Chp 30 Flashcards
(48 cards)
define property insurance
a type of insurance companies purchase to compensate them for losses to their assets due to fire, storm damage, vandalism, earthquakes and other natural and environmental risks
define business liability insurance, business interruption insurance and key personnel insurance
Business liability insurance, which covers the costs that result if some aspect of the business causes harm to a third party or someone else’s property
Business interruption insurance, which protects the firm against the loss of earnings if the business operations are interrupted due to fire, accident, or some other insured peril
Key personnel insurance, which compensates for the loss or unavoidable absence of crucial employees in the firm.
define insurance premium
the fee a firm pays to an insurance company for the purchase of an insurance policy - In this way, insurance allows the firm to exchange a random future loss for a certain upfront expense.
When a firm buys insurance, it transfers the risk of the loss to an insurance company. The insurance company charges an upfront premium to take on that risk.
define actuarially fair
when the NPV from selling insurance is zero because the price of insurance equals the present value of the expected payment
what’s the formula for fair insurance premium
insruance premium = ( Pr(loss) x E[payment in the event of loss]) / (1 + risk of loss)
where Pr(Loss) is the probability that the loss will occur, E[.] is the expected payment if the loss occurs, and is the appropriate cost of capital.
rL cost includes a risk premium
depends on risk beta
no beta = no risk premium included
For risks that cannot be fully diversified, the cost of capital, , will include a risk premium.
what’s the value of insurance
the value of insurance must come from reducing the cost of market imperfections on the firm
benefit of insurance
When a firm experiences losses, it may need to raise cash from outside investors by issuing securities. Issuing securities is an expensive endeavour. In addition to underwriting fees and transaction costs, there are costs from underpricing due to adverse selection as well as potential agency costs due to reduced ownership concentration. Because insurance provides cash to the firm to offset losses, it can reduce the firm’s need for external capital and thus reduce issuance costs.
When a firm is subject to graduated income tax rates, insurance can produce a tax savings if the firm is in a higher tax bracket when it pays the premium than the tax bracket it is in when it receives the insurance payment in the event of a loss.
Firms limit their leverage to avoid financial distress costs. Because insurance reduces the risk of financial distress, it can relax this tradeoff and allow the firm to increase its use of debt financing.
By eliminating the volatility that results from perils outside management’s control, insurance turns the firm’s earnings and share price into informative indicators of management’s performance. The firm can therefore increase its reliance on these measures as part of performance-based compensation schemes, without exposing managers to unnecessary risk. In addition, by lowering the volatility of the stock, insurance can encourage concentrated ownership by an outside director or investor who will monitor the firm and its management.
Insurance companies specialize in assessing risk. In many instances, they may be better informed about the extent of certain risks faced by the firm than the firm’s own managers. This knowledge can benefit the firm by improving its investment decisions. Requiring the firm to purchase fire insurance, for example, implies that the firm will consider differences in fire safety, through their effects on the insurance premium, when choosing a warehouse. Otherwise, the managers might overlook such differences. Insurance firms also routinely monitor the firms they insure and can make value-enhancing safety recommendations.
what are the 3 main frictions that may arise between the firm and its insurer
First, transferring the risk to an insurance company entails administrative and overhead costs. The insurance company must employ sales personnel who seek out clients, underwriters who assess the risks of a given property, appraisers and adjusters who assess the damages in the event of a loss, and lawyers who can resolve potential disputes that arise over the claims. Insurance companies will include these expenses when setting their premiums. In 2018, expenses for the property and casualty insurance industry amounted to over 28% of premiums charged.
