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Study Guide

Risk ManagementBy

A. J. Cataldo

About the Author

A. J. Cataldo is currently a professor of accounting at West Chester

University, in West Chester, Pennsylvania. He holds a B.S. degree

in accounting/finance and a master of accounting degree from

the University of Arizona. He earned a Ph.D. from the Virginia

Polytechnic Institute and State University. He is a certified public

accountant and a certified management accountant. He has worked

in public accounting, as a government auditor, controller, and

provided expert testimony in business litigation engagements. His

publications include three Elsevier Science monographs, and his

articles have appeared in Journal of Accountancy, National Tax

Journal, Research in Accounting Regulation, Journal of Forensic

Accounting, and Accounting Historians Journal, among others. He

has also published in and served on editorial review boards for

Institute of Management Accounting association journals, including

Management Accounting, Strategic Finance, and Management

Accounting Quarterly, since January 1990.

Copyright © 2009 by Penn Foster, Inc.

All rights reserved. No part of the material protected by this copyright may bereproduced or utilized in any form or by any means, electronic or mechanical,including photocopying, recording, or by any information storage and retrieval system, without permission in writing from the copyright owner.

Requests for permission to make copies of any part of the work should be mailed to Copyright Permissions, Penn Foster, 925 Oak Street, Scranton,Pennsylvania 18515.

Printed in the United States of America

All terms mentioned in this text that are known to be trademarks or service marks have been appropriately capitalized. Use of a term in this text should not beregarded as affecting the validity of any trademark or service mark.

INSTRUCTIONS 1

LESSON ASSIGNMENTS 7

LESSON 1: INTRODUCTION TO RISK MANAGEMENT 11

EXAMINATION—LESSON 1 23

LESSON 2: GENERAL THEORY OF INSURANCE MARKETS 27


LESSON 3: LOSS CONTROL AND LEGAL LIABILITY 55


LESSON 4: PERSONAL INSURANCE ISSUES 67


LESSON 5: EMPLOYEE-EMPLOYER RELATIONSHIPS 83

GRADED PROJECT 109


LESSON 6: BUSINESS RISK MANAGEMENT—THEORY 119


LESSON 7—BUSINESS RISK MANAGEMENT—TYPES OF CONTRACTS 133


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Contentsiv

LESSON 8—BUSINESS RISK MANAGEMENT—ADDITIONAL TOPICS 149


SELF-CHECK ANSWERS 165

INTRODUCTIONWelcome to Risk Management! This course will provide youwith insights into how the insurance industry operates. Allbusiness decisions involve risk, and while all risks might notbe quantified with a high degree of certainty, the objective ofyour business education is to learn how to minimize the sub-jective component and maximize the objective component ofany business decision and the risks associated with it.

While there are quantitative components to risk management,the vast majority of this course requires you to master newterminology. Therefore, you’ll succeed in easily passing thiscourse if you

� Proceed to a new assignment only after you’ve masteredthe terminology and concepts from the prior assignment

� Proceed to take the lesson exam only after you’ve mas-tered the terminology and concepts from all assignmentsand related quizzes contained in that lesson

� Proceed to take the final exam only after you’ve masteredthe terminology and concepts from all lessons andrelated lesson exams

This study guide focuses, primarily, on most of the termsthat are in bold type in the body of the text. The study guidewill prepare you for the questions in the Self-Checks that follow each assignment, for the lesson exams, and for thefinal exam. Many chapters and lessons don’t require home-work, so, in these cases, you should focus on mastering newterminology and concepts.

Lesson 4 covers automobile, homeowner’s, and life insurance;Lesson 5 covers employee benefits, retirement plans, workers’compensation, and Social Security. These seven assignmentswill contain information likely to better prepare and benefitanyone taking this course, regardless of their field of expert-ise and/or area of professional employment.

