Question

• Explain who the counter-party is to a risk management derivatives contract that an insurance company would engage in and what his or her motives are to engage in the derivatives contract.
• What are the main considerations in determining the proper mix of retention and transfer in handling potential loss exposures?
• Explain the concept of self-insurance. Why is all self-insurance assumption, but not all assumption self-insurance?
• How do deductibles affect moral hazard?

Answer 1

1)

The counter-party is to a risk management derivatives contract that an insurance company would engage in and what his or her motives are to engage in the derivatives contract .

Derivatives are important risk management tools that have made it possible for financial and non-financial institutions to buy and sell exposures, thereby diversifying their risk portfolio and reducing earnings volatility. Given the benefits of using derivatives, the market in derivative products has undergone explosive growth over the last 15 years. Today, derivatives are being extended beyond the mainstream interest rate, currency, commodity, equity and credit markets to manage new underlying risks, such as catastrophe, pollution, electricity, weather and inflation risk.

An insurance derivative is a financial instrument that derives its value from an underlying insurance index or the characteristics of an event related to insurance. Insurance derivatives are useful for insurance companies that want to hedge their exposure to catastrophic losses due to exceptional events, such as earthquakes or hurricanes.

Unlike financial derivatives, which typically use marketable securities as their underlying assets, insurance derivatives base their value on a predetermined insurance-related statistic. For example, an insurance derivative could offer a cash payout to its owner if a specific index of hurricane losses reached a target level. This would protect an insurance company from catastrophic losses if an exceptional hurricane caused unforeseen amounts of damage.

Insurers can use derivatives to effectively manage their risks. A life insurer with a large portfolio of Guaranteed Minimum Death Benefit annuities can hedge against a steep decline in equity markets. Life insurers offering interest rate guarantees on their life savings products can use derivatives to hedge against low interest rates. Property and casualty insurers can transfer some of their catastrophic risk to the capital markets via swap transactions. Finally, insurers can use derivatives to manage their assets and liabilities and to enhance their capital adequacy: for example, they can use derivatives to redress any asset-liability mismatches by adjusting the duration of their assets in line with that of their liabilities. Furthermore, they can purchase options to sell their equity to a counterparty at a pre-negotiated price should they face a liquidity crisis.

The counterparty to the derivatives contract is likely a speculator who has a different prediction about future price movements compared to the insurance company. Hence they are willing to take a risk and will charge a fee for taking this risk.

Insurers have actuarial, market, liquidity, credit and operational/legal risks. When it comes to derivatives, the main actuarial risks are the pricing of embedded options, such as interest rate and principal guarantees. Market risk arises when the economy affects product performance through an impact on equity markets, interest rates, inflation, exchange rates, etc. Liquidity risk arises when a financial institution finds it has insufficient liquid assets to meet its immediate obligations. Credit risk stems from a counterparty potentially failing to meet its debt obligations.

Today’s usage of derivatives has seen the development of multiple strategies, into which companies incorporate derivatives. The use of hedging through derivatives is still highly prevalent. Companies, both in-and-out of the financial industry have begun to use derivatives a method of speculating and generating income. Arbitrage firms have also started to use derivatives as a method creating arbitrage opportunities.

Hedging, which was the original purpose for the creation for derivatives, continues to be one of the uses of these instruments today. Derivatives are commonplace for risk management techniques by corporations both in an out of the financial industry. At the core of hedging, derivatives allow a simple transfer of risk. When a company purchases a derivative as a part of a risk management strategy, the risk is not eradicated. Instead, the risk has been moved. A derivative allows risk to be shift from those unwilling to hold it, to those willing to take on the risk. The counterparty to the hedger, therefore, will be a speculator— someone willing to take on risk in hopes of receiving a payment regarding the future value of an asset.

The biggest motive of the counterparty to a risk management derivative contract is speculation. Investors that took up significant speculation positions and won big are frequent market headlines. Speculation is also purported to be the biggest risk to take in the market.
Speculation is a broad term, that be defined as an investment process where the investor is a making a judgment call on the direction of the value of an asset in the future. Speculation in the derivatives market involves an investor, betting that the price of the underlying asset or commodity will move in a particular direction over the life of the contract. For example, an investor who believes that the French franc will rise in value relative to the U.S. dollar can speculate by taking a long position in a forward contract on the franc.

Any derivative instrument can be used to speculate; therefore, speculation is commonplace in each area of the derivatives market. Speculators tend to flock to the derivatives market for multiple reasons. First, using derivatives levers an investor. As the investor’s decision starts to pay-off, it will be significantly magnified if the bet was placed in the derivatives market. Second, derivatives take very little capital to make those significant bets. When entering a derivatives contract neither party puts any money up-front. This allows investors and firms to speculate multiple times over on a smaller capital base.

