Transcript Chapter 2 - Bauer College of Business

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W. Jean Kwon, Ph.D., CPCU
School of Risk Management, St. John’s University
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Risk Management and Insurance: Perspectives in a Global Economy
2. Risk Perceptions and Reactions
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Study Points
 Decision-making under uncertainty:
• Individuals
• Businesses
• Society
 Economic Theories
3
Individual Decision-making under Uncertainty
4
What Are You – Risk-loving, Averse or Neutral?
5
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
School of Risk Management
7
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
9
Risk Decisions and the Expected Value
10
11
Risk Decisions and Expected Value
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
12
Expected Value Theory
 The expected value (EV)
of a set of n possible
outcomes equals the sum
of these outcomes, each
outcome (xi) weighted by
the probability of its
occurrence (pi)
13
Does Expected Value Theory Always Work?
Let’s Play Another Game!
The St. Petersburg Paradox
 Coin flipping until the first tail
appears.
 Win $2 if the tail appears on the
first toss
 Win $22 or $4 if on the second
toss
 Win $23 or $8 if on the third toss
….
14
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
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
How about Risk Loving and Neutral?
Risk Loving
Risk Neutral
 Utility = (Wealth)2
 Utility = (Wealth)1
17
Risk-Averse Utility Function  Errata
10,700
18
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
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
Utilities with and without Insurance
 Maria uses the risk-averse utility theory.
• Expected utility with insurance
• Expected utility without insurance
21
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
A Little Bit about Insurance Premiums
(The U.S. Market)
23
Premium
 A consideration by the purchaser of the insurance contract
 Paid in advance
 Insurers invest premiums until used (e.g., claims payment)
24
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
25
Where the Premium Dollar Goes?
http://www2.iii.org/index.cfm?instanceID=237597
26
Where the Premium Dollar Goes (2006)
 Automobile insurance (2007)
 $111 billion paid for claims
 $97 billion for personal
automobile insurance claims
27
http://www.iii.org/media/facts/statsbyissue/auto/
28
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
Insurance Demand & Lifetime Utility Maximization
30
Insurance Demand and Lifetime Utility Maximization
31
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
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
Economic Theories of Consumption
34
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
Illustrative Prospect Theory Value Function (Figure 2.5)
36
Probability Weighting Function (Figure 2.6)
37
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
Business Decision-making under Uncertainty
39
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
Reaction to Risk – Sole Proprietors and Partners
Sole Proprietorship
Partnership
 Being indistinguishable from the
individual who owns it
 Reflects some combination of
the owners’ degrees of risk
aversion – except the cases:
 The risk perception and behavior
logically is that of its owner
•
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
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
Why Do Corporations Manage Risks?
 Managerial self-interest
• Principal-agent problems
Refer also to Chapter 19
(Economic Foundations of Insurance)
 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
Societal Decision-making under Uncertainty
44
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
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
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
www.medscape.com/viewarticle/406707_4
47
A Perfect Market
Conditions
In the Market
 A sufficiently large number of
buyers and sellers are present.
 Price based solely on the laws of
supply and demand
 Sellers have freedom of entry
into and exit from the market.
 Optimal use of resources
 Sellers produce identical
products.
 Also known as a Pareto optimal
market
 Buyers and sellers are well
informed about the products.
48
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
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
These problems are discussed
throughout the book and class!
50
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
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
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
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
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
Externalities – Trait
With Negative Externalities
With Positive Externalities
 Too much of the good or
service produced or consumed
 Too little of the good or
service produced
 The price becoming too low
 The price becoming too high
 Too little effort and resources
devoted to correct/reduce the
externality
 Too little effort devoted to
enhancing the externality
56
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
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
59
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
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
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
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
Discussion Questions
64
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
Discussion Question 3
 Why would we ordinarily expect corporations whose shares
were widely held to be risk neutral?
66
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
Discussion Question 5
 Justify the following statement: “If externalities did not exist,
society would have no worry about pollution.”
68
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