Bepp Module 3
crisis risk management
type of risk control: -loss reduction activity: -occurs post-loss to lower the severity of damage associated with a crisis -damage includes losses associated with firm reputation, stock price, credit rating, etc. good crisis RM : -have coordinated plan in place, pre-crisis -erm focus on managing hazard, operational, strategic and financial risks -media control -relationship with investors etc. -reputation management example: tylenol poisoning crisis: good practices: -creating strategy team -product recall/warnings -campaign to reintroduce product ex: coupons, safety statements, new packaging -keep public informed, hot line -news conferences + safety presentations
thought questions w/ torts
who pays for right to easily sue for pain and suffering: -consumers through higher prices do consumers buy insurance for pain and suffering -rarely might it be inefficient to offer damages for pain and suffering -too much insruance
duty to defend
with liability coverage: insurance co has duty to defend the policy holder -broader than the duty to indemnify -insurer may have to defend claims with no indemnity 0insurer provides defense if any claim in a lawsuit is covered -insurer has right to control the defense and settlement unless there is a conflict of interest -defense costs do not apply towards policy limits
how does insurance look similar to a put option
**
limited liability risk and bankruptcy
-HH has potential to get sued, should she buy insurance -depends on wealth levels: -with lower wealth levels: actuarily fair insurance eliminates possibility to go bankrupt --> don't buy (LL puts lower bound of loss @ 0) explained: -insurance reduces wealth when no loss (bc paying premium) -insurance increase wealth when loss occurs (indemnity), but not as much at the lowest value where she could've gone bankrupt -with higher wealth, potential to go bankrupt is reduced, thus insurance is more valuable **hh is risk averse, but bankruptcy and insurance are substitutes!
athlete's ipo
-application: way for athletes to insure/get $ upfront, they benefit from it because getting income for sure, and investors can get a good return but watch the moral hazard issues ex) track pole vaulter record
risky debt is a short put option
-as long as firm value > debt, extra goes to equity holders, once below the default option, equity holders get less
alternative to tort system
-aside from threat of paying damages: -consumers can provide incentives for safer products through prices (WTP for safety) with the tort system: consumers ultimately pay the cost imposed on firms through raised prices
3. manage risk to satisfy an objective
-broad objective of erm: achieve a more efficient distribution of risk between individuals, corporations, generations etc. -erm = decision making that results in changing one probability distribution to a more favorable one
2. asset distribution + impact of losses
-consultants: look @ data, models, frequency + severity of losses -portfolio vs silo approach
value of firm with insurance: diversifiable risk
-does not increase the value of the firm because the discount rate (r) remains the same because the risk premium would not change (the risk premium is only dependent of the risk in the market) --buying insurance doesn't change the discount rate , so only effect comes from changing expected cash flows, if insurance premium is at least actuarily fair, insurance cannot increase firm value
Methods of risk identification
-financial statement analysis: debt, forex exposure, industry exposure etc. -contract analysis: concerned about the people you work w/ -physical inspections past data + info: ex) worker's comp + past history about cost + injury type -talk to managers + employees -survey questionnaire flow chart analysis thoughts about risk identification: -top surveyed risks = financial: because difficult to manage/predict outcomes -hazard risks are lower bc have more info and can better manage pure risks -costly risks are hard to predict -political uncertainty --> index: -terrorism + political violence
non-diversified risks
-for these risks, investors need to receive higher expected returns
limited liability risk and bankruptcy
-from bob's burgers: paying with your personal wealth: gives you the option to keep the firm alive, if less risk averse, the option is worth more (assuming business have positive expected value in future) - more risk averse = bankruptcy -less risk averse = continue -the decision to go bankrupt or not when a publically traded company: choose whichever outcome has a higher expected value (effectively risk neutral)
5. improving investment decisions: asset substitution
-highly leveraged firms have an incentive to undertake risky, negative NPV projects --firms have a choice over many projects, debt creates a preferences for riskier project why: default/put option more valuable with more risk -creditors anticipate tendency for higher risk projects which raises the cost of debt --> THUS firms would like to commit to avoid risky, negative NPV projects in order to lower the cost of borrowing and allow them to borrow more asset substitution: riskier projects, move to riskier markets, increase leverage, unwind hedges
