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PowerPoint Slides for Professors Spring 2010 Version PowerPoint Slides for Professors Spring 2010 Version This file as well as all other PowerPoint files.

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Presentation on theme: "PowerPoint Slides for Professors Spring 2010 Version PowerPoint Slides for Professors Spring 2010 Version This file as well as all other PowerPoint files."— Presentation transcript:


2 PowerPoint Slides for Professors Spring 2010 Version PowerPoint Slides for Professors Spring 2010 Version This file as well as all other PowerPoint files for the book, “Risk Management and Insurance: Perspectives in a Global Economy” authored by Skipper and Kwon and published by Blackwell (2007), has been created solely for classes where the book is used as a text. Use or reproduction of the file for any other purposes, known or to be known, is prohibited without prior written permission by the authors. Visit the following site for updates: To change the slide design/background, [View]  [Slide Master] W. Jean Kwon, Ph.D., CPCU School of Risk Management, St. John’s University 101 Murray Street New York, NY 10007, USA Phone: +1 (212) 277-5196 E-mail:

3 Risk Management and Insurance: Perspectives in a Global Economy 2. Risk Perceptions and Reactions Click Here to Add Professor and Course Information

4 Study Points  Decision-making under uncertainty: Individuals Businesses Society  Economic Theories 3

5 Individual Decision-making under Uncertainty 4

6 What Are You – Risk-loving, Averse or Neutral? 5

7 Individuals Are Likely Risk Averse! Want to avoid if possible: –Losing property –Losing health, dying prematurely, or out-surviving own asset –Becoming liable for someone else’s loss Risk-averse persons (entities) wish to have someone else to bear the consequence, even if the cost of transfer is higher than the expected cost of the risk. 6

8 7 School of Risk Management

9 John’s Case  John Is a reasonable person Received an inheritance of $10,000 from an uncle Unsure of what to do with the money for investment purpose  Decision-making theories Expected value (function) Expected utility (function) Risk-averse expected utility (function) 8

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11 Risk Decisions and the Expected Value 10

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13 Risk Decisions and Expected Value 12 Option 1 = $10,000 + 1 x$0 Option 2 = $10,000 + 1 x $700 = $10,700 Option 3 = $10,000 + 0.5 x $3,000 – 0.5 x $1,500 = $10,750

14 Expected Value Theory  The expected value (EV) of a set of n possible outcomes equals the sum of these outcomes, each outcome (x i ) weighted by the probability of its occurrence (p i ) 13

15 Does Expected Value Theory Always Work? Let’s Play Another Game!  Coin flipping until the first tail appears.  Win $2 if the tail appears on the first toss  Win $2 2 or $4 if on the second toss  Win $2 3 or $8 if on the third toss …. The St. Petersburg Paradox 14

16 Risk-Averse Utility Function  A utility function for the risk-averse person exhibits two characteristics: Increasing wealth leads to increasing levels of satisfaction. The marginal utility of wealth decreases as wealth increases.  The law of diminishing marginal utility as shown Figure 2.1  Risk-averse individuals will select the option with the highest expected utility. 15

17 Diminishing Marginal Utility in a Functional Form  Find utility of a risk-averse person with wealth 100, 500 and 1000.  If assuming a natural log function: Ln(100) = 4.6 Ln(500) = 6.2 Ln (1000) = 6.9  If assuming a square root function: Sqrt (100) = 10 Sqrt (500) = 22.30 Sqrt (1000) = 31.62 16

18 How about Risk Loving and Neutral? Risk Loving  Utility = (Wealth) 2 Risk Neutral  Utility = (Wealth) 1 17

19 Risk-Averse Utility Function  Errata 18 10,700

20 Case – Now, Maria!  Maria Is risk averse Owns a home worth $150,000 Has $50,000 in a savings account  The earthquake Probability of 10% in any given year An earthquake will totally destroy her house  XYZ Insurance Company Fully indemnifies the insured for earthquake-related loss Charges a premium equaling the expected value of the loss  that is, actuarially fair premium 19

21 Maria’s Case  The insurance company is a risk-neutral entity. Thus, employs the expected value concept to price risks  Two outcomes in Maria’s case No earthquake  no loss= 90% Earthquake  total loss = 10% Expected value of the risk So, XYZ Insurance charges $15,000 to all persons facing this type of loss exposure. 20

22 Utilities with and without Insurance  Maria uses the risk-averse utility theory. Expected utility with insurance Expected utility without insurance 21

23 Using a Natural-log Function, for Example:  No insurance 0.9 x LN(200,000) + 0.1 x LN(50,000) = 10.98 + 1.08 = 12.06  Insurance (0.9 + 0.1) x LN(185,000) = 12.13 LN(200,000) = 12.20 LN(50,000) = 10.82 LN(185,000) = 12.13 22

24 A Little Bit about Insurance Premiums (The U.S. Market) 23

25 Premium  A consideration by the purchaser of the insurance contract  Paid in advance  Insurers invest premiums until used (e.g., claims payment) 24