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OBJECTIVESWhen you complete this course, you’ll be able to

� Discuss different meanings of the term risk, includingbusiness risk, personal risk, pure risk, and other typesof risk

� Describe major risk management methods and organiza-tion of the risk management function within business

� Explain how minimizing the cost of risk maximizes busi-ness value and the possible conflicts between businessand societal objectives

� Describe how pooling of independent loss exposuresreduces risk

� Discuss the role of insurer capital and factors that affectinsurer capital decisions

� Explain the fundamental legal doctrines underlyinginsurance contracts

� Discuss the circumstances in which the assignment oflegal liability affects safety incentives

� Explain compulsory and no-fault automobile insurancelaws and their rationale and effect

� Analyze the impact of catastrophes on property insur-ance and the market’s response to large catastrophes

� Describe the tax benefits associated with life insuranceand annuity products

� Analyze the pricing of basic life insurance policies andannuities

� Explain major types of employee benefits and why firmsprovide them

� Describe the basic history, features, and economicrationale of workers’ compensation laws and liabilityinsurance

Instructions to Students2

� Describe Social Security retirement, survivor, and disability and Medicare programs, benefits, and theirfinancing

� Identify major types of property-casualty insurance contracts purchased by businesses and describe thenegotiation of commercial insurance programs

� Explain basic derivative contracts (options, forwards,futures, and swaps) commonly used for hedging, anddistinctions between insurance and derivatives contracts

� Describe major types of risk typically hedged using derivatives

YOUR TEXTBOOKSuccessfully completing your course depends heavily on theknowledge and understanding you acquire from your primarytextbook, Risk Management and Insurance. So, please takesome time to look through it to see what’s in the book andhow the material is arranged. Here are some of the importantfeatures of that text. It’s a good idea to become familiar withthem.

The Brief Contents, on page xiv, gives you a quick overview ofthe chapters in the text. The contents, on pages xv–xxiv, giveyou a detailed outline of the content for each chapter, includ-ing main topic headings. A preface begins on page ix. It givesyou the key concepts that inform the authors’ approach toinsurance, as well as text updates. A subject index begins onpage 646.

Each chapter begins with an outline of major and minor top-ics to be covered. Scan it to orient yourself to the materialahead. Within the text, topics are divided by major headingsand subheadings devoted to particular ideas or concepts.Tables, figures, and boxed features appear throughout thetext. All of these provide data that’s essential to masteringthe text material. Don’t skip over them. The chapter end matter provides you with key terms, a chapter summary,questions to challenge your capacity for critical thinking, and

Instructions to Students 3

suggested readings. Use these features to further master thechapter material. Pay special attention to the chapter sum-mary as an aid to reviewing the material.

The textbook used for this course, as is frequently the casefor university courses in risk management, has beendesigned for a two-semester course. Generally, the same textwould be used for the second or more advanced course, butby those pursuing a degree in finance or risk management.Therefore, this risk management course has been designed tobe and is comparable to any undergraduate, third, or junioryear course at any undergraduate university program.

COURSE MATERIALSThe course includes the following materials:

1. This study guide, which contains an introduction to yourcourse, plus

� A lesson assignments page with a schedule of studyassignments

� Assignment introductions emphasizing the mainpoints in the textbook

� Self-checks and answers to help you assess yourunderstanding of the material

� An examination for each of the lessons in thiscourse

� A graded project to allow you to put your learninginto practice

2. Your course textbook, Risk Management and Insurance,

Second Edition, by Scott Harrington and GregoryNiehaus, which contains the assignment reading material


A STUDY PLANThink of this study guide as a blueprint for your course. Youshould read it carefully. Use the following procedures toreceive the maximum benefit from your studies:

1. Set aside a regular time for study.

2. Write down your reading and study schedule. You mightwant to use a wall calendar—the kind with space to writein—to show what you need to do and when. Check offassignments as you complete them to see your progress.

3. Read everything twice—or at least review it after readingit carefully. No one gets everything on the first reading.

4. Don’t look up answers in the key before you do the self-checks at the end of a chapter. That defeats the purposeof the exercises. However, do make sure you correct anyerrors.

