1. FINA 3210C/D Risk Management and Insurance
Jason Yeh, ASA (Society of Actuaries), PhD (UW-Madison)
Associate Professor, Dept. of Finance, CUHK
Tel: (852)

2. Grading Participation: 10% Quizzes: 10% Tests: 40%
Spring 2017
Grading
Participation: 10%
Quizzes: %
Tests: %
Group work for mini insurance cases 40%

3. Spring 2017
The Pulse of World
WTC tragedy triggers a dispute which is by-far the most expensive…
TWO WTC Towers are down…
ONE Attack or TWO Attacks?

4. One Occurrence or Two? A USD 3.5 Billion Difference……
Spring 2017
One Occurrence or Two? A USD 3.5 Billion Difference……
瑞 士 再 保 險(Swiss Re) 與 紐 約 世 貿 中 心 租 約 持 有 人 Mr. Silverstein 就 保 險 賠 償 發 生 爭 議，入稟 要求 紐 約 曼 哈 頓 聯 邦 地 區 法 院 澄 清。
世 貿 中 心 之 保 險 合 同 中，有 每 次 事 故 賠 償 上限 美 元 35 億 的 條 文，Swiss Re 認 為 兩 次 撞 機 實屬 單 一 事 件，只 可 作 一 次 保 險 索 償 看 待，故最 高 賠 償 額 為 35 億 美 元。
Mr. Silverstein 認 為 兩 架 客 機 分 別 撞 上 世 貿 中 心南 北 大 樓 是 兩 次 個 別 事 件，故 保 險 公 司 應 分 別 賠 償 35 億 美 元。他 要 求 保 險 商 就「九一一」事 件 賠 償 70 億 美 元。
(1) The cause test relates events to their root cause, thereby minimizing the number of occurrences; (2) the effects test treats events separately and so increases the number occurrences; and (3) the unfortunate event test takes a middle line between the two. (“One Occurrence or Two: How the Courts Decide”, by Jeannine Chanes and Mary Daniels in Risk Management Magazine Vol. 49 No. 1, January 2002)

5. Chapter 1: Risk & Its Treatment
Spring 2017
Chapter 1: Risk & Its Treatment
Different Definitions of Risk
Chance of Loss, Peril and Hazard
Classification of Risk
Major Personal and Commercial Risks
Burden of Risk on Society
Techniques for Managing Risk
Cost of Risk and Value Maximization

6. What Is Risk? Expected loss
Spring 2017
What Is Risk?
Expected loss
Riskier ==> greater frequency or severity of loss
Example: high risk of earthquake; “that driver is a poor risk”; “that building is an unacceptable risk”, etc.
Variability of loss (around expected value)
Riskier ==> more difficult to predict
Example: cat risks (relative to fires); prices of equities (relative to bonds), etc.

7. Different Definitions of Risk
Spring 2017
Different Definitions of Risk
Risk: uncertainty concerning the occurrence of a loss.
Loss Exposure: Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs.
Objective Risk vs. Subjective Risk
Objective risk is defined as the relative variation of actual loss from expected loss
It can be statistically calculated using a measure of dispersion, such as the standard deviation (or what?)
declines as the number of exposure units increases
Subjective risk is defined as uncertainty based on a person’s mental condition or state of mind
Two persons in the same situation may have different perceptions of risk
High subjective risk often results in conservative behavior

8. Spring 2017
Chance of Loss
Chance of Loss: The probability that an event will occur.
Objective Probability vs. Subjective Probability
Objective probability refers to the long-run relative frequency of an event assuming an infinite number of observations and no change in the underlying conditions
It can be determined by deductive or inductive reasoning
Subjective probability is the individual’s personal estimate of the chance of loss
A person’s perception of the chance of loss may differ from the objective probability

9. Chance of Loss vs. Objective Risk
Transparency Master 1.2
Spring 2017
Chance of Loss vs. Objective Risk
Chance of loss is the probability that an event that causes a loss will occur.
Objective risk is the relative variation of actual loss from expected loss
The chance of loss may be identical for two different groups, but objective risk may be quite different!
City
# homes
Average # fires
Range
Chance of Fire
Objective Risk
Philadelphia
10,000
100
75 – 125 1%
25%
Los Angeles
10%

10. Risk Identification: Key Terms
Spring 2017
Risk Identification: Key Terms
Peril: a potential cause of a loss, e.g., fires, hurricanes, theft, heart attack, and etc.
Hazard: conditions that increase the probability or expected magnitude of a loss, e.g., smoking when considering potential healthcare losses.
An insurance contract covers a policyholder for economic loss caused by a peril named in the policy

