1. 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: http://facpub.stjohns.edu/~kwonw/Blackwell.htmlhttp://facpub.stjohns.edu/~kwonw/Blackwell.html. 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: Kwonw@stjohns.eduKwonw@stjohns.edu

2. Risk Management and Insurance: Perspectives in a Global Economy 4. Societal Risk Assessment and Control Click Here to Add Professor and Course Information

3. Fundamentals  In a market economy, government intervention should be limited.  Many aspects of societal RM are best left to individuals and businesses.  Government has a critically important role when market outcomes are unacceptable. For example, They are hindered by imperfections. They fail to capture societal notions of fairness.  Governmental intervention should reflect the level of risk reduction that society desires: How do we determine society’s risk-reduction preferences? Under what circumstances is intervention justified?  How much are you willing to pay (WTP)? Vehicles we can drive? Water we drink? 3

4. Society’s Risk-reduction Preferences  The value that society places on incremental risk reduction  Two important matters Statistical lives – not the lives of specific individuals How much is a society willing to spend to reduce from an estimated 100 to 50, the number of children who die each year from swallowing aspirin? The landfill example (page 87 and next slide) Societal RM concerned with marginal reductions in the likelihood of death, injury and damage by certain perils rather than changes that eliminate all possibility of injury, death and damage 4

5. Example: Landfill (Page 87)  Case A landfill gradually contaminates drinking water of the city of 1 million inhabitants. Relocating the landfill saves on average 2 lives per year. Each citizen is willing to pay $5 per year for this level of risk reduction but no more. Citizens pay a total of $5 million per year. The economic value of one expected life saved is $2.5 million.  Interpretation It does not mean anyone would accept certain death for $2.5 million. Neither does it mean that these WTP amounts measure what our survivors should be willing to accept in a wrongful death case or in the purchase of life insurance 5

6. Implied Value of Worker Life (Figure 4.1) 6

7. The Value of Earnings Lost (New York Times, Sept. 9, 2007)  Economists and the Military Academy used three measures to set payments: Economic loss Pain & suffering of $250,000 + $100,000 per surviving family member (spouse and children) Subtraction of any life insurance Final minor adjustment based on income by Fund Special Master  Examples Virginia Tech victims – began with a uniform sum of $180,000 9/11 (next page) 7

8. The Value of Earnings Lost (New York Times, Sept. 9, 2007) 8

9. When is Government Intervention Justified? 9

10. Why Society Can’t Reply Exclusively on Competition? 1.Public goods 2.Information problems 3.Externalities 4.Market power 5.Other problems 10

11. 1. Public Goods (e.g., national defense, police)  With public goods, social benefits exceed private benefits.  The market will produce too few of the affected goods because of the free rider problem.  Implication Having government provide the public good improves efficiency. How to make it available and fair to all? How to make citizens make informed decisions? 11

12. 2. Information Problems  Individuals Do not have access to relevant risk-related information Likely unable to interpret or evaluate the information  Government Ensures that citizens have sufficient information to make informed risk assessments Be in a better position to assess tradeoffs in risk management than are individuals 12

13. 3. Externalities  Most environmental problems involve externalities; that is, social costs exceed private costs. Negative externalities are byproducts of industrialization. With externalities of this sort, one party – usually a business – successfully imposes costs on others. Figure 4.2  The importance of property rights Coase’s theorem 13

14. Private vs. Social Costs (Figure 4.2) 14 P’ and Q’ are the price and quantity in the market without negative externality cost. Government imposes C for higher healthcare cost for production of steel. Assuming constant demand, the price goes up to P” and consumption decreases to Q”.

15. Coase’s Theorem  World with a rancher and a farmer.  Rancher’s benefits His cattle graze on the farmer’s crops The farmer realizes losses from the rancher’s business  With the first cow The rancher gets a marginal gain of $60. The farmer suffers a marginal loss of $10 Thus, the society enjoys a marginal benefit of $50.  Additional cows Diminishing marginal gains up to a certain number of cows and then negative gains thereafter. To the rancher To the society 15

16. Coase’s Theorem – Rancher and Farmer (Table 4.1) 16 When property rights are unambiguous and there are no transactions costs, markets will generate efficient outcomes, even with externalities. Maximum benefits: (with no property right) Society at 3 cows, the rancher at 6 cows, and the farmer at 0 cow.