5. Give yourself credit for completing each assignment.Your work and self-discipline will take you through thiscourse. You deserve the credit. So give yourself a pat onthe back as you complete each assignment.

6. Note the pages for each assignment and read the assign-ment in the textbook to get a general idea of its content.Then study the assignment, paying attention to alldetails, especially definitions and main concepts.

7. Read the corresponding lesson in the study guide toreinforce what you learned in the text and learnadditional tips.

8. Answer the questions provided in the self-checks in thestudy guide. This will serve as a review of the materialcovered.

9. After answering the self-checks, check your answers withthose given at the back of the study guide.

10. Complete each assignment in this way. If you miss anyquestions, review the pages of the textbook coveringthose questions. The self-checks are designed to reveal

Instructions to Students 5

weak points that you need to review. Don’t send yourself-check answers to the school. They’re for you to evaluate your understanding of the material.

11. After you’ve completed the assignments for Lesson 1,turn to the first examination and complete it.

Follow this procedure for all eight lessons. You’re now readyto begin. Good luck with your studies. Remember, if you haveany questions during your studies, you should e-mail yourinstructor.


Lesson 1: Introduction to Risk ManagementFor: Read in this Read in

study guide: the textbook:

Assignment 1 Pages 12–14 Pages 1–14



Examination 50082100 Material in Lesson 1

Lesson 2: General Theory of Insurance MarketsFor: Read in this Read in





Assignment 7 Page 37 Pages 115–133





Lesson 3: Loss Control and Legal LiabilityFor: Read in this Read in





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Lesson Assignments8

Lesson 4: Personal Insurance IssuesFor: Read in this Read in






Lesson 5: Employee-Employer RelationshipsFor: Read in this Read in






Graded Project 50082900


Lesson 6: Business Risk Management—TheoryFor: Read in this Read in




Assignment 22 6 Pages 484–499


Lesson 7: Business Risk Management—Types of ContractsFor: Read in this Read in






Lesson Assignments 9

Lesson 8: Business Risk Management—Additional TopicsFor: Read in this Read in







Lesson Assignments10

NOTES

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Introduction to RiskManagement

INTRODUCTIONLesson 1 introduces many new terms that you haven’t beenexposed to in earlier courses. You should spend a significantamount of time and effort learning and becoming very com-fortable with these new terms.

The majority of the material contained in Chapter 3 is verybasic review material from business statistics. This is rela-tively easy material, but very important for later lessons andassignments, so the time you spend reviewing this materialwill pay off later.

OBJECTIVESWhen you complete this lesson, you’ll be able to

� Discuss different meanings of the term risk, includingbusiness risk, personal risk, pure risk and other types ofrisk

� Describe major risk management methods and organiza-tion of the risk management function within business

� Define and explain the overall objective of risk manage-ment and the cost-of-risk concept

� Explain how minimizing the cost of risk maximizes busi-ness value and the possible conflicts between businessand societal objectives

� Discuss frameworks for identifying business and individual risk exposure

� Review concepts from probability and statistics, applyingmathematical concepts to understand the frequency andseverity of losses, and the concepts of maximum proba-ble loss and value at risk

Risk Management12

ASSIGNMENT 1Read the following introduction. Then, read Chapter 1 in yourtextbook, Risk Management and Insurance.

RiskThere are two meanings of risk, as defined in Figure 1.1 onpage 2 of the text:

1. One situation is riskier than another if it has greaterexpected loss.

2. One situation is riskier than another if it has greateruncertainty.

Types of Risk Facing Businesses and IndividualsBusiness risk is comprised of (1) price risk, (2) credit risk,and (3) pure risk (see Figure 1.3). Price risk refers to cashflow uncertainties arising from uncertainties due to possiblechanges in output and input prices (e.g., commodities,exchange rates, and interest rates). For example, as thiscourse is being written, in mid-2008, oil is approaching $140per barrel, and droughts and floods within the United Statesare reducing inputs available for a substitute product,ethanol. These factors have led both directly and indirectly toincreased energy and food prices.