11. Exposure, Peril, Hazard Hazard
Spring 2017
Exposure, Peril, Hazard
Hazard
Physical hazard- physical condition that increases the chance or severity of loss
Moral hazard- dishonesty or characteristics of an insured individual that increase the chance or severity of loss
Morale (Attitudinal) Hazard- carelessness or indifferences to a loss because of the existence of insurance.
Example: Given the following scenario, state which is the hazard, the peril, and the exposure, respectively? A person recently moved from Beijing to Shenzhen and bought a home. A typhoon occurs and it destroys his home.
Example: True or False? A house of wood construction burns to the ground resulting in a complete loss. The fact that the construction was of wood is the peril involved in this loss.

12. Categorizing Risk Pure and speculative risk
Spring 2017
Categorizing Risk
Pure and speculative risk
Pure - there are only the possibilities of loss or no loss.
Speculative - both profit or loss are possible
Diversifiable Risk v. Nondiversifiable Risk
A diversifiable risk affects only individuals or small groups (car theft). It is also called nonsystematic or particular risk.
A nondiversifiable risk affects the entire economy or large numbers of persons or groups within the economy (hurricane). It is also called systematic risk or fundamental risk.
Government assistance may be necessary to insure nondiversifiable risks.

13. Spring 2017
Fundamental Risks...

14. Enterprise Risk Risk from the CFO’s Perspective
Spring 2017
Enterprise Risk
Enterprise risk encompasses all major risks faced by a business firm, which include: pure risk, speculative risk, strategic risk, operational risk, and financial risk
Risk from the CFO’s Perspective

15. Pure Risk: Characteristics and Expertise Needed
Spring 2017
Pure Risk: Characteristics and Expertise Needed
Characteristics
Large downside risk but NO (or low) upside return
Firm-specific
Controllable (to some degree)
Usually managed by insurance
Wealth losses to society
Expertise needed
Risk analysis
Safety management
Loss control
Insurance contracts

16. Pure Risk versus Other Types of Risk
Spring 2017
Pure Risk versus Other Types of Risk
Generalizations:
Pure risk involves events that are firm-specific
Price risk affects many firms
Pure risk is managed by insurance
Price risk is managed by derivatives
Pure risk involves wealth losses to society
Price risk involves wealth redistributions in society
Nevertheless, use the same framework for management of pure risk and price risk

17. Major Types of Personal Risks
Spring 2017
Major Types of Personal Risks
Risk of Life
Die too soon (premature)
Die too late (longevity risk)
Risk of Poor Health
INSIGHT 1.1: Medical Bills Account for 40% of Bankruptcies
Risk of Property: direct and indirect
Liability Risk: resulting in property losses, physical injury, and/or pain & suffering of others
Financial Risk: stock; bonds; credit; liquidity
Unemployment Risk

18. Major Types of Personal Risks
Spring 2017
Major Types of Personal Risks
Property risks involve the possibility of losses associated with the destruction or theft of property:
Physical damage to home and personal property from fire, tornado, vandalism, or other causes
Direct loss vs. indirect loss
A direct loss is a financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a home
An indirect loss results indirectly from the occurrence of a direct physical damage or theft loss, such as the additional living expenses after a fire to a home. These additional expenses would be a consequential loss.

19. Major Types of Personal Risks
Spring 2017
Major Types of Personal Risks
Liability risks involve the possibility of being held liable for bodily injury or property damage to someone else
There is no maximum upper limit with respect to the amount of the loss
A lien can be placed on your income and financial assets
Defense costs can be enormous
INSIGHT 1.2: Surgeons Leave Tools inside 1,500 Patients a Year
In 2005, former outside directors of WorldCom and Enron agreed to pay a total of $31 million out of their own pockets to settle securities class action lawsuits. (D&O insurance paid an additional $36 million to settle the WorldCom suit, and $155 million to settle Enron.) Stanford Lawyer, 71: 36–39.