17. Coase’s Theorem – Rancher and Farmer: Cases with Property Rights  Cases: 1.The rancher is unambiguously liable for any damage done to the farmer. 2.The rancher is not liable at all. 3.The law is not clear whether the rancher is liable.  Possible outcome for each case? 1.The rancher buys up to 3 cows while compensating the farmer for the loss for each (additional) cow. 2.The farmer compensates the rancher for the harm likely caused by from the 6 th cow ($301) until the rancher has 3 cows. 3.Depends on the agreement between the farmer and the rancher, likely “split the difference,” i.e., at 3 cows. 17

18. 4. Market Power  Businesses strive to keep production costs low, thereby maximizing profits. When a firm has market power: Part of this market power might materialize as lower wages than otherwise. The firm may impose negative externalities on the small community in which it is located.  Market power also can result when companies secure preferential treatment – rents – from government. 18 Can You Identify Other Problems?

19. Alternative Social Risk Management Approaches 19

20. Alternative Social RM Approaches 1.Privatization of risk reduction 2.Provision of economic incentives 3.Regulation of risk-related activities 4.Establishing legal liability for damages 5.Creating victim compensation funds 20

21. 1. Privatization of Risk Reduction  Individuals and organizations are capable of making their own decisions and should do so, provided that They have sufficient information and Property rights are clear. 21

22. 2. Provision of Economic Incentives  Encourage a reduction in harmful activities by risk generator  Common instruments Pigovian taxes Refundable deposits & fees Tradable emission rights  With economic-incentive approaches, government does not tell firms how to achieve a desirable societal goal, but rather lets them decide. There appears to be limited potential for using standard ex ante economic-incentive mechanisms for managing accident-type risks. 22 Pigovian tax – The activity causing negative externality is taxed for the amount equaling social cost.

23. Pigovian Tax (Using Figure 4.2) 23

24. 3. Regulation of Risk-related Activities  The actions must be observable at reasonable cost.  Those actions should be somewhat standardized.  The regulatory body should have better information about the risk than those whose actions generate it.  Table 4.2  Insight 4.2 24

25. Estimated Costs per Life Saved (Table 4.2) 25

26. 4. Establishing Legal Liability for Damages  Legal liability as an alternative to the use of a priori regulation It provides an incentive for risk generators. Liability compensates victims who suffer damages.  The incentive effects of liability directly related to the probability that a risk generator will be held liable for the full amount of damages While legal liability has its place in social risk management, it cannot be a substitute for all other policy approaches. 26

27. 5. Victim Compensation Funds  Often intended to make available compensation or indemnification to the injured without incurring the high transaction costs and being subject to uncertainty of the tort system 9/11 Victim Compensation Fund  These funds are essentially a form of third-party insurance. They carry the same advantages and disadvantages of all insurance including the moral hazard problem of dulling risk-reduction efforts by insureds. 27

28. 28

29. Social Risk Perceptions 29

30. Theories  Individualist risk theories Focus on the behavior of individuals when faced with risky conditions Generalize about group risk behavior Psychological and economic theories  Contextualist risk theories Examine the context in which risk-based decisions are made E.g., culture, affinity group, organization Draw inferences about group and possibly individual risk behavior 30

31. The Fallacy of Objective Risk  Psychological (psychometric) theory of risk perception Risk is inherently subjective. Our perceptions of risk influenced by social, political, cultural, psychological and other factors Risk perception, dread and the unknown Table 4.3 31

32. Hazard Descriptions (Table 4.3) 32

33. Economic Theories of Risk Perception  Utility theory  Assumption of rationality in economic behavior  Refer also to Chapter 2 33

34. Anthropology: Group-Grid Topology  Group (Who am I?) The degree to which the individual is incorporated into a social unit Strong or weak?  Grid (What may I do?) The degree to which members of a social grouping are constrained by internally or externally imposed classifications Strong or weak? 34

35. Are You Belonging to…? 35

36. Anthropology: Hofstede (1995)  Anglo countries more individualistic (low-group/low- grid) Australia, Canada, New Zealand, the U.K. and the U.S.  Value solidarity more Denmark, Finland, Netherlands, Norway and Sweden  Take a middle position Belgium, France and Spain 36

37. Anthropology: Cultural Risk Theory 37

38. Discussion Questions 38

39. Discussion Question 1  Assume that it has been determined that certain enhanced crumple zones on cars would reduce fatality rates by 1/100,000. Automobile manufacturers estimate that production costs would increase by $150 per car to include this new design: Analyze whether the marginal benefit is reasonable in light of the marginal cost. Might your answer in part (a) differ between rich and poor countries? Is this “fair?” Speculate about why the expected fatality rate reduction might not be realized even if the new crumple zones were added to cars. 39

40. Discussion Question 2  Critically analyze the following quote: “Attempts to place a monetary valuation on life are morally repugnant.” 40

41. Discussion Question 3  Explain how taxes can be used to achieve a socially acceptable level of pollution. Could fines for pollution accomplish the same goal? 41

42. Discussion Question 4  Is pollution always a negative externality? 42

43. Discussion Question 5  Argue both the pros and cons of the following: “Government has no right to discourage smoking.” 43