Credit risk refers to the risk that the firm’s customers andparties to which it has lent money will default, failing tomake promised payments. For example, as this course isbeing written, in mid-2008, foreclosures continue in thehousing market, as what has been characterized as “sub-prime issues” remain problematic and depress housingprices.

Pure risk refer to the risk of reduction in business assets dueto factors such as

� Physical damage

� Theft

Lesson 1 13

� Expropriation, where the government seizes companyassets (examples include Mexico’s PEMEX, created fromforeign oil industry facilities in the 1930s, and Venezuelain recent years)

� Legal liability for damages or harm to customers, suppliers, shareholders, and other parties

� Injuries to employees (not covered by workers’ compensation insurance)

� Death, illness, and disability to employees and/or familymembers, for which employer benefit plans may require-ment payments, including obligations under pension orother retirement savings plans

Personal risk (see Figure 1.4) includes

� Loss of earnings (i.e., death, disability, aging, and unemployment)

� Medical expenses

� Liability (auto and home)

� Loss of physical assets (auto, home and other) or financial assets (stocks and bonds)

� Longevity

Risk ManagementRisk management involves

1. Identification of all significant risks

2. Evaluation of the potential frequency and severity oflosses

3. Development and selection of methods for managingrisks

4. Implementation of one or more of these methods

5. Ongoing monitoring of the performance and suitability ofthe risk management methods and strategies undertaken

Risk Management14

Major risk management methods include

1. Loss control—reduce risky activity and increase precautions

2. Loss financing—retention and self-insurance, insurance,hedging and other contractual risk transfers

3. Internal risk reduction—diversification and informationinvestments

In most firms, the director of risk management is subordi-nate to and reports to finance or treasury executives.

Make sure you completely understand the contents ofFigures 1.1, 1.3, and 1.4 in the textbook. This material represents the foundation for the remainder of the course.

Now that you’ve finished Assignment 1, complete Self-

Check 1. Check your answers with those provided at the backof this study guide. When you’re sure that you completelyunderstand the material from Assignment 1, move on toAssignment 2.

Self-Check 1

At the end of each section of Risk Management, you’ll be asked to pause and check

your understanding of what you’ve just read by completing a “Self-Check” exercise.

Answering these questions will help you review what you’ve studied so far. Please

complete Self-Check 1 now.

Indicate whether each of the following statements is True or False.

______ 1. Business risk includes price risk, credit risk, and pure risk.

______ 2. Price risk includes the risk of customer loan default.

______ 3. Personal risk includes risk of loss of earnings through disability.

(Continued)

Lesson 1 15


Understanding the Cost of RiskRisk is costly, and so is the management of risk. Just as the cost of an accounting system and financial statementaccuracy shouldn’t exceed the benefit, the cost of risk management shouldn’t exceed the benefit.

Self-Check 1

Select the one best answer to each question.

4. Which of the following is not a method of loss financing?

a. Diversification c. Insuranceb. Retention d. Hedging

5. What impact does routine inspection of aircraft for mechanical problems have on the risk ofairplane crashes for United Airlines?

a. Reduced frequency of crashesb. Reduced magnitude of loss if the crash occursc. Elimination of airplane crashesd. It has no impact on the risk of airplane crashes.

6. Ted’s Brewery imports beer from Thailand to the United States. To facilitate the transactionsTed’s Brewery holds large amounts of Thai currency. The uncertainty that Ted faces regardingthe U.S. dollar value of his holdings of Thai currency is an example of

a. credit risk. c. pure risk.b. international risk. d. price risk.

Check your answers with those on page 165.