value of a firm
= expected value (cash flows ) ^t / (1+r) ^t
diversification
= pooling risks that are not perfectly correlated across firms -investors can diversify away idiosyncratic risk -since diversification is cheap+ easy, investors are not compensated for bearing idiosyncratic risk
loan convenants
corporate credit agreements include contractual agreements to curb excess risk taking -firms have an incentive to reduce risk and make creditors happy becuase 1. benefit through lower cost of debt 2. loan contracts force firms to behave
law term: civil
covers acts against a person or entity examples contract dispute tort: harm caused where no contract exists *tort costs: biggest commercial risks borne by us firms
law term: criminal branch of law
covers acts against the state
traditional insurance: occurrence based
covers losses for accidents that occur during the policy period, regardless of when the claim is filed why: timing of insured events can ambiguous, can manifest years later ex)mold -can create very long tail **transfers most risk to insurer because occurrence based you cant adjust prices during claims based insurance allows insurers to re-price risk based on new information
traditional insurance: claims-made policies
covers losses for claims that are made during policy period, regardless of when the accident happened -retroactive date: claims related to accidents prior to fixed date are not covered
owner's/equity holder's claim is a call option
default boundary (zero or the value of sdebt) -stake owned by equity holders = call option -creditors are a put option
why have tort system
economic justification for tort system relies on the failure of the coarse theorm -positive transaction costs that prevent prices from adjusting easily -information problems that limit consumers ability to influence firm's choices tort awards also provide compensation: similar to insurance -compensates for unexpected losses -premium embedded in prices of goods and services optimal compensation: amount of insurance that people would have purchased -if fully informed about the risk -in terms of insurance reflected the costs associated with insurance through the tort system **essentially: transaction costs create more distortion in market, preventing a natural equilibrium --. torts help this , kinda like insurance -like insurance: -purchase full only if prices are actually fair, but because of premium loadings, moral hazard and adverse selection, partial insurance is standard THUS: awarding full compensation for economic losses and pain and suffering is more than optimal level of compensation
benefits of captives
efficient means retaining risk: -firms understand that they are retaining risk + want to finance it as cheaply as possible -helps with underwriting (example if good year, premium goes down) and price cyles -tax treatment: as captive can deduct both paid losses and expected value of future payments -also can get benefits from moving captive offshore to countries with lower corporate tax rates access to reinsurance = less regualted risk pooling = insuring others, pools exposure with other firms --> risk pooling benefits selling insurance for a profit = captive provides opportunity for making money by selling to others `
layering policies
either buy 240 x/s 10 or 4 policies from 4 insurers: 15 x/s 10 25 x/s 25 50 x/s 50 150 x/s 100 ^good option becuase default risk of insurer is low
law term: statutes
enacted by government bodies
law term: common law
evolved over time through court decisions
partial insurance terminology: per occurrence policy limits
firm pays all losses above the policy limit for each loss occurrence
partial insurance terminology: aggregate deductible
firm pays all losses up to the deductible amount on all losses that occur during the policy period
partial insurance terminology: per occurrence deductible
firm pays all losses up to the deductible amount on each loss that occurs
5. improving investment decisions: cost of external financing
firms generally like to fund investment from internal funds -because internal capital cheaper than external capital -avoiding having to access external markets provides motivation for managing risk because if firm loses internal funds either 1. cuts back on investment 2.seek to raise external funds to finance investment ^^ these are costly *hedging benefits: -avoid low cash flows, that requires external financing or cutbacks in investment -what's the cost of hedging: -must give up a small investment for sure -firms will cut back on the least profitable project first
heat map: assessing F and S
frequency: on a scale from almost never to definitely will happen severity: on a scale from slight to severe where severe requires org to finance the loss or not survive
corporation
legal entity separate from owners: has legal powers like individuals, corporation solely responsible for obligations
directors and officers coverage
