery
• Inland marine

49
Commercial Property Coverage

• Five components of ISO property coverage
• Policy declarations
• Coverage forms
• Causes of loss forms
• Policy conditions
• Endorsements

50
Coverage Forms

• Damage to buildings and contents
• Buildings
• Personal property of insured
• Personal property of others
• Insured chooses one or more
• Loss of business income (business interruption
  coverage)
• Loss of normal income following physical damage
• Continuing expenses
• Expenses to reduce loss
• Extra expense coverage covers extraordinary
  expenses to continue operations

51
Causes of Loss Forms

• Basic form covers losses arising from 13 listed
  perils
• Fire, lightning, explosion, windstorm/hail
• Smoke, vandalism, riot, aircraft/vehicles
• Sprinkler leakage, sinkholes, volcanic action
• Broad form adds weight of ice and snow, water
  damage, falling objects, glass breakage
• Special form covers all causes of property loss
  unless specifically excluded

52
Exclusions

• Examples of basic and broad form exclusions
• Flood
• Earth movement
• War
• Special (all-risk) form exclusions are similar
  with some additions such as wear and tear
• Separate stand alone coverage is often
  available for some of the excluded causes of loss

53
Commercial Liability Product Lines

• Auto liability
• Employers liability and workers compensation
• Medical liability
• Other professional liability and related
  coverages
• General liability
• Losses that do not fall within other product
  lines
• Losses arise out of
• Premises and operations
• Products and completed operations
• Assumptions of liability by contract

54
CGL Coverage

• Commercial General Liability Insurance (CGL)
• All hazards covered unless specifically excluded
• Exclusions
• Hazards covered by other types of liability
  coverage
• Uninsurable hazards
• Hazards insurable only with special conditions
  and pricing

55
CGL Covered Losses

• Judgments, settlements, defense for injuries to
  third-parties
• Bodily injury (BI) property damage (PD)
• Optional coverages
• Personal injury and advertising injury
• Medical payments
• Policy limits
• Per occurrence (or claim)
• Aggregate annual

56
Defense

• CGL insurer has the duty to defend
• The duty to defend is broader than the duty to
  indemnify
• Generally must provide a defense if any claim in
  a lawsuit is potentially covered
• Insurer has the right to control the defense and
  settlement unless there is a conflict of interest
• Defense costs do not apply toward policy limits

57
CGL Exclusions

• Expected or intended injury
• Worker injury / workers compensation
• Liability from sale or distribution of alcohol
• War, most pollution
• Auto, aircraft, watercraft, mobile equipment
  liability
• Damage to property owned, rented to, or in care,
  custody or control of insured
• Damage to the insureds product or work (not a
  performance guaranty)
• Product recall and damage to impaired property
• Liability arising from certain types of contracts
  and advertising

58
CGL Occurrence Coverage

• How occurrence coverage works
• Policy in force when injury occurs must defend
  and indemnify, regardless of when claim made
• Occurrence definition accident, including
  continuous and repeated exposure to the same
  general harmful conditions
• BI or PD must occur during policy period
• Coverage is not limited to sudden injuries
  gradual injuries are covered unless otherwise
  excluded

59
When the Date of Injury is Uncertain

• Examples gradual environmental damage and
  injury from exposure to asbestos
• Courts have applied a variety of coverage
  triggers
• Early bodily injury cases held that injury
  occurred during the period of exposure to a toxic
  substance
• The most common doctrines
• Manifestation trigger injury occurred when
  injury manifests itself to plaintiff
• Injury-in-fact trigger court estimates when the
  injury actually occurred based on expert testimony

60
Allocation Among Triggered Years

• If more than one years policies are triggered,
  costs must be allocated among the triggered
  policies
• Some states allocate losses based on the
  insurers time on the risk
• Some states instead hold all triggered policies
  jointly and severally liable
• Policyholder chooses policy for defense and
  indemnity
• Insurers of triggered policies negotiate or
  litigate how to divide the costs

61
Single vs. Multiple Occurrences

• Another issue is whether multiple injuries
  represent a single occurrence or multiple
  occurrences
• E.g., one type of product damages many different
  properties
• The answer can be very important to insureds and
  insurers because of per occurrence and aggregate
  deductibles, retentions, and policy limits
• Cause test (majority view) all injuries arising
  out of the same basic cause are a single
  occurrence
• Event test each injury is separate occurrence

62
Claims-Made Coverage

• Basic concept Insurer defends and indemnifies
  claims made during policy period, or within a
  relatively short, specified time after policy
  period
• Use
• Reduces risk for insurers and premium for buyers
• Medical malpractice coverage since early 1970s
• Otherwise primarily used for very high risk
  hazards, such as environmental liability and
  directors and officers liability
• Became coverage option in ISO CGL policy in mid
  1980s, but option is rarely purchased with that
  policy

63
Occurrence vs. Claims-Made
64
ISO Claims-Made Form

• Claim covered if
• Injury occurred after the retroactive date
  specified in the contract, and
• Claim made during policy period or extended
  reporting period
• Retroactive date
• Coordinates coverage if a policyholder switches
  from occurrence to claims-made coverage
• Reduces premiums and adverse selection

65
Extended Reporting Periods

• Allow claims to be made for some time after the
  policy period
• The ISO form
• Automatically covers claims made for occurrences
  reported within 60 days of end of the policy
  period if the claim is made within 5 years
• Allows the insured to convert to occurrence
  coverage at the end of the policy period for
  injuries that occurred during the policy period
• New policy limit
• Pay a premium no more that 200 of original
  premium
• Non-standard claims-made forms without an option
  to convert to occurrence are common

66
Pricing and Underwriting

• Compared with personal and small business
  insurance, pricing and underwriting of coverage
  for medium to large businesses differ on three
  dimensions
• Underwriters often have substantial discretion to
  negotiate the premium rate, special coverage
  features, and services
• Rating plans are often loss-sensitive (charges
  paid by the policyholder depend on its loss
  experience during the coverage period)
• Less stringent regulation of rates and policy
  forms