1. 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

2. 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

3. 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

4. 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

5. 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, $100,000
Wealth
$80, $100,000
Wealth
$80, $100,000

6. 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?

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 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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?

18. 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

19. 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

20. 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

21. 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

22. 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

23. Why Do Corporations Manage Risk?
Reducing risk lowers expected tax payments for several reasons:
discussed in greater detail in Chapter 10