A second factor that raises the cost of insurance is adverse selection. Just as a manager’s desire to sell equity may signal that the manager knows the firm is likely to perform poorly, so a firm’s desire to buy insurance may signal that it has above-average risk. If firms have private information about how risky they are, insurance companies must be compensated for this adverse selection with higher premiums.
gency costs are a third factor that contributes to the price of insurance. Insurance reduces the firm’s incentive to avoid risk. For example, after purchasing fire insurance, a firm may decide to cut costs by reducing expenditures on fire prevention. This change in behaviour that results from the presence of insurance is referred to as moral hazard. The extreme case of moral hazard is insurance fraud, in which insured parties falsify or deliberately cause losses to collect insurance money. Property and casualty insurance companies estimate that moral hazard costs account for more than 11% of premiums.
how do insurance companies try to reduce risk
Insurance companies try to mitigate adverse selection and moral hazard costs in a number of ways. To prevent adverse selection, they screen applicants to assess their risk as accurately as possible. Just as medical examinations are often required for individuals seeking life insurance, plant inspections and reviews of safety procedures are required to obtain large commercial insurance policies. To deter moral hazard, insurance companies routinely investigate losses to look for evidence of fraud or deliberate intent
Insurance companies also structure their policies in such a way as to reduce these costs. For example, most policies include both a deductible, which is the initial amount of the loss that is not covered by insurance, and policy limits, which limit the amount of the loss that is covered regardless of the extent of the damage. These provisions mean that the firm continues to bear some of the risk of the loss even after it is insured. In this way, the firm retains an incentive to avoid the loss, reducing moral hazard. Also, because risky firms will prefer lower deductibles and higher limits (because they are more likely to experience a loss), insurers can use the firm’s policy choice to help identify its risk and reduce adverse selection
insurance is most likely to be attractive to firms that are…
urrently financially healthy, do not need external capital, and are paying high current tax rates. They will benefit most from insuring risks that can lead to cash shortfalls or financial distress, and that insurers can accurately assess and monitor to prevent moral hazard.
Full insurance is unlikely to be attractive for risks about which firms have a …
great deal of private information or that are subject to severe moral hazard. Also, firms that are already in financial distress have a strong incentive not to purchase insurance—they need cash today and have an incentive to take risk because future losses are likely to be borne by their debt holders.
define vertical integration
vertical integration entails the merger of a firm and its supplier (or a firm and its customer). Because an increase in the price of the commodity raises the firm’s costs and the supplier’s revenues, these firms can offset their risks by merging
While vertical integration can reduce risk, it does not always increase value. Recall the key lesson of Modigliani and Miller: Firms add no value by doing something investors can do for themselves. Investors concerned about commodity price risk can diversify by “vertically integrating” their portfolios and buying shares of the firm and its supplier. Because the acquiring firm often pays a substantial premium over the current share price of the firm being acquired, the shareholders of the acquiring firm would generally find it cheaper to diversify on their own.
Vertical integration can add value if combining the firms results in important synergies.
Finally, vertical integration is not a perfect hedge: A firm’s supplier is exposed to many other risks besides commodity prices. By integrating vertically, the firm eliminates one risk but acquires others.
how to use storage as a way to hedge against risk
A related strategy is the long-term storage of inventory. An airline concerned about rising fuel costs could purchase a large quantity of fuel today and store the fuel until it is needed. By doing so, the firm locks in its cost for fuel at today’s price plus storage costs. But, for many commodities, storage costs are much too high for this strategy to be attractive. Such a strategy also requires a substantial cash outlay upfront. If the firm does not have the required cash, it would need to raise external capital—and consequently would suffer issuance and adverse selection costs. Finally, maintaining large amounts of inventory would dramatically increase working capital requirements, a cost for the firm. Storage of inventory also does not work for firms that produce and sell commodities; managers at these firms are concerned about the price at which their commodity is sold. Storage of inventory would actually be counterproductive as a hedging strategy for commodity sellers as they would have a greater quantity waiting to be sold and would be subject to the commodity price risk on this greater quantity.