26 25 Major Components of Insurance Premium  Cost of risk or “expected value of the risk”  Operational and transaction costs Product design and pricing  actuaries Marketing  sales staff and agents Underwriting  underwriter Claims handling  claims investigator Investment (to invest premiums collected) Accounting and other overhead costs Taxes and other government-imposed fees  Profits

27 Where the Premium Dollar Goes? 26

28 27 Where the Premium Dollar Goes (2006)  Automobile insurance (2007)  $111 billion paid for claims  $97 billion for personal automobile insurance claims

29 28

30 Risks Covered by Insurance (A U.S. Classification)  Automobile  Property  Flood (federal)  Unemployment (federal/state)  Mortgage guaranty  Ocean marine  Medical malpractice  Earthquake  Products liability  Professional liability  Fidelity  Surety  Credit  Reinsurance …,  Life  Disability Short-term Long-term  Health  Annuity …,  Social Security (federal) Old Age Survivor (spouse) Disability Health  Medicare 29

31 Insurance Demand & Lifetime Utility Maximization 30

32 Insurance Demand and Lifetime Utility Maximization 31

33 Life Cycle Hypothesis  The typical individual’s income: Low in the beginning and end stages of life High during the middle stage of life  The individual maintains a constant or increasing level of consumption. 32

34 Consumption Theories and Insurance  Risk-averse individuals increase their expected lifetime utility by the purchase of: Life insurance to provide payments on death and Annuities to provide payments during retirement 33

35 Economic Theories of Consumption 34

36 Prospect Theory: Loss Aversion and the Value Function  Kahneman and Tversky Each one has a personal value function – reflecting our degree of satisfaction derived from gains and losses from some reference point. The reference point is each individual’s point of comparison or standard against which risky decisions are contrasted. The point is not static and can vary for the same individual depending on how the choices are framed or presented.  The Kahneman-Tversky value function Concave in gains, as with a utility function, but convex in losses Figure 2.5 35

37 Illustrative Prospect Theory Value Function (Figure 2.5) 36

38 Probability Weighting Function (Figure 2.6) 37

39 Other Anomalies  Decision regret We feel far worse about having made bad choices than we do about our failures to have made smart choices.  Mental accounting We tend to separate a whole into components.  Endowment effect The tendency to set a higher price to sell that which we already own than what we would be willing to pay to purchase the identical item if we did not own it. 38

40 Business Decision-making under Uncertainty 39

41 Types of Business  Sole proprietorship  Partnership General partners Limited partners  Corporation Limited liability of its owners Easy transfer of ownership Continuity of existence Closely held corporations 40

42 Reaction to Risk – Sole Proprietors and Partners Sole Proprietorship  Being indistinguishable from the individual who owns it  The risk perception and behavior logically is that of its owner Partnership  Reflects some combination of the owners’ degrees of risk aversion – except the cases: Partnership interest is held by many partners, has a ready market or is a small portion of the partners’ overall investment portfolio Partners clearly understand how the value of their partnership interest changes with changes in the value of other investments 41

43 Corporate Reactions to Risk  The goal of the firm and owner risk profiles Owners know how to determine their own consumption and risk profiles Managers simply maximize net present values of the firm Acting as risk-neutral agents for the owners and Undertaking all projects with positive NPV, irrespective of its risk  Risk-neutral utility function Increasing wealth leads to increasing levels of satisfaction. The marginal utility of wealth is constant as wealth increases. Figure 2.7 42

44 Why Do Corporations Manage Risks?  Managerial self-interest Principal-agent problems  Corporate taxation  Cost of financial distress Bankruptcy risk and cost vs. the cost of insurance  Capital market imperfections High transaction costs associated with external finance Imperfect information about firm riskiness by those who might provide the external finance 43 Refer also to Chapter 19 (Economic Foundations of Insurance)

45 Societal Decision-making under Uncertainty 44

46 Economic Efficiency as a Social Goal  Like individuals, societies want to maximize their welfare.  Due to differences in individual preferences, there is no such thing as a societal utility function. Economics offers an alternative.  Efficient allocation of resources Individuals and businesses should undertake risk management actions so long as the marginal benefit is greater than the marginal cost. Economists measure benefits based on the concept of “willingness to pay.” 45

47 Willingness to Pay (WTP)  The value of a good to a person as what s/he is willing to pay, sacrifice or exchange for it  The maximum monetary cost that a person, or a group of persons (e.g., citizens), would pay to obtain a benefit  The foundation of the economic theory of value 46

48 WTP: How Much Willing to Pay for Pharmacist Service?  $5 of out-of-pocket expense if the pharmacist could reduce the risk of a medication-related problem  If the risk is reduced From 10% to 5%  36% From 20% to 10%  54% From 40% to 20%  60%  $15 of out-of-pocket expense About 8% of the respondents in all three cases  $30 of out-of-pocket expense Almost none of the respondents 47

49 A Perfect Market Conditions  A sufficiently large number of buyers and sellers are present.  Sellers have freedom of entry into and exit from the market.  Sellers produce identical products.  Buyers and sellers are well informed about the products. In the Market  Price based solely on the laws of supply and demand  Optimal use of resources  Also known as a Pareto optimal market 48

50 Economic Efficiency as a Social Goal  Even if it’s efficient, is it fair? Society may not necessarily prefer a Pareto efficient allocation of its resources  Even if it’s fair, is it efficient? Market prices do not always equal opportunity costs. 49

51 Imperfections in Markets – Market Failures  Some goods or services may be unavailable or available only in some suboptimal way.  Four general classes of problems Market power Externalities Free rider problems Information problems 50 These problems are discussed throughout the book and class!