Many companies have started to turn to using derivatives and financial techniques for income generation since income from derivatives, even if being used for hedging is treated as ordinary income. Enron is an example of a firm that started to drift from the original business in favor of financial derivatives. Enron originated as an energy producer, but at the time of the firms collapse, the company had become a full-time energy derivatives dealer.

2)

The main considerations in determining the proper mix of retention and transfer in handling potential loss exposures

Risk exposure is the measure of potential future loss resulting from a specific activity or event. An analysis of the risk exposure for a business often ranks risks according to their probability of occurring multiplied by the potential loss if they do. By ranking the probability of potential losses, a business can determine which losses are minor and which are significant enough to warrant investment.

Retention and loss exposure are important aspects that affect a business’ risk management practices. Risk management involves reducing the business’ exposure to risks and losses while absorbing and transferring some risks and losses. The business must find a balance between retention and loss exposure to ensure stabilized earnings while maintaining a productive growth rate.

Loss Exposure

Loss exposure is the category of factors that can cause the business to lose money and its financial stability. The losses are caused by an array of factors, including property exposures, liability exposures and business income exposures. These aspects can appear as downfall of the property prices, injuries caused by the business’ products and losses incurred due to faulty investments, etc.

Managing Risk

While many loss exposures can be prevented with careful planning and quality production, some loss exposures cannot be avoided. The company must manage its risks in order to control the business’ loss exposure. To manage the risk, the business can implement various strategies to provide protection, including monitoring the quality of its products, seeking professional advice from banking and investment professionals, as well as placing insurance on various areas of the business.

Retention

In order to manage the potential risk, the business must first identify the loss exposures and then measure the impact each exposure can have on the business. The strategies to control the risk are developed around those measurements. While building these strategies, the business may elect to retain some of the risks rather than insure or finance the exposure. The retained losses are then paid directly by the business as they occur. For instance, a business may elect to eliminate collision coverage from certain vehicles on its business auto policy. The elimination of the coverage is an acknowledgement that the business will absorb the potential costs incurred if the vehicles are involved in collision accidents.

Active vs. Passive

Retention is often placed into active and passive categories. Exposures that are recognized by the business and planned for accordingly are actively retained. Exposures that are ignored by the business or never identified until the exposure occurs are passively retained. Though all loss exposures impact the business, passively retained exposures are most detrimental to the business’ existence because the business is unprepared for the risk when it occurs. It is important to manage risk effectively to avoid unexpected losses and resulting financial loss.

A risk manager of a company is the person who purchases insurance for his firm. He also has the deductibles and/ or the self insured retentions (SIRs)  also referred to as retained risk. If he retains significant amounts of risk, his company incurs a capital charge for retaining such risk, regardless of whether the company recognizes the charge on its balance sheet.
Calculating this charge has proven to be a challenge.

Insurance is like a form of contingent capital—the insurance company is willing to provide, for a premium cost, access to a considerable amount of funds in the event you have a loss. Access to the insurance proceeds is contingent on experiencing an insurable loss. Hence the question arises: Is insurance an efficient use of capital? The answer is dependent on several factors:  The cost of the insurance v/s the value of retaining the risk. However, some insurance purchases cannot be avoided; those for catastrophic loss, for example, but unless a company can identify the actual cost of retaining risk, the question of whether insurance premiums constitute an efficient use of capital will remain unanswered.

Insurance premiums purchase are off-balance sheet risk protection, and risk you retain, either through deductibles or self-insured retentions, remain on the balance sheet.

The question then becomes what is the optimal combination of risk retention and risk transfer?

Most companies not only do not understand that retaining risk has a capital impact, but they have no financial metrics for comparing retention v/s transfer . They also have no way of determining if the risk transfer premiums represent economic value.

Many externalities contribute to the confusion surrounding this question. Pure economic factors do not usually drive the price of excess insurance; the markets do. This means that in most years, the cost of the protection bears little resemblance to your individual risk profile.

Another factor that contributes to the lack of understanding of the financial impacts of this decision is the role of insurance companies. When an insurer promulgates rates for excess risk transfer, it does so at convenient dollar amount intervals. For example, $100,000, $250,000, and $500,000 are quite popular retention amounts.

There is a way to calculate the costs of retained risk and risk transfer, similar to how a company calculates its internal rate of return (IRR), and the relationship between the IRR associated with its risk management decisions and its weighted average cost of capital (WACC). It doesn't alleviate the endemic problems of negotiating the cost of excess insurance, but the co. will have a better idea of what the coverage should cost.

