Chapter 22 Risk Retention-Reduction Decisions

Chapter 22 Risk Retention/Reduction Decisions I. Multiple Choice 1. Which of the following is not a potential benefit to a firm from increasing retention? a. b. c. d. savings on premium loadings increased moral hazard avoiding implicit taxes that arise from insurance price regulation reduced exposure to insurance market volatility Answer: b Type: K 2. Which one of the following firms is more likely to use retention? a. b. c. d. closely held firm publicly traded and widely held firm a firm with a high level of financial leverage a small firm Answer: b Type: K 3. Bilbo Industries is a technology company that prides itself on the ability to react quickly to new product developments. It maintains a significant research and development budget. Regarding risk-reducing activities, Bilbo Industries is a. b. c. d. more likely to retain risks thereby retaining use of more funds more likely to retain risk because of their ability to react to changing developments less likely to retain risks to concentrate on what they do best less likely to retain risk to help ensure they have a steady supply of investment funds Answer: d Type: A 4. A disaggregated risk management approach will generally result in a. b. c. d. lower transactions costs higher transactions cost lower expected losses higher expected losses Answer: b 192 Type: K 5. Which one of the following is an example of an aggregated approach to risk management? a. b. c. d. hedging exchange rate risk hedging interest rate risk purchasing a high level of liability insurance developing a (derivative) contract to stabilize fluctuations on total revenue Answer: d Type: A Use these loss distributions to answer questions 6-8. Liability Exposures Amount Probability of Loss of Loss $8,000,000 .015 $0 .985 Property Exposures Amount Probability of Loss of Loss $4,000,000 .035 $0 .965 6. If the premium loading for the liability exposure is 35% of expected losses, what is the fair insurance premium for the liability exposure? (Don’t be concerned with the time value of money.) a. b. c. d. $120,000 $135,000 $147,000 $162,000 Answer: d Type: A 7. If the premium loading for the property exposure is 25% of expected losses, what is the fair insurance premium for the property exposure? (Don’t be concerned with the time value of money.) a. b. c. d. $140,000 $155,000 $175,000 $185,000 Answer: c Type: A 193 8. If both the property & liability exposures are bundled together and covered under a single contract that has a premium loading equal to 28% of the bundled expected losses, how much savings in premium will be achieved? (Assume these exposures are independent and as before, don’t be concerned with the time value of money.) a. b. c. d. $4,200 $5,350 $8,100 $11,400 Answer: a Type: A 9. The underwriting cycle affects the retention/reduction decision because a. b. the retention/reduction decision is often part of a long-term business plan a firm usually wants to correctly alternate between retention and reduction as the underwriting cycle dictates purchasing insurance in soft market will stabilize cash flows The underwriting cycle has little effect on the retention/reduction decision. c. d. Answer: a Type: A 10. Residual markets regulation can create an incentive to self-insure a. b. c. d. when residual premiums are higher than those in the voluntary market because firms who self-insure do not participate in residual market financing because self-insured firms are subsidized by the residual markets whenever residual markets provide coverage for compulsory coverages Answer: b Type: K 11. A large firm with a high degree of correlation across loss exposures will tend to rely on a. b. c. d. risk retention risk reduction via an insurance contract self-insurance risk reduction via internal diversification Answer: b Type: A 194 12. A basic guideline for the retain/insure decision is ‘Insure those exposures that… a. b. c. d. have reasonably predictable losses.’ (This makes for stable premiums.) can potentially result in large, disruptive losses have high frequency and high severity are measurable Answer: b Type: K 13. Firms concerned with their probability of insolvency will tend to a. b. c. d. retain more risks so as to keep use of funds otherwise spent on premiums retain more risks to avoid increasing their debt financing insure more risks in order to decrease their reliance on debt financing insure more risk to stabilize their cash flows Answer: d Type: A 14. A bundled insurance policy with a single overall retention limit can help a firm a. b. c. d. avoid purchasing unnecessary coverage avoid the problem of two contracts providing duplicate coverage develop simpler contracts understand the disaggregated loss distributions Answer: a Type: K 15. Newly designed bundled contracts will face the uncertainty of legal interpretation and the settling of disputes thereof. This uncertainty, relative to established separate contracts, is an example of a. b. c. d. minimal risk transfer ‘bundled’ contract law moral hazard increased transactions costs (for a bundled policy) Answer: d Type: K 195 II. Fill-Ins 1. Optimal retention for many firms involves the retention of predictable losses and buying insurance against large, potentially disruptive losses. 2. Reducing exposure to insurance market volatility is a benefit risk exposure. 3. A firm who very actively seeks out new investment opportunities is most likely to use risk retention when evaluating the retention/reduction decision. 4. The complexity of the contract is a disadvantage to the approach to the risk retention/reduction decision. 5. A firm with a high level of financial leverage is retention. of retaining a aggregate less likely to use III. Problems and Short Answer Questions 1. The development and selection of alternative risk management methods involves a fundamental tradeoff between the benefits of retention and the increased costs from greater risk. What are the benefits of increased retention? Answer: The potential savings from increased retention include: a) savings on premium loadings; b)reduced exposure to insurance market volatility; c) reduced moral hazard; d) avoiding high premiums that may accompany asymmetric information; e) avoiding implicit taxes that arise from insurance price regulation; and f) maintaining the use of funds until losses are paid. Type: K 2. Consider two firms: Firm A has 2,000 workers in twenty different states. Firm B has 500 workers at a single plant. All else equal, which firm would be more likely to retain their workers compensation losses? Explain. Answer: Firm A would be more likely to retain because the lower correlation among workers reduces the variability of losses compared to Firm B where many workers could be hurt in a single accident. Type: A 3. Killebrew Inc. has historically purchased separate policies for property insurance and liability insurance. Each of the policies had $4 million retention. The company is now considering the purchase of a bundled policy which covers both property and liability exposures. The retention of the bundled policy is to be $8 million. Draw a 196 graph illustrating the areas of unnecessary coverage that will exist if Killebrew continues with separate policies. Liability Loss Answer: 8 4 Unnecessary Coverage 4 8 Property Loss Type: K 4. Why does a firm which is very active in seeking out new investment opportunities, e.g. a technology research firm, have less incentive to use retention? Answer: A firm which is engaged in cutting-edge technology will desire a steady flow source of investment funds. If such a firm suffers a loss on a retained risk exposure some investment opportunities may have to be foregone as the funds will not be available for the investment or the cost of raising funds externally may be too great. Type: K 5. Detail some of the difficulties in the aggregated approach to risk management. Answer: The primary difficulty of the aggregate approach to risk management is the complexity of the undertaking. Detailed knowledge of the individual risk exposures and their correlations must be obtained. Given the breadth of some corporations this might be quite difficult. The insurer (or whoever is assuming the risk under a bundled policy) must understand how to price such an amalgamation of risks. All of this complexity gives rise to higher transactions costs. Additional issue that exists once a contract is established is how any disputes will be resolved. These new types of contract will not have a established set of laws governing interpretation of the contracts. Type: A 197