20. Major Types of Commercial Risks
Spring 2017
Major Types of Commercial Risks
Firms face a variety of pure risks that can have serious financial consequences if a loss occurs:
Property risks, such as damage to buildings, furniture and office equipment
Liability risks, such as suits for defective products, pollution of the environment, and sexual harassment
Loss of business income, when the firm must shut down for some time after a physical damage loss
Other risks to firms include crime exposures, human resource exposures, foreign loss exposures, intangible property exposures, and government exposures

21. Spring 2017
Property Risks

22. Burden of Risk on Society
Spring 2017
Burden of Risk on Society
Need for a Larger Emergency Fund
Put aside $25,000 annually for damages (due to fire, windstorm,theft etc.) to your home valued at $200,000?
Loss of Needed Goods and Services
Some 250 companies once manufactured childhood vaccines, now just a few firms do.
Fear and Worry

23. Methods of Handling Risk
Spring 2017
Methods of Handling Risk
Avoidance
Loss Control
Loss prevention (aims at reducing loss frequency)
Loss reduction (aims at reducing loss severity)
Retention
Active (desirable) is the deliberate choice to assume part or all of a loss exposure.
Passive (dangerous) often results from ignorance or inertia.
Noninsurance Transfers
Contracts (hold-harmless or indemnity clause)
Hedging
Incorporation (LLC)
Insurance

24. Chapter 1 CASE APPLICATION
Spring 2017
Chapter 1 CASE APPLICATION
Mike is a college senior majoring in BBA.
He owns a high-mileage 2000 Ford with current market value of $2,500.
The current replacement value of his personal property in a rented apartment totals $10,000.
He wears disposable contact lenses, which cost $300 for a six-month supply.
He also has a waterbed in his rented apartment that has leaked water in the past.
As avid runner, Mike run five miles daily in a nearby public park that has reputation of being extremely dangerous due to drug dealers.
Mike’s parents both work to help him pay for his tuition.

25. Mike’s Methods of Handling Risks
Spring 2017
Mike’s Methods of Handling Risks
For each of the following risks and loss exposures, identify an appropriate RM technique that could have been used to deal with the exposure.
Physical damage to the 2000 Ford due to a collision with another motorist.

26. Mike’s Methods of Handling Risks
Spring 2017
Mike’s Methods of Handling Risks
Liability lawsuit against Mike arising out of the negligent operation of his car.
Total loss of personal property due to a fire in the kitchen of his rented apartment.

27. Mike’s Methods of Handling Risks
Spring 2017
Mike’s Methods of Handling Risks
Disappearance of one contact lens.
Waterbed leak that cause property damage to the apartment.

28. Mike’s Methods of Handling Risks
Spring 2017
Mike’s Methods of Handling Risks
Physical assault on Mike by gang members who are dealing drugs in the park where he runs.
Loss of tuition assistance from Mike’s father who is killed by a drunk driver in an auto accident.

29. Major Risk Management Methods
Spring 2017
Major Risk Management Methods

30. Exercise: Loss Control
Spring 2017
Exercise: Loss Control
How to reduce the risk of injury to construction firm employees by the two major approaches of loss control?
Reduced level of risky activity
Taking on less hazardous projects
Reducing total number of projects
Increased precautions
Giving employees safety instruction
Making employees wear protective devices

31. Spring 2017
Risk Management
Risk Management is the decision making process by which adverse consequences of risk are minimized.

32. What Are the Adverse Consequences of Risk?
Spring 2017
What Are the Adverse Consequences of Risk?
Expected cost of losses
Cost of risk control
Costs of risk financing
Cost of internal risk reduction
Costs of residual uncertainty

33. Components of the Cost of Risk
Spring 2017
Components of the Cost of Risk

34. Cost of Risk and Value Maximization: The Big Picture
Spring 2017
Cost of Risk and Value Maximization: The Big Picture
Risk imposes costs on businesses and individuals
Risk Management (e.g., loss control and insurance) also are costly
Tradeoffs must be made
Criteria for Making Choices: Value Maximization

35. Value Maximization and Minimizing the Cost of Risk
Spring 2017
Value Maximization and Minimizing the Cost of Risk
Firm value depends on net cash flows
Net cash flows = cash inflows - cash outflows
Important characteristics of net cash flows:
Expected magnitude
Timing
Variability (uncertainty)
Define
Cost of Risk = Value without risk - Value with risk
Then
Value with risk = Value without risk - Cost of risk
Maximizing value is equivalent to minimizing the cost of risk

36. Example: Costs of Risk Component
Spring 2017
Example: Costs of Risk Component
Worker Injuries
Cost of risk component Specific examples
Expected losses expected EC benefits; expected employee replacement costs; expected lost productivity
Loss Control safety expenditures
Loss Financing Loading on EC ins. premiums
Internal risk reduction investments in information
Residual uncertainty reduction in value due to risk aversion; higher wages demanded

37. Spring 2017
Cost of Risk Example
Value of firm in ideal world of no risk = $100,000.
Issues to be examined:
What is value with risk of worker injuries?
What is relation between firm value and cost of risk?