Risk Management16

There are five primary components to the cost of risk (seeFigure 2.1):

1. Expected losses (direct and indirect)

2. Cost of loss control (increased precautions and reducedactivity)

3. Cost of loss financing (retention, insurance, and hedging)

4. Cost of internal risk reduction (diversification in informa-tional investment)

5. Cost of residual uncertainty (impact on shareholders andother stakeholders)

Firm Value Maximization and the Cost of RiskA firm’s value is determined by future net cash inflows. Firm

value maximization occurs when the cost of risk is minimized,as follows:

Value with risk = Value without risk – Cost of risk

or

Value without risk – Value with risk = Cost of risk

Individual Risk Management and theCost of RiskAn individual is risk averse if, when deciding between tworisky alternatives that have the same expected outcome, theperson chooses the alternative with less risk or variability.

Greater variability = Greater risk

or

Less variability = Less risk

Lesson 1 17

Risk Management and Societal WelfareThere are efficient or optimal levels of risk. Private cost of riskrefers to the cost to a business; social cost of risk refers tothe cost to society. When the private cost of risk differs fromthe social cost of risk, business value maximization will generally not minimize the total cost of risk to society. Forexample, if the fine or penalty and for an individual’s illegalactivity is modest, when compared to the profitability andrisks associated with detection of the illegal activity, we couldexpect more of the illegal activity (e.g., cheating on your indi-vidual income tax return or paying the maid under the table).



Self-Check 2


______ 1. Firm value maximization occurs when the cost of risk is minimized.

______ 2. Value with risk = Value without risk + Cost of risk

______ 3. Greater variability = Greater risk

______ 4. Private cost of risk refers to the cost to society.

______ 5. Social cost of risk refers to the cost to a business.

(Continued)

Risk Management18

Self-Check 2


6. The cost of loss control for potential fire damage to a firm’s warehouses would include the

a. cost of fire insurance.b. cost of damage to goods in the building.c. cost of installing sprinklers.d. potential loss of business that would occur if goods couldn’t be shipped on time due to the

fire.

7. If unexpected increases in losses from price risk aren’t offset by cash inflows from insurancecontracts, hedging arrangements, or other contractual risk transfers, they’ll result in

a. an increased stock price.b. a reduced stock price.c. bankruptcy.d. increased diversification.

8. Which one of the following is not an example of the cost of loss financing?

a. Expected direct/indirect lossesb. The loading in insurance premiumsc. Transaction costs involved with making hedging arrangementsd. The opportunity cost of maintaining self-insurance loss reserves

Textbook Questions and Problems

Answer Question 1 on page 28 in the textbook. This should be a one-sentence response.Devote the remainder of your time to the development of a complete understanding of thecontents of the chapter. This material represents the foundation for the remainder of thecourse.


Lesson 1 19


Risk IdentificationThe first step in the risk management process is risk

identification. The need to quantify property loss exposureleads us to consider alternative valuation methods, as follows:

� Book value = Cost – Accounting depreciation

� Market value = Highest valued use

� Firm-specific value = Value in current use

� Replacement cost new = Cost of replacing with a newcomparable

Book value has little or no correspondence to economic valueand is seldom relevant for risk management purposes. Ifthere are no firm-specific benefits, firm-specific value willequal market value. Alternatively, firm-specific value mayexceed market value. Replacement cost will often exceed themarket value of a property.

If an event results in an interruption of business operations,profits are lost, in addition to the cost of physical propertyreplacement, despite the fact that some operating expensesmay continue. For example, if a fire results in a plant or facil-ity shutdown, salaries for certain employees continue. This isreferred to as business income exposure. The insurance forthis component of risk is referred to as business interruption

insurance.

Extra expense exposure may also apply. For example, theshutdown of a facility may require the temporary use of amore costly facility. This may be the case, for example, whena complete shutdown would result in higher costs when com-pared to those associated with the temporary use of a morecostly facility. Insurance purchased to reimburse the firm forthese higher costs is referred to as extra expense coverage.

Risk Management20

Basic Concepts from Probability and StatisticsThis material is review of the basic concepts of business statistics. Chapter 26 also represents a review of quantitativeapplications from prior coursework. Review these terms andmaterials.

A random variable is one with an uncertain outcome.Information about a random variable is summarized by therandom variable’s probability distribution, which identifies all possible outcomes for the random variable and the probability of outcomes. The expected value of a probabilitydistribution provides information about where the outcomestend to occur, on average.