what’s hedging with long-term contracts
Firms routinely enter into long-term lease contracts for real estate, fixing the price at which they will obtain office space many years in advance. Similarly, U.S. utility companies sign long-term supply contracts with Canadian power generators, and steelmakers sign long-term contracts with mining firms for iron ore. Through these contracts, both parties can achieve price stability for their product or input.Of course, similar to insurance, commodity hedging does not always boost a firm’s profits. Consider a steelmaker and an iron ore producer that lock in the iron ore price for future transactions through long-term contracts. The steelmaker agrees to buy the iron ore and the iron ore producer agrees to sell it; they fix the price today for future transactions. If the market price of iron ore rises, then the steelmaker’s profits will be boosted and the iron ore producer’s profits will be reduced relative to what would have happened without the long-term contracts. On the other hand, if the market price of iron ore falls, then the steelmaker’s profits will be reduced while the iron ore producer’s profits will be boosted relative to what would have happened without the long-term contracts. In other words, the long-term contracts can be used to stabilize earnings at an acceptable level, no matter what happens to the iron ore prices
define forward contract
A forward contract is a customized agreement between two parties who are known to each other, whereby they agree to trade a certain quantity of an asset on some future date at a price that is fixed today. Forward contracts and many other types of long-term supply contracts are bilateral contracts negotiated by a buyer and a seller to suit their particular needs
whats the disadvantages to forward contract
They expose each party to the risk that the other party may default and fail to live up to the terms of the contract. Thus, although long-term contracts insulate the firms from commodity price risk, they expose them to credit (default) risk.
Long-term contracts cannot be entered into anonymously; the buyer and seller know each other’s identity. This lack of anonymity may have strategic disadvantages as your willingness to enter into the contract reveals information to your rivals about your risk exposures.
The market value of the long-term contract at any point in time may not be easy to determine, making it difficult to track gains and losses, and it may be difficult or even impossible to cancel the contract if necessary.
define futures contracts
is a standardized agreement to trade an asset on some future date, at a price that is locked in today. Futures contracts are traded anonymously on a futures exchange at a publicly observed market price and are generally very liquid. The party who has entered into a futures contract to buy a commodity is said to be “long” in the futures contract; the party who has entered into a futures contract to sell a commodity is said to be “short” in the futures contract. Both the buyer and the seller can get out of the contract at any time by finding a third party to take over the contract at the current market price.
, futures contracts are designed to almost completely eliminate credit risk.
a forward contract traded on an exchange
how dies future contracts prevent buyers/sellers from defaulting
First, investors (both the long and short parties to the futures contract) are required to post collateral, called margin, when using futures contracts. This collateral serves as a guarantee that traders will meet their obligations. In addition, cash flows are exchanged on a daily basis, rather than waiting until the end of the contract, through a procedure called marking to market. That is, gains and losses are computed each day based on the change in the market price of the futures contract. After the marking to market each day, both parties essentially have new futures contracts rewritten with prices based on the new market conditions. The combination of rewritten contracts at the new futures price and the exchange of cash flows through marking to market results in two effects: (1) there is no longer an incentive to default on the futures contract as it reflects current market conditions and (2) each party’s net purchase or sale price for the commodity (based on a combination of the new futures price and the marking to market cash flows exchanged) is kept at the original futures price that existed when the parties entered the futures contract.
future contract vs forward contract
he May 2025 futures contract is the same as a forward contract with a set price of $50.83 per barrel of oil. However, with a forward contract that is between two individual parties, there is potential for one party to default if the market price diverges from the forward price. With a futures contract, the buyer and the seller of a futures contract can close their positions at any time (and accept the cumulative losses or gains in their margin accounts), and the contract will then be reassigned to a new buyer or seller because the contract is continually rewritten to reflect current market conditions. Because of this liquidity and the lack of credit risk, commodity futures contracts are the predominant method by which many firms hedge oil price risk. Similar futures contracts exist for many other commodities, including natural gas, coal, electricity, silver, gold, aluminum, canola, barley, soybeans, corn, wheat, rice, cattle, pork bellies, cocoa, sugar, carbon dioxide emissions, and even frozen concentrated orange juice. In addition, futures contracts exist for many financial products such as currency exchange, fixed income (interest-rate related) instruments, and stock indices.
hedging with options contracts
To summarize, if a company will need to purchase a commodity in the future, its management can hedge with options by buying a call option on the commodity. If a company will need to sell a commodity in the future, its management can hedge with options by buying a put option on the commodity.
futures hedging strategy vs option hedging strategy
When an options contract is purchased, the buyer must pay for it (i.e., it is costly). With a futures hedging strategy, there is no cost to enter into the contract. In effect, the party who takes the long futures position does not have to pay the party who takes the short futures position at the time the contract is entered because both parties are simply signing onto a contract at a fair market price for a future transaction. (Note, the initial margin requirement is paid by both the long and short parties to a futures contract; the margin is collateral backing up the contract but it is not a cost of the contract.)