38. Cost of Risk Example Business is faced with the following risk:
Spring 2017
Cost of Risk Example
Business is faced with the following risk:
Probability of worker injury = 1/10
Losses from a worker injury:
medical expenses $10,000
lost pay $50,000
total $60,000
Expected loss = $

39. Cost of Risk Example Option 1: Do Nothing Firm value = Cost of risk:
Spring 2017
Cost of Risk Example
Option 1: Do Nothing
Cost of risk:
Expected loss =
Cost of residual uncertainty = $4,000 (assumed)
Cost of loss control =
Cost of loss financing =
Cost of internal risk reduction =
Total cost of risk =
Firm value =

40. Cost of Risk Example Option 2: Loss Control
Spring 2017
Cost of Risk Example
Option 2: Loss Control
Spend $2,000 to reduce probability of loss to 1/20
Cost of risk:
Expected loss =
Cost of residual uncertainty = $3,000 (assumed)
Cost of loss control =
Cost of loss financing =
Cost of internal risk reduction =
Total cost of risk =
Firm value =

41. Cost of Risk Example Option 3: Additional Loss Control
Spring 2017
Cost of Risk Example
Option 3: Additional Loss Control
Spend an additional $2,000 to reduce probability of loss to 1/40
Cost of risk:
Expected loss =
Cost of residual uncertainty = $2,700 (assumed)
Cost of loss control =
Cost of loss financing =
Cost of internal risk reduction =
Total cost of risk =
Firm value =

42. Cost of Risk Example Option 4: No loss control, but FULL Insurance
Spring 2017
Cost of Risk Example
Option 4: No loss control, but FULL Insurance
Premium = $7,500
Loading = Premium - expected loss = $
Cost of risk:
Expected loss =
Cost of residual uncertainty = $500 (assumed)
Cost of loss control =
Cost of loss financing =
Cost of internal risk reduction =
Total cost of risk =
Firm value =

43. Cost of Risk Example Key Points:
Spring 2017
Cost of Risk Example
Key Points:
Do NOT minimize risk, Minimize Cost of Risk
There are tradeoffs:
Increase insurance ==>
Pay loading
Decrease in residual uncertainty
May decrease loss control incentives (Moral Hazard)
Additional loss control ==>
Decreased expected losses
Increase loss control costs

44. Cost Tradeoffs in Risk Management
Spring 2017
Cost Tradeoffs in Risk Management
Loss control costs vs. expected cost of losses (direct and indirect)
Zero risk or zero probability of loss would be too costly
Cost of loss financing & internal risk reduction vs. expected cost of indirect losses
E.g., more insurance increases loss financing costs, but might reduce the likelihood of bankruptcy and the likelihood of having to raise costly external capital (to pay for losses and to adopt new investment projects)

45. Cost Tradeoffs in Risk Management
Spring 2017
Cost Tradeoffs in Risk Management
Cost of loss financing & internal risk reduction vs. cost of residual uncertainty
E.g., more insurance increases loss financing costs, but would reduce uncertainty in cash flows, which might (a) cause investors to place a higher value on the firm and/or (b) change the terms that risk averse employees will contract with the firm

46. Risk Management & Societal Welfare
Spring 2017
Risk Management & Societal Welfare
Minimizing the Cost of Risk is an appropriate objective for
Nonprofit organizations
Individuals
Society
because it generally results in an efficient level of risk for society
efficiency ==> activities are pursued until the marginal costs exceed the marginal benefits

47. Business Objectives and Other Claimants
Spring 2017
Business Objectives and Other Claimants
Does maximizing shareholder wealth imply that you ignore the effect of risk on employees, customers, etc. (ignoring regulation and legal liability)?
Not necessarily, because
informed employees, customers, etc will demand compensation for risk
Thus, risk management decisions that shareholder wealth generally also consider the effect of risk on other claimants

48. Conflicts between Business & Societal Objectives
Spring 2017
Conflicts between Business & Societal Objectives
What if business cost of risk < societal cost of risk?
Possible scenarios:
workers are uninformed about injury risk
chance of being caught dumping waste is zero
Then, business might engage in excessively risky behavior (they may not consider the effects of risk on other claimants)
Thus, there is a potential role for regulation and legal liability