liability insurance payable to d&o's of companies as reimbursement for losses or advancement of defense costs in the event an insured suffers such a loss as a result of a legal action brought for alleged wrongful acts in their capacities as d and o's essentially coverage for defense costs from investigations/ trials brought against d's or o's covers: -shareholder actions ex)stock fraud -reporting errors/inaccurate/inadequate disclosure -misrepresentation in a prospctus -failure to comply with regulation or laws excluded -fraud, intentional non-compliant acts -illegal remuneration or personal profit -property damage/bodily harm -legal actions already started when policy begins -claims made under previous policy -claims covered by other insurance in us most often cases of employment or HR-related
negotiated prices
markets with flexible prices permits consumers to pay for safer priducts: signal higher willingness to pay for safer products -need: -safety knowledge -prices able to adjust without cost
risk financing (as way to manage risk)
methods: 1. internal funds: retention: includes self-insurance and captive insurers 2. external funds: contingent wealth transfers: contractual agreements that transfer $ contingent on the state of the world Insurance contracts Financial contracts: swaps, forwards/futures, derivatives, catastrophe bonds, etc. Government: insurance, bailouts, loan guarantees
systematic risk
multiple firms in industry/economy , correlated with the market, cannot be diversified away
risk financing: insurance
promise to identify the policy holder in the event of a loss -indemnify = make whole in exchange for a pre-paid premium -what determines the price of insurance: -value of asset + -risk: prob of loss + -length of contract + -discount rate - -**insurance is not identical to an option because of provisions (exist because unlike options: you are locked into for a certain amount of time) examples of provisions: unemployment insurance vest period, job tenure
1. Identify risk types (pure vs speculative)
pure risk = possibility for loss/no loss (just 2 outcomes) ex) fire, theft, death speculative risks = multiple outcomes
3. two methods to manage risk
risk control: investments to reduce expected costs of risks risk financing
catastrophe bonds
risk-linked securities which transfer a specific set of risks from an issuer or sponsor to investors investors take on risks of specified catastrophe in return for attractive rates of investment *when QUALIFYING catastrophe event occurs investors lose principal and issuer (usually (re)insurance cos) receives that money to cover losses
captives: tax treatment
taxable income: -non-insurance firms can deduct losses paid during calendar year -insurers can deduct losses paid plus reserves for expected future payments ^this difference permits insurers to deduct losses earlier which increase the present value of tax benefits -paid losses: amounts actually paid during calendar year -incurred losses: paid losses plus discounted liability for unpaid losses
3. purchase real services
-insurance cos are efficient at providing certain services why: -efficiencies from specialization, economies of scale 1. claims processing: -assess damage, repair assets, pay claims -requires time + expertise -good at defending liability claims/fighting big ones -good to bundle because insurance co's are incentivized to investigate claims, reducing moral hazard 2. risk control methods: -advantage in assessing loss exposures and administering safety measure why: organization capital, data, expertise 3. insurance for specialized risks -ex) boiler and machinery insurance -covering equipment breakdown -don't really provide that much coverage: value comes from inspections, testing, etc. this benefit: doesn't come from lowering r, but from avoiding costs that accrue if cash flows are low
traditional coverage
-insured pays fixed premium for coverage of a particular type of exposure for a fixed period of time
diversified portfolios
-investors have well-diversified portfolios where the return = sum of weighted returns -the discount rate does not reflect the firm's idiosyncratic risk
LL like a put option
-ll creates options for firm to go bankrupt: let them avoid their obligations -like a put option: losses can be put to another entity (for example the creditors, or claiment) -like a financial option: insolvency put option is more valuable the higher the chance of bankrupcy/the riskier the underlying asset is
insurance applications to individuals
-logic doesn't apply because personal assets aren't diversified -hard to diversify because limited in capital + moral hazard: the less you own in yourself, the less likely you are to care after yourself/put in effort
financial institutions: limited liability
-more extreme moral hazard issues -guaranteed funds exacerbate mh by removing creditors incentives -often thought of as too big to fail -government support and bailouts
tort rules