Example: Assume that the following probability distributionexists for automobile damage (see Table 3.3 on page 36 ofyour text):

Solution: The computation of the expected value of damages

follows:

Possible Outcomes

for DamagesProbability

$11,500 50%

,500 30%

1,000 10%

5,000 6%

$10,000 4%

Possible Outcomes


Expected Value

of Damages

$11,500 50% $ 0

500 30% 150

1,000 10% 100

5,000 6% 300

$10,000 4% 400

Total 100% $ 950

Lesson 1 21

The variance of a probability distribution provides informa-tion about the likelihood and magnitude by which aparticular outcome from the distribution will differ from the expected value. The square root of this variance is thestandard deviation. Higher variances and standard deviationsare associated with higher risk.

Evaluating the Frequency and Severity of LossesThe frequency of loss measures the number of losses in agiven time period. Frequency and probability are comparable,in the above table. The severity of loss measures the magni-tude of loss per occurrence. Severity and possible outcomesfor damages are comparable, in the above table.


Check 3. Check your answers with those provided at the backof this study guide. When you’re sure that you completelyunderstand the material from the first three assignments,move on to the examination for Lesson 1.

Self-Check 3


______ 1. Book value has little or no correspondence to economic value and is seldom relevant

for risk management purposes.

______ 2. A random variable is one with an uncertain outcome.

______ 3. Information about a random variable is summarized by the random variable’s

probability distribution.

(Continued)

Risk Management22

Self-Check 3


______ 4. The expected value of a probability distribution provides information about where the

outcomes tend to occur, on average.

______ 5. Higher variances and standard deviations are associated with higher risk.

______ 6. The square root of the standard deviation is the variance.


7. Which type of risk would you expect to have the most skewed probability distribution?(Assume a time period of one year.)

a. Product liability claims for a drug manufacturerb. Shoplifting losses for a small bookstorec. Collision damage to vehicles for a delivery serviced. Employee injuries in a grocery store

8. Unidentified risk exposures will result in

a. reduced insurance premiums.b. increased insurance premiums.c. implicit retention.d. purchasing too much insurance.

9. The expected loss per exposure is the

a. expected frequency per exposure.b. expected severity per occurrence.c. expected frequency per exposure times the expected severity per occurrence all divided by

the number of exposures.d. expected frequency per exposure times the expected severity per occurrence.


Complete Questions 1–4 on page 51 in the textbook.


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1. One situation is riskier than another if it has

A. a greater expected loss.B. a lower uncertainty.C. a lower expected loss.D. no uncertainty.

2. Which of the following is not considered part of business risk?

A. Price risk C. Pure riskB. Credit risk D. Longevity risk

3. All of the following are types of price risk except

A. commodity price risk.B. exchange rate risk.C. stock market risk.D. interest rate risk.

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Lesson 1Introduction to Risk Management

When you feel confident that you have mastered the material in

Lesson 1, go to http://www.takeexamsonline.com and submit

your answers online. If you don’t have access to the Internet,

you can phone in or mail in your exam. Submit your answers for

this examination as soon as you complete it. Do not wait until

another examination is ready.

Questions 1–15: Select the one best answer to each question.

EXAMINATION NUMBER

50082100Whichever method you use in submitting your exam

answers to the school, you must use the number above.

For the quickest test results, go to

http://www.takeexamsonline.com



Examination, Lesson 124

4. Which of the following is the definition of credit risk?

A. Uncertainties due to possible changes in input pricesB. The risk that parties to which the firm has lent money will defaultC. The risk that a firm won’t be able to get credit from lendersD. The risk that a firm won’t have sufficient funds to make payments to its creditors

5. Gallagher Winery is attempting to identify its pure risks. Which of the following is anexample of an indirect loss for Gallagher?