A second difference between hedging with options versus futures is the nature of the final cash flows. With a futures contract, the final price is fixed regardless of whether the market price rises or falls. For example, for a firm that has contracted to buy a commodity through a long futures contract, the firm is protected against a price rise but the firm also misses out on the potential savings if the price falls. In comparison, using a long call option hedge, the firm is protected against a price rise because the call option can be exercised; however, if there is a favourable price change (i.e., the price drops), the call option can be left to expire unexercised and the firm can transact at the new favourable price
An additional benefit of an options hedge versus a futures hedge arises when there is the possibility that the hedge will not actually be needed
what are the risks with hedges
Account for Natural Hedges. Even though purchases of a commodity may be a firm’s largest expense, they may not be a source of risk if the firm can pass along those costs to its customers. For example, gas stations do not need to hedge their cost of oil, because the price of gasoline—and thus their revenues— fluctuates with it. When a firm can pass on cost increases to its customers or revenue decreases to its suppliers, it has a natural hedge for these risks. A firm should hedge risks to its profits only after such natural hedges are accounted for, lest it over-hedge and increase risk. In the case of Air Canada and WestJet, WestJet may not be able to pass on the full increase in its fuel cost if, because of Air Canada’s hedges, Air Canada does not increase ticket prices. Thus, a requirement for being able to pass price changes through to customers is that your competitors will do so too.Liquidity Risk. When hedging with futures contracts, the firm stabilizes its earnings by offsetting business losses with gains on the futures contracts and by offsetting business gains with losses on the futures contracts. In the latter scenario, the firm runs the risk of receiving margin calls on its futures positions before it realizes the cash flows from the business gains. To effectively hedge, the firm must have, or be able to raise, the cash required to meet these margin calls or it may be forced to default on its positions. Hence, when hedging with futures contracts the firm is exposed to liquidity risk. Such was the case for Metallgesellschaft Refining and Marketing (MGRM), which shut down in 1993 with more than $1 billion in losses in the oil futures market. MGRM had written long-term contracts to supply oil to its customers and hedged its risk that oil prices might rise by buying oil futures. When oil prices subsequently dropped, MGRM faced a cash flow crisis and could not meet the margin calls on its futures positions. Hedging with options contracts does not create the potential for this problem (although options do entail a significant upfront cost that does not exist with futures contracts).Basis Risk. Futures contracts are available only for a set of standardized commodities, with specific delivery dates and locations. Thus, while a futures contract that promises to deliver crude oil in Oklahoma in June 2023 is a reasonable hedge for the cost of jet fuel in Calgary in July 2023, it will not be a perfect match. Basis risk is the risk that arises because the value of the futures contract will not be perfectly correlated with the firm’s actual exposure (e.g., between April 30, 2010 and May 25, 2010, oil prices dropped from $86 to $68 per barrel).
hedging commodity price vs buying insurance
Hedging commodity price risk has similar potential benefits as buying insurance, but it does not have the same costs. In comparison to the market for hazard insurance, the commodity markets are less vulnerable to the problems of adverse selection and moral hazard. Firms generally do not possess better information than outside investors regarding the risk of future commodity price changes, nor can they influence that risk through their actions. Also, futures and options contracts are very liquid and do not entail large administrative costs.
Firms that hedge commodity price risk must hire expert traders who understand the nature of the contracts and the various markets in which they trade. Often, a firm will allow its traders some leeway to do additional trading (beyond what is needed for hedging). In effect, the firm also allows its traders to speculate by entering into contracts that do not offset actual risks. Traders who speculate use securities to bet on the direction in which they believe the market price is likely to move. Speculating increases the firm’s risk rather than reducing it. When a firm authorizes traders to trade contracts to hedge, unless there is careful monitoring, it opens the door to the possibility of speculation. The firm must guard against the potential to speculate (adding risk to the firm) through appropriate governance procedures.
