MANAGING EVENT RISKS

Damodaran/ch.10

Contents
1. Reclassifying risks from a risk
management perspective
2. Event risks
3. Why should we manage event risks?
4. The benefits of insurance
5. The effectiveness of insurance
6. The insurance mechanism
7. Should cos. insure or not?

1. Reclassifying Risks
Risks

Noninsurable
risks

All others

Insurable
risks

Life

Nonlife

1A: Insurable Risks

Insurable risks are those risks for which
solutions are provided by the insurance
industry
There may standard products widely available
in the insurance market such products suit
the requirement of many clients
Or there may be customised products not
widely available in the insurance market
such products suit the requirement of specific
clients

1A: Insurable Risks

Typically insurable risks follow the
law of large numbers & the
economies of scale
Because such risks follow the law of
large numbers their probabilities can
be estimated from a large sample (a
large portfolio of risks)
Because there are economies of
scale in managing such risks the
larger the portfolio of risks, the larger

1A: Insurable Risks

Due to these characteristics such risks can
be managed profitably when handled in
large numbers large portfolio of risks
This has given rise to the development of
the insurance industry
Insurance cos. handle risks in large
numbers (large portfolio of risks)
Within this category life & non-life risks
are two distinct classes of risks

1A: Insurable Risks

Life risks represent a relatively
homogeneous class of risks
Non-life risks represent a relatively
heterogeneous class of risks
These two classes of risks require different
techniques to manage
Hence different cos. specialise in handling
these risks
Generally event risks belong to insurable
risks

1B: Non-Insurable Risks

Non-insurable risks are those risks for which
solutions are not provided by the insurance
industry
There may be many parties who would benefit
from protection from such risks
However the insurance industry has not
designed solutions for such risks
This is because insurance cos. cannot exploit
such risks profitably
Solutions for such risks happen outside the
insurance industry

1B: Non-Insurable Risks

Non-insurable risks typically consist
of continuous risks
Such risks occur continuously over
small intervals of time foreign
exchange risk, interest rate risk,
commodity price risk, stock market
risks market risk
Hence there is no need to estimate
their probability (it is 100%)

1B: Non-Insurable Risks

Managing such risks involves selecting the
appropriate hedging technique
Typically institutions which are exposed to
such risks enter into hedging contracts
with each other
There are institutions which act as
intermediaries in arranging such contracts
Market risks can be managed using
hedging tools and non-hedging tools

1C. Other Risks

Where should we classify the
following?
1. Credit risks
2. Operational risks

2. Event Risks
Event risks tend to occur very infrequently
once in very long intervals of time
Probability of occurrence in any period is
very low
Economic impact is very high
Eg. Natural calamities (acts of god cyclone, earthquakes, floods, fires);
Political events (war, change of power,
riots, nationalisation); Terrorism; Accidents

2. Event Risks
Insurance cos. generally have
standard products to cover several
types of event risks
Standard products are available for
some of the common types of event
risks
Since standard products are offered
by many insurance cos. they tend to
be competitively priced

2. Event Risks
Some of the event risks are very rare
phenomena
Because they are rare it is extremely
difficult to estimate their likelihood of
occurrence
Hence the correct price for insurance
protection would be difficult to determine
So standard insurance products for such
risks are generally not available

2. Event Risks
Moreover there would be very few
parties who would seek protection from
such risks
Hence insurance products for such risks
tend to be very expensive
Also the insurance products for such
risks are customised for specific clients
There would be few insurance cos. which
would offer such customised solutions

3. Why Should We Manage Event

Risks?
Generally the magnitude of impact of event
risks is so high that the affected party
would be completely financially destroyed
Most of the business (or non-business )
entities are established to exist perpetually
In order to maintain their existence even
after such damages, event risks should be
managed
Generally such risks are managed by
insurance products

3A: What is Insurance?

Insurers Perspective:
It is the business of exploiting risks for
earning profits
Since the phenomenon of risk is
widespread & affects individuals &
institutions in various forms, there is an
opportunity to do business
Insurance cos. do not offer protection from
every risk they offer protection from
specified risks only

3A: What is Insurance?

Insureds Perspective:
It is essentially a contract of indemnity
This contract can be bought for a price
the insurance premium
By paying the price the insured can buy
compensation for the risk from the
insurer
In order to get the cover it has to
comply with the T&C of the insurer

4. The Benefits of Insurance

Insurance does not eliminate the risk but
transfers it from the insured to the insurer
Insurance cos. have expertise in managing
portfolios of risks & they gain from
diversification benefits which the client cos.
cannot do
Insurance cos. have the experience &
expertise to evaluate risks & handle them,
which the client cos. do not have
Insurance cos. also provide related services
viz. inspection & safety which prevent risks

4. The Benefits of Insurance

The benefit of insurance to the insured
is protection against those risks which
have a low likelihood but high impact
should they occur
The cost of procuring insurance
protection is an operating cost for the
insured co. and it reduces its operating
income & also the taxes
The benefit is increased stability of
income & cash flows over time

5. The Effectiveness of Insurance

It is effective against firm-specific risks
that affect only a few firms at any point
of time i.e. such risks are not
widespread phenomena
It is not effective against market risk
factors
It is more effective to use insurance for
protecting against large risks than small
ones
Small risks can be protected by a co. on
its own

