Is the final cumulative?
Define risk aversion.
Risk aversion is when SOMEONE GIVES UP VALUE to reduce risk.
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
The 2 adverse consequences of risk are ________ and ______________.
Giving up opportunities
Spending resources to mitigate risk (risk control, risk financing)
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))
Insurance isn’t cost efficient for ____ risks.
High frequency, low severity
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
Among the retention methods we have discussed, which would a company never actively choose to use? And why?
Passive retention
This is a mistake - we didn't see it coming! Thus, never choose to use
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).
Why could a guarantee complicate the ability for a pure captive with a fronting company to be considered insurance?
Risk transfer issues - the parent company (owning the captive) is also guaranteeing the fronting company for reinsured losses of the 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.
Order the following based on the ability of risk pooling to reduce risk per person: positively correlated (not perfect), uncorrelated, no pooling at all.
Uncorrelated > Positively correlated > No pooling at all
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)