The WACC is what it costs a firm to maintain its capital base. It is comprised of the cost of issuing common and preferred stock, the cost of issuing debt, and in come cases the cost of retained earnings. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows. This is the weighted average cost of capital. Some companies , however, express a cost for retained earnings, while others do not consider retained earnings as a source of capital, just funds "left over" after the equity and debt capital are optimally employed.

The internal rate of return (IRR) is the discount rate that makes the net present value of periodic cash flows equal to zero. It is the return a company would earn if it invested in itself rather than investing elsewhere. In standard capital budgeting exercises, the IRR of a venture or project must surpass the company's WACC. If it falls beneath the WACC, the project has no value to the company. The internal rate of return formula assumes a series of positive and negative cash flows, resulting in a positive or negative percentage result. A negative outcome usually suggests that the project or business is a bad investment.

Hence, we may use IRR calculation to compare  for the "investment" in risk retention and insurance. The next question, then, is what combination of retention and insurance produces the highest internal rate of return? Another way to think of this is what combination of retention and insurance produces the least opportunity costs?

While the calculation may be straightforward, estimating the variables is not. Since each "payment," whether for retained loss or insurance premiums, is a cash outflow, we need one or more assumed inflows to complete the calculation.

We can consider certain factors :

• Loss prevention - this i by avoiding those things that might bring about losses.
• Avoiding risk - This is done by not buying goods and services thus becoming free of losses.
• Financing risks/ insuring risks - focuses on those firms that finance loses in case they occur since not all risks can be avoided.
• Use of risk retention - they are more likely handled by the individual firm as they may be too expensive to insure.

3) The concept of self-insurance. Why is all self-insurance assumption, but not all assumption self-insurance?

Self-insure is a risk management technique in which a company or individual sets aside a pool of money to be used to remedy an unexpected loss. Theoretically, one can self-insure against any type of damage (like from flood or fire) In practice, however, most people choose to purchase insurance against potentially significant, infrequent losses.

Self-Insurance can be defined as when a company or a group of companies pays all or part of its own insurance losses and assumes the role of an insurer by implementing systems to pay those claims.

Sometimes referred to as ‘alternative risk transfer’, Self-Insurance can enable a company or group of companies to design its own insurance program. This means that they can often obtain broader or more appropriate insurance coverage than would otherwise be available commercially. Self-Insurance also creates an incentive to make factories and offices safer places to work and, if managed properly, can reduce insurance premiums.

With Self-Insurance, a company or a group identifies its loss exposures and then makes the decision to assume the role of an insurance company by becoming responsible for settling all, or part, of any claims arising from those risks. By becoming its own insurer, a self-insured company or group can modify or design its insurance program, making insurance coverage more available than might otherwise be possible in the traditional commercial insurance market.

Self-Insurance differs from standard insurance policies that have large deductibles, as it requires the self-insurer to adopt a formal system for paying its losses. This function is often outsourced to a claims manager, such as a third party administrator.

Self-insurers need an increased awareness of potential losses as well as savings. Self-Insurance therefore provides an incentive to reduce claims, save premiums and consequently increase profits or cash flow.

For example. in the United States, self-insurance applies especially to health insurance and may involve, for example, an employer providing certain benefits – like health benefits or disability benefits – to employees and funding claims from a specified pool of assets rather than through an insurance company. In self-funded health care, the employer ultimately retains the full risk of paying claims, whereas when using insurance, all risk is transferred to the insurer.

Assumption of risk

The technique of risk management ( known as retention or self insurance) under which an individual or business firm assumes expected losses that are not catastrophic, but protects against catastrophic losses through the purchase of insurance. For example, a business firm assumes the risk of absenteeism by its employees because of minor illness, but buys disability insurance to cover absences due to extended illness.

4) How do deductibles affect moral hazard?

Insurance deductibles are common to property, casualty, and health insurance products. They're out-of-pocket costs that you must pay before your insurance coverage kicks in.

Typically, the higher your policy's deductible, the lower the annual or monthly premium payments. That's because you're responsible for more costs before coverage starts.

Deductibles help insurance companies share costs with policyholders when they make claims. But there are two other reasons why companies use deductibles: moral hazards and financial stability.

Moral Hazards

Deductibles help mitigate the behavioral risk of moral hazards. A moral hazard is the risk that a policyholder may not act in good faith. Insurance policies protect policyholders from losses, so an inherent moral hazard exists: The insured party may engage in risky behavior without having to suffer the financial consequences.

For example, if drivers have car insurance, they may have the incentive to drive in a reckless manner or leave their vehicle unattended in a dangerous area because they're insured against damage and theft. With no deductible, they have no liability of their own.

A deductible mitigates that risk because the policyholder is responsible for a portion of the costs. In effect, deductibles serve to align the interests of the insurer and the insured so that both parties seek to mitigate the risk of catastrophic loss.