5. The Effectiveness of Insurance

Insurance protection is more effective
against event risks which are discrete in
nature than against risks of a
continuous nature
For discrete risks the probabilities &
financial impact can be estimated from
historical data
Examples of event risks/discrete risks:
flood, fire, natural calamity, burglary
etc.
Examples of continuous risks: inflation,

6. The Insurance Mechanism

Insurance cos. manage portfolios of risks
Typically a portfolio will be for a specific risk
They gain from diversification benefits as the
portfolio of risks becomes larger
Diversification happens because when more
& more clients are added to the portfolio the
chances are that most of them will not be
affected by the risk if clients are selected
wisely

6. The Insurance Mechanism

How does the insurance co. diversify?
The insurance co. diversifies along two
dimensions
1. It adds more & more clients to a portfolio of a
specific risk diversification within the portfolio
2. It offers various types of insurance products for
various risks so it balances out products for
risks of higher likelihood with products for risks
of lower likelihood diversification across
portfolios

6. The Insurance
Mechanism
Based on this principle the entire portfolio
of risks of a particular type can be divided
into two parts: good risks & bad risks
Good risks are those insured clients in the
portfolio who will not be affected by the
risk
Bad risks are those insured clients which
will be affected by the risk resulting in
losses for the insurance co.

6. The Insurance
Mechanism
The insurer earns its revenues from
premiums collected from all clients good
& bad risks
However it has to pay for losses only to the
bad risks (the affected clients)
Hence it tries to keep the risk portfolio
heavy on good risks by minimising bad
risks
The higher the concentration of good risks
the more the profits of the insurer

6. The Insurance
Mechanism
So the larger the portfolio of risks &
the higher the concentration of good
risks therein, the higher would be the
revenues & lower would be the losses
The larger the portfolio of risks the
greater would be the economies of
scale because the operating fixed
costs could be spread over greater no.
of clients higher profitability

6. The Insurance
Mechanism
The premium charged by the insurer for a
specific type of risk is determined by its
expected losses & its operating costs
The lower the expected losses & the
lower the operating costs, the lower
would be the premium charged
The lower the premiums the larger would
be the no. of clients that can be added to
the portfolio, resulting in higher revenues

6A: Portfolio Risks

The important portfolio management
risks faced by an insurance co. are:
Adverse selection
Moral hazard

6A: Portfolio Risks

Adverse selection: It is the risk of
selecting more bad risks as clients than
good ones
As a result higher proportion of clients in
the portfolio would be converted to claims
This would result in massive losses to the
insurance co. because the amount of
premiums collected from such clients
would be much less than the sum assured

6A: Portfolio Risks

Moral Hazard: This risk arises when the
good risks turn into bad risks because
they tend to become negligent &
careless, & act in a risky manner
because they have insurance
protection
The result is that increasing no. of claims
are to be paid by the insurer resulting in
heavy losses

6B: Other Critical Issues

All insurance cos. worry about natural
calamities & catastrophes
During a catastrophe there are widespread
losses of property & lives
A single event of catastrophe can affect the
entire portfolio of risks of a general insurance
co. resulting in losses arising out of claim
payments
Similarly for a life insurance co. the entire
portfolio of lives covered can result into claims
Many insurance cos. have become bankrupt

7. Should Cos. Insure or

Not?
An important issue that cos. face is
to decide on the risks that they
should insure & those which they
need not
The solution to this issue lies in a
comparison of the expected costs of
not taking insurance & the costs of
taking insurance

7A: Caselet: British

Petroleum (BP)
Conventional practice of cos is to buy insurance
against large potential losses & not to buy insurance
against routine losses because large losses can
cause financial distress but not the small ones
BP questioned the conventional practice & changed
its insurance strategy
It allowed local managers to buy insurance against
routine risks (those risks in which insurance cos.
were more efficient in assessing & pricing risk, &
charge competitive premiums due to intense
competition)
It decided not to buy insurance for losses over $10
m
34

7A: Caselet: BP
According to BP insurance cos. were less
efficient in assessing such large & specialised
risks than BP itself & hence less effective in
advising on the protective measures
Hence the insurance premiums charged on
such large risks were not competitively priced
BP assessed large losses of over $ 500 m
have a very low probability of occurrence
(once in 30 years ). For smaller cos. this
would mean bankruptcy. But for a giant like
BP, such loss after tax adjustment would be
less than 1% of its equity value
35

7A: Caselet: BP
Before implementing the new
insurance strategy BP was paying
$ 115 m a year in premiums &
receiving $ 25 m a year in claims
Assume that $ 35 m of premiums
& the entire amount of claims
were for routine risks and its
opportunity cost of capital is 10%
36

7A: Caselet: BP
Que 1: What would be the value of
savings made by the change in strategy
without considering the expected cost of
not insuring for the big risks?
Que 2: What would be the expected cost
of not taking insurance protection for the
big risks?
Que 3: Is the change in insurance
strategy justified financially?
37

7A: Caselet: BP
Conclusions: For very low-probability risks
Very large cos. need not buy insurance &
allow the losses to affect shareholder
wealth
Investors themselves can eliminate the
impact by holding diversified portfolios
(thus stock market could absorb the risk
more efficiently than the insurance
industry)
38