Looking at Lloyd's of London
Lloyd's of London is not an insurance or reinsurance company; rather, it is _______.
An insurance exchange
In a reinsurance contract, the party transferring risk is called the ____, and the party accepting risk is the _____.
Ceding company; reinsurer
What are the tax benefits of insurance?
Tax deductibility of premiums and insurer's reserves
In what kind of theoretical setting should risk management add no value to a firm?
Perfect market with shareholders who have well-diversified portfolios.
FINAL JEOPARDY TOPIC
Layers on Layers
What are the main roles of the names and the syndicates at Lloyd's of London?
Names are the investors of syndicates, which are mini-insurers at Lloyd's.
Schmit Happens Insurance Company is considering providing property insurance to the Bean in Chicago, a single, large-valued exposure. However, they will only do so if they can successfully reinsure the exposure. What type of reinsurance contract would Schmit Happens seek?
Facultative reinsurance
Explain what is required for a captive to be considered "insurance."
Risk transfer and risk distribution (and pure risk)
What component of firm value does risk management affect?
Expected net cash flows (not the cost of capital (r))
If you are a broker at Lloyd's of London, what is your main role?
Brokers represent policyholders who seek insurance at Lloyd's.
In a non-proportional (excess) reinsurance contract, what is likely true about the cost of reinsurance per dollar of coverage as the layers increase?
The layers become cheaper.
What notable feature distinguishes broad captives from pure captives?
Broad captives sell insurance to non-affiliates
DAILY DOUBLE
A firm's sources of risk can be decomposed into diversifiable risk and non-diversifiable risk. Provide an example of each.
Diversifiable (idiosyncratic) - relatively independent
Non-diversifiable (systematic) - relatively positively correlated
Provide an example of an exposure that would likely be insured at Lloyd's of London.
Single, large-valued, unusual/unique exposure (e.g. Loch Ness Monster) or reinsurance
Explain one way reinsurance can create efficient pooling.
Lessen positive correlation, split into multiple exposures, affect maximum probable loss, better loss control and underwriting (more efficiently).
Identify the following captive structure: SEE PICTURE FOR REFERENCE
Association captive
How can purchasing insurance help a firm delay tax payments?
Premiums are tax deductible in the present, rather than in the future if/when losses occur.
How does Lloyd's of London work as the "Law of Large Numbers in reverse"?
Splits a single large value into many observations.
*See image for reference.
DAILY DOUBLE
Explain one way reinsurance can provide efficient services.
Expertise, evaluate underlying insurer, allow insurer to get out of a "line" of business.
Provide and explain a reason why a corporation may want to use a captive.
ERM, tax benefits, retention, access to reinsurance market, cost distribution within large organization, investment of premium
Given we do not operate in a perfect market, explain two ways in which purchasing insurance can add value to a firm with well-diversified shareholders.
Insurer services, financial distress costs, cost of raising new funds, tax outflows (also decision anomalies)