52 Market Power  The ability of one or a few sellers or buyers to influence the price of a product or service  Causes 1.Governmentally created barriers to entry 2.Economies of scale 3.Product differentiation/price discrimination 51

53 Market Power – Governmentally Created Barrier  Market power arises when a market has entry or exit barriers and few sellers. Monopoly Oligopoly In financial services, (national) licensing requirements technically are entry barriers, although they may be justified on consumer protection grounds.  National tax regimes can lead to the creation of market power. 52

54 Market Power – Economies of Scale  Economies of scale When a firm’s output increases at a rate faster than attendant increases in its production costs  Minimum efficient scale (MES) At which long-run average costs are at a minimum and further growth yields no additional efficiencies If efficiency increases over a market’s entire relevant output range, the MES is so large relative to market size that only one firm can operate efficiently – a so-called natural monopoly case.  Contestable market A monopolist or oligopolist unable to exercise market power 53

55 Market Power – Product/Price Differentiation  Product differentiation When firms produce similar but not identical products, they are in monopolistic competition which gives the firms an element of monopoly power (i.e., the ability to influence price).  Price discrimination Firms offer identical products at different prices to different groups of customers  Predatory pricing  also known as dumping Lowering prices to unprofitable levels to weaken or eliminate competition with the idea of raising prices after competitors are driven from the market 54

56 Externalities  Benefits or costs that occur when a firm’s production or an individual’s consumption has direct and uncompensated effects on others Positive externalities Negative externalities (e.g., pollution)  Societal risk management is particularly concerned about negative externalities.  Purely competitive economic model does not accommodate externalities easily Prices of goods and services that carry externalities fail to reflect their true (opportunity) costs. 55

57 Externalities – Trait With Negative Externalities  Too much of the good or service produced or consumed  The price becoming too low  Too little effort and resources devoted to correct/reduce the externality With Positive Externalities  Too little of the good or service produced  The price becoming too high  Too little effort devoted to enhancing the externality 56

58 Externalities – the Importance of Property Rights  Negative externalities (e.g., pollution) can persist in competitive markets because the persons adversely affected by the negative spillovers have poorly defined, dispersed or no property rights.  Too often, property rights are not well established or they are widely dispersed, thus precluding meaningful actions by private citizens against the polluter. 57

59 Free Rider Problems  Some collectively consumed goods/services that are desired by the public – called public goods – carry extensive positive externalities. Examples are: Public education Lighthouse Police and fire protection services  When such goods/services are available to others at low or zero cost, they can cause a free rider problem.  Left to itself, a competitive market is unlikely to provide as much of public goods as society really wants. 58

60 59

61 Information Problems  Information problems occur when buyers (or sellers) lack sufficient information to make an informed purchase (or sales) decision.  Markets that suffer such information asymmetries often are regulated if the goods or services involved are important elements of our lives or the economy. 60

62 Information Problems – Asymmetric Information  The problems arise when one party to a transaction has relevant information that the other does not have. A Lemons problem when the buyer knows less than the seller about the seller’s products A principal-agent (or agency) problem when the buyer of services knows less about its agent’s actions than does the agent An adverse selection problem when the seller knows less than the buyer about the buyer’s situation Moral hazard is the propensity of individuals to alter their behavior when risk is transferred to a third party. 61

63 Information Problems – Asymmetric Information  Tradeoffs are inevitable between The additional expenses incurred to become better informed and The additional costs inherent in making decisions with less information 62

64 Information Problems – Non-existent Information  Desired information simply does not exist. This uncertainty leads the buyer and the seller to take ameliorating actions intended to reduce their risk exposure. These offsetting actions require the expenditure of additional resources, thus decreasing overall benefits to society.  These situations can be addressed through diversification and government creation of “safety nets” for its citizens For example, under the premises that individuals will not or cannot fully arrange for their own financial security, government force them to participate in social insurance programs. 63

65 Discussion Questions 64

66 Discussion Questions 1 & 2  “If individuals were not risk averse, insurance would not exist.” Do you agree with this statement?  “If individuals were not risk averse, risk management would not exist.” Do you agree with this statement? 65

67 Discussion Question 3  Why would we ordinarily expect corporations whose shares were widely held to be risk neutral? 66

68 Discussion Question 4  Even corporations whose shares are widely held often seem to be risk averse. Offer some sound economic reasons for such corporate behavior. Offer some practical reasons for such corporate behavior. 67

69 Discussion Question 5  Justify the following statement: “If externalities did not exist, society would have no worry about pollution.” 68

70 Discussion Question 6  “If a market is operating with reasonable efficiency, government should leave it alone.” Under what circumstances would you (a) agree and (b) disagree with this contention? 69

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