A. Loss of grapevines due to hailB. Employee health problems due to insecticide usageC. Loss of profit due to bad publicity about a liability claimD. Cost of replacing equipment after a fire

6. By increasing spending on safety equipment, Charley’s Meat Packing has reduced totalworker injury costs by 15%. This is an example of the

A. tradeoff between loss control costs and loss financing.B. importance of loss control.C. tendency of business firms to spend too little on loss control.D. tradeoff between loss control costs and expected direct losses.

7. Which one of following is not a major method of managing risk?

A. Loss identification C. Loss financingB. Loss control D. Internal risk reduction

8. Which of the following is incorrect?

A. Value with risk = Value without risk – Cost of riskB. Value without risk – Value with risk = Cost of riskC. Less variability = More riskD. Greater variability = Greater risk

9. Which of the following statements is correct?

A. There are no efficient or optimal levels of risk.B. There are efficient or optimal levels of risk.C. Risk is less costly than the cost associated with the management of risk.D. Risk can’t be effectively managed.

10. All of the following are important components of the cost of risk for a pharmaceuticalcompany that’s developing a new prescription drug for the treatment of AIDS, exceptthe cost of

A. testing the product for safety.B. defending against and settling future liability claims.C. product liability insurance.D. marketing the product to doctors.

Examination, Lesson 1 25

11. Which of the following statements is true of book value?

A. It has little or no correspondence to economic value.B. It’s often relevant for risk management purposes.C. It’s often used for pricing insurance.D. It’s based on historical cost.

12. Assume that the following probability distribution exists for automobile damages:

What is the expected value for damages?

A. $12.40 C. $1,240B. $124 D. $12,400

13. Which of the following statements is true of random variables?

A. They have a certain outcome.B. They have an uncertain outcome.C. They may have a certain or an uncertain outcome.D. Outcome certainty or uncertainty doesn’t apply to random variability.

14. A listing of a random variable’s possible outcomes and the respective probabilities ofthose outcomes is called the

A. probability distribution. C. standard deviation.B. expected value. D. correlation.

15. Which of the following statements is true about expected value?

A. It’s used to determine the value of a company’s assets.B. It uses the probability distribution to develop information about where outcomes

are unlikely to occur, on average.C. It focuses on providing information about where outlier or extreme ranges of

outcomes may occur.D. It provides information about where outcomes tend to occur, on average.

Possible Outcomes


$11,500 50%

,600 30%

2,000 10%

7,000 6%

$11,000 4%


NOTES

General Theory ofInsurance Markets

INTRODUCTIONLesson 2 covers a relatively large number of chapters. InLesson 2, we focus on general theory, legal theory, regulatorytheory, agency theory, and the practice of insurance markets.Pay particular attention to the boxed features and appen-dices, which include terms like agent, principal, adverse

selection, and moral hazard. These are theoretical terms, butparticularly applicable in the insurance and risk assessmentmarkets and applications.

Much of the material contained in Assignment and Chapter 4is very basic review of the concepts of business statistics.


� Show how pooling arrangements provide the foundationfor insurance transactions

� Discuss how insurers reduce insolvency risk throughdiversification of underwriting risk, reinsurance, andinvestment choices

� Describe different types of insurance company ownership

� Discuss the role of insurer capital and factors that affectinsurer capital decisions

� Briefly describe state insurance regulation and summa-rize major activities that are regulated

� Discuss the normative view that regulation should servethe public interest by mitigating market imperfectionsand how political pressure may cause the practice of regulation to deviate from the public interest view

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Risk Management28

� Summarize the historical record of insurance companyinsolvencies,

� List the primary features and functions of solvency regulation, including solvency monitoring, capitalrequirements, and insurance guaranty funds

� Explain why and how insurers classify buyers into differ-ent groups based on estimates of expected claim cost

� Explain how insurance premiums may be affected byshocks to insurer capital

� Summarize the evidence and explanations for the insurance underwriting cycle

� Define what it means to be risk averse and why risk-averse individuals buy insurance

� Explain how business risk management differs from individual risk management

� Identify, describe, and explain factors that can limit theinsurability of risk and the major provisions that limitcoverage in insurance contracts

� Explain the fundamental legal doctrines underlyinginsurance contracts


Risk Reduction through PoolingIndependent LossesYour text uses a two-person pooling arrangement example toillustrate how pooling doesn’t reduce the expected cost, butdoes reduce the standard deviation. Accident costs, therefore,through this pooling process, have become more predictable,or less uncertain. Uncertainty reduction is equated with riskreduction, for each of the individuals involved in the pool.

Lesson 2 29

At the extreme, or as the number of people in the poolingarrangement becomes very large, the standard deviation ofeach participant’s cost becomes very close to zero and therisk, therefore, becomes negligible for each participant. Theexpected cost would, therefore, remain at $500, but the stan-dard deviation would decline, so that the expected cost wouldapproach certainty. This law of large numbers leads to theappropriate application of a normal distribution for large sam-ples (n = 30), due to findings from statistical research andbased on the central limit theorem.

To reinforce, recall the following, which applies universally:

Higher Risk = Higher Variance = Higher StandardDeviation = Higher Uncertainty

and

Lower Risk = Lower Variance = Lower StandardDeviation = Lower Uncertainty

Pooling arrangements result in overall risk reduction for eachindividual participant in the pool.

Insurers as Managers of Risk Pooling ArrangementsThe costs associated with marketing and specifying the termsof agreements for risk pooling arrangements are referred toas distribution costs. The procedures associated with identify-ing (estimating) a potential risk pooling participant’s expectedloss is known as underwriting. The cost associated with monitoring claims by members of the risk pool is a part ofthe loss adjustment cost.

Other Examples of Diversification:Stock MarketsRisk diversification examples are, perhaps, most evident inthe stock market, where shareholders represent pools of risk-takers for new and existing business ventures.

Risk Management30



Self-Check 4


______ 1. Pooling reduces the expected cost.

______ 2. Pooling doesn’t reduce the standard deviation.

______ 3. Accident costs, through pooling, become more predictable.

______ 4. Higher risk = Higher variance = Higher standard deviation = Higher uncertainty

______ 5. Lower risk = Lower variance = Lower standard deviation = Lower uncertainty

______ 6. Pooling arrangements result in overall risk reduction for each individual participant in

the pool.


7. Which of the following is not a type of contracting cost associated with the creation and operation of pooling arrangements?

a. Distribution costs c. Premiumsb. Underwriting expenses d. Loss adjustment expenses

8. Insurers that rely, to some degree, on exclusive agents to sell their policies are known as

a. mutuals. c. independents.b. direct writers. d. brokers.

(Continued)

Lesson 2 31


Insurer CapitalEconomic capital is defined as the difference between themarket value of assets and the market value of liabilities, asfollows:

Economic Capital = Market Value of Assets – Market Value of Liabilities

Ownership and Sources of CapitalA mutual insurer is the most common form of policyholder-owned insurer. A stock insurer is an incorporated insurancecompany, owned by investors who have purchased the stockor equity of the company.

Lloyd’s of London is a different form of an investor-ownedinsurer. Owners of insurance organizations that conductbusiness at Lloyd’s are called names and have unlimited

liability.

Self-Check 4

9. The main (economic) reason for the existence of insurance companies is

a. individuals’ need to diversify risk.b. insurers’ ability to predict individual losses.c. insurers’ ability to form efficient risk pools with minimal contracting costs.d. individuals’ inability to determine expected loss.


Risk Management32

Insurer Operations, Reinsurance, and Insolvency RiskUnderwriting risk is the risk that an average claim cost willdiffer from the amount expected when a policy is sold. Justas businesses and individuals purchase insurance, insurersalso purchase insurance, referred to as reinsurance. Thebuyer, known as the ceding insurer or primary insurer, paysthe reinsurer a premium. A reinsurance treaty covers multiplepolicies written by the ceding insurer. An alternative to tradi-tional catastrophe reinsurance is called a catastrophe bond.

Insurer value