-negligence standard: loss must be a direct result of defendant's actions test: -but for -foreseeability -injury to plaintiff: some economic loss must occur terms: tortfeasor: one who commits a wrong no liability = tortfeasor cannot be liable, makes other parties liable for their own loss absolute liability = tortfeasor is liable provided tat if can be proven that actions caused injury: no defenses allowed liability for negligence = tortfeasor cab be held liable but burden on plaintiff to prove negligence standard: -defendant had legal duty to behave to protect others from harm -breach of duty: defendant must have failed to exercise required standard of card test: -reasonable prudent person -cost-justified precautions defenses to negligence: -assumption of risk: plaintiff voluntarily assumed a known risk -contributory negligence: plaintiff behaved negligently contributing to the loss strict liability: lower burden to prove liability: tortfeasor can be held liable for tortfeasors losses without negligence ex) product related liability types of damages: compensatory damages: designed to compensate injured party for their loss -special damages: lost wages, property damage ,medical expenes -general damages, pain and suffering -punitive damages: punish and deter
value of firm with insurance: non-diversifiable risk
-no the discount rate would fall, but the expected cash flows would also fall --> firm value does not increase -cash flows increase because insurer demands extra compensation for taking on systematic risk
insurance pooling: how it works
-policy holders share losses among themselves, each having an expected average loss -as the number of the poll increases that expected value remains the same, but the variance decreases
limits of coverage
-policy limits: maximum insurance supplied by insurer --deductibles: portion of loss paid by firm **changes when applied per occurrence or aggregated to all events in the policy period ex) world trade center 1 or 2 occurrences: changes how much of deductible they owe
example of optimal loss control
-producer has product that can harm consumer $10,000 preferences: consumer = risk neutral: make decisions only on expected value moral hazard: accident probability depends on $ invested into safety/loss control **safety expenditure while be where the marginal benefit of safety >= marginal cost of safety BUT: cost of safety falls of firm, but benefit of safety goes to consumers (marginal firm benefit not that high) BUT if firm is liable for injury then will investment in safety (now firm bears the cost + benefit of safety)
2. avoid costs of financial distress
-reduce risk = reducing likelihood of incurring financial distress costs -costs of distress often fall on creditors --> reducing volatility can increase debt capacity --> good because debt is cheap form of financing + receives preferential tax treatment aka. interest = tax deductible types of financial distress costs -bankruptcy: legal process generates deadweight costs ex) cost of administering process ex)disruption of governance, loss of investment opportunity, loss of valuable employees, reputation, market share -ex-posts costs: cost of financial distress derive mainly from direct costs and loss of investment -ex-ante costs: many costs happen pre-bankruptcy in anticipation: costs tend to happen in bad times, makes it harder to borrow on top of that real world examples: -auto-bailouts because thought consumers might stop buying from auto-makers in severe distress, backed their warranty
5. improving investment decisions
-reducing risk can increase the chance that firms undertake positive NPV projects and decrease chance firms take negative NPV projects how: a. asset substitution b. debt overhang c. cost of external financing
why do individuals purchase insurance
-risk aversion --> diminishing marginal utility --> EU not equal to Expected value -losses hurt more than gains
4. protect un-diversified shareholders
-some firm stakeholders aren't investors and sometimes have concentrated stake in firm (not diversified) -managing risk --> better relationships with these types of stakeholders examples: -employees -suppliers -customers example with executive compensation -incentive based compensation, but risky for undiversified stakeholders, making them require high premium -reducing risk can ease that trade-off between risk premium and incentives -risks should be hedged -when unrelated to performance -hedging: benefits firm by requiring the manager to have lower risk premium while inducing him to have high effort *best to hedge risks where manager has little influence **if manager receives options instead of fixed share of profits: might not want to hedge, because assuming he's a diversified stakeholder, prefers more upside (risk)
1. reduce tax payments
-tax schedules are progressive in pretax earnings (meaning tax at different amounts of earnings), reducing risk will increase after tax expected earnings (in reality tax rates are progressive, but drop down after 355 K + ability to carry forward or backward reduces this convexity) -tax schedules are convex, making after tax earnings concave -insurance (or hedging) reduce expected tax payments and increase expected after tax earnings by reducing the upside earnings that are taxed more heavily
limited liability
-think of as form of insurance: -liabilities are limited to corporations assets, claims against the corp cannot reach the personal assets of individual shareholders -important for claims against the org, fraud, slander, etc.
impact of tort system
-tort system provides incentives for firm to invest in safety --> when compensation to victims is equal to the actual damages, firm invests optimally --> when compensation is less than complete, the firm under-invests in safety if compensation was $0 -the firm would not invest at all if 20,000 the firm will over invest in safety
Steps to ERM
1. identify risks 2. aggregate distribution (to firm level) /impact of losses 3. manage risk to satisfy an objective -rm strategies: risk control and risk financing -reduce, retain (internally finance), finance (externally) 4. communicate, monitor, adjust
5 reasons to manage corporate risk
1. reduce tax payments 2. avoid costs of financial distress 3. purchase real services from industries 4. protect undiversified stateholdes 5. improve inestment decisions
limited liability and tort system
LL undermines tort system because ability to walk away from damages ex-post can reduce ex-ante incentives to create optimal safety --> could say entity is judgement proof for damages in excess of the assets they can keep after filing bankruptcy limited liability might justify -mandatory insurance like: workers comp, unemployment insurance, auto-liability insurance or alternative to tort system: government to enforce safety requirements -firms forced to invest in optimal amount of safety -tort provides incentives BUT: -safety requirements might be hard to enforce because optimal level of safety might no be determinable (or at least for reasonable price)
benefits of limited liability
although it makes firms like risk and thus creates potential for moral hazard its good becuase -stimulates innovation -firms take on riskier projects that they otherwise wouldn't
partial insurance terminology: stop-loss prevention
amount firm pays on occurrence deductibles limited by a stop loss provision that applies to the sum of all deductible payments
captive insurance
a wholly-owned subsidiary that provides insurance to the parent firm form of self insurance (planned, funded, retained) pure captive = insurer that only insures its parent group captive = insurer with multiple parents designed to provide insurance to parents diversified captive = captive insurer also insures firms other than parents captive insurance evovled because of expensive property liability insurance
negative loan covenants
actions a borrowing firm cannot take ex) acquistions, paying a huge dividend to shareholders, capital expenditure restrictions (cant spend in excess of X%, because creditors fear bad investments/risky projects when spending more $)
affirmative loan covenants
actions a borrowing firm must take ex) comply with regulations, pay taxes
risk retention:
active vs passive: -passive = didn't know about it/underestimate it finded vs unfunded: -unfunded = don't put aside $ (common with smaller risks) self insurance = active funded retnetion
1. identify risk types (risk quadrants)
hazard: -pure risks, usually managed with insurance examples: fire, property damage, natural perils, health, safety, personal injury, disease, disability, liability claims financial: -risks arising from changing market conditions that impact a firm's financial position; typically speculative risks examples: -input-output prices, foreign exchange, credit losses, int rate risk, commodity risk, legislative changes operational: -risks arise from day-2-day operations examples: -supply chain, business interruptions, information technology, fraud, workplace violence, kidnap, turnover strategic: -risks associated with firm's business plan/mgmt decisions examples: -competition, reputation, demographics, ethics, social responsibility, media coverage, R&D decisions
2. avoid costs of financial distress: methods
how to reduce prob of loss: hedging -hedging = making an investment to reduce the risk of adverse price movements of an asset -->example: taking an offsetting position in a related security -similar to insurance, protects against negative event *to hedge perfectly, buy two negatively correlated securities -if debt has already been issued, equity holders: won't hedge because hedging reduces the tails of payoff for equity holders (higher risk = higher reward) -if the debt has not been issued, equity holders: -will hedge, will get more $ issued from creditors, effectively like getting a lower interest rate commitment: -must commit to hedging to get lower interest rate debt is issued equity holders would like to take on more risk --> loan covenants to control this! --> after
ERM historically
in 1950's: RM just consisted of buying insurance 1960's: contingency planning, loss prevention, safety mgmt 1970's: risk retention, now an option 1980'/90's: financial risk mgmt 2000's: ERM, chief risk officer, --> recognizing that risks are correlated so not just a department, but relevant throughout the industry --> moves up boardroom agenda --> cro report directly to ceo
tension between equity + debt holders (moral hazard)
increase in value with risk since they capture upside but do not suffer the down side *conflict of interest between equity and debt holders -equity likes risk: creates more upside -debt dislikes risk: less chance of being paid back --> creditors understand this tension and write clever loan contracts limited liability: like a form of insurance that makes firms like risk--> creating moral hazard
insurance w/ risks
insurance = essentially large pools of diversified risks -policy holders share losses among themselves -insurance co shareholders provide capital that covers losses in excess of premiums -works best with diversifiable risks, in practice insurance covers pure risks
coarse theorm
investing in safety: -private market solution is efficient where marginal safety benefit = marginal safety cost MSB = MSC -need zero negotiation costs -all parties must have full information
risk control (as way to manage risk)
investments to reduce the expected costs of risks -reduce the frequency of loss -make the loss more predictable -can be implemented ex-ante and ex-post -impact direct/indirect cost of risk methods: 1. avoidance -don't engage with risk -some risks that you can't avoid ex) multi-dose vials: lawsuit > revenues (making the loss more predictable) 2. loss prevention -reduce loss prior to occurrences (ex-ante) -ex) training, inspection, building codes (reduction in frequency) 3. loss reduction -pre-loss ex) sprinklers, safety drills -post-loss ex)disaster recovery, legal defenses (reduction in severity) 4.duplication of exposure units -key assets replaced but held in reserve -benefit: reduced net income losses + business interruption -cost: creating duplicate (reduction in severity) 5.separation of exposure units - break down asset/activity into small parts -benefit: decrease the chance of high severity loss -cost: increased frequency of losses (reduction in severity) 6. diversification (reduction in severity)
why cat bonds
investors like: because high risk, high reward security typically underlying risk has low correlation with other assets in investor's portfolio firms like: because allow them to spread risk among larger group, reinsurers can transfer risk to capital markets
5. improving investment decisions: debt overhang
issue: with high leverage (aka debt), some of value of new projects makes old debt more valuable to creditors --> making equity holders reluctant to undertake positive expected NPV projects ex) homeowners who are underwater don't want to take on home maintenance moral hazard: when people don't put their own money down on a house, signal -example with remedial action --> post loss-occurrence: action primarily benefits creditors --> equity holders don't want to pay for a cost that benefit goes to creditors *insurance creates commitment to these types of good action
economic role of tort system
objectives 1. optimal safety: meant to provide incentives to invest in safety 2.optimal compensation for victims: provides insurance coverage to victims -use economic efficiency as measure: -ignore distributional issues/fairness -issues: -transaction costs -risk preferences -information
idiosyncratic risk
only one firm, uncorrelated with the market, can be diversified
real options
option created by LL -not a financial option, but an operating option -created from ability to make decisions over time as information changes why: uncertainty often decreases with time -more valuable with more risk what does an option do: -provides downside protection -increase in risk taking only creates upside what about purchasing revenue insurance with option: -no because they like riskier revenues with option option -increases upside when revenues can be higher (choose to pursue in those instances) types of options: -options to expand -options to delay/abandon
what is enterprise risk management?
organization assess, control, exploit finances and monitors risks in order to increase short/long term example: pro-active rm: doing fire/bomb drills re-active rm: penn changing policy after penn state
risk mapping
plot risks by frequency and severity use: compare risks in an organization/firm -help determine which risks deserve the most attention + resources -discuss the correlation of risks -create coordinated cross-functional teams **IDEA: first manage risks that threaten the long-run viability of organization these maps are: -not the same for every company -not the same for a firm within an industry -not the same for the firm across time
partial insurance terminology: excess policies
policies with large dedictlbes and policy limits, policy covers firms losses from $D (deductible) to $D+L (loss + deductible)
risk control: loss reduction
pre-loss: 1. prepare for potential losses in the most economic way 2. reduction of anxiety 3. meet any legal obligations post-loss: 1. survival of the firm 2. continue operating 3. stability of earnings 4. growth of firm 5. social responsibility is to minimize the effects that a loss will have on other people and on society
loss-sensitive contracts
premiums that are ultimately paid depend on the losses that occur during the policy period example: premiums can change if losses are high, might get refund if losses are low -experience rating: for larger corporations: premiums charged reflect firm's past loss experience -this makes future premiums very sensitive to past losses -retrospectively rated policies: ultimately charged current premiums depend on losses that happen during policy period -floors and caps determine amount of insurance
risk control: avoidance
problems: not always possible/avoidance might require giving up some important advantages benefits: sometimes benefits of risky activity are outweighed by the costs associated with them