T7.1H&N, Ch. 7

Chapter Outline

7.1 Risk Aversion and Demand for Insurance by Individuals

The Effects of Insurance on Wealth

Risk Aversion

Other Factors Affecting an Individual’s Demand for Insurance

Premium Loading

Income and Wealth

Information

Other Sources of Indemnity

Non-Monetary Losses

T7.2H&N, Ch. 7

Chapter Outline

7.2 Business Risk Management and Demand for Insurance

Shareholder Diversification

Closely-Held Firms Are Similar To Individuals

Why Purchase Insurance when Shareholders are Diversified?

Insurer Services

Reducing the Expected Cost of Financing Losses

Reducing Financing Costs for New Investment

Reducing the Likelihood of Financial Distress

Reducing Expected Tax Payments

7.3 Summary

T7.3H&N, Ch. 7

Demand for Insurance by Individuals

Why do individuals take actions to reduce risk?

• essentially because they are risk averse

• Risk aversion ==> prefer certain outcome to an uncertain outcome with the same expected value

• Examine risk aversion in more detail

T7.4H&N, Ch. 7

The Effects of Insurance on Wealth

• Begin by examining the effects of insurance on a person’s 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

T7.5H&N, Ch. 7

The Effects of Insurance on Wealth

• Wealth with no insurance

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

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

Wealth$80,000 $100,000

Wealth$80,000 $100,000

$80,000 $100,000

Wealth

T7.6H&N, Ch. 7

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?

T7.7H&N, Ch. 7

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 person’s expected wealth, but it makes the person’s wealth uncertain

• A risk-averse person therefore would prefer not to accept the gamble

T7.8H&N, Ch. 7

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

T7.9H&N, Ch. 7

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

T7.10H&N, Ch. 7

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

T7.11H&N, Ch. 7

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

T7.12H&N, Ch. 7

Other Factors Affecting the Demand for Insurance

Premium Loadings

• As loading increases, quantity of insurance purchased generally falls

Income and Wealth

• Degree of risk aversion may decline as wealth increases

• Limited liability may cause poor people to buy less liability insurance coverage

T7.13H&N, Ch. 7

Other Factors Affecting the Demand for Insurance

Information

• Individual’s perception of loading

• Underestimate the true risk ==> buy less insurance

• Overestimate the true risk ==> buy more insurance

Other Sources of Indemnity

• If others will pay uninsured loss, buy less coverage

T7.14H&N, Ch. 7

Other 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

T7.15H&N, Ch. 7

Other 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

T7.16H&N, Ch. 7

Other 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

T7.17H&N, Ch. 7

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?

T7.18H&N, Ch. 7

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

T7.19H&N, Ch. 7

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

T7.20H&N, Ch. 7

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

T7.21H&N, Ch. 7

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

T7.22H&N, Ch. 7

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

T7.23H&N, Ch. 7

Why Do Corporations Manage Risk?

• Reducing risk lowers expected tax payments for several reasons:

• discussed in greater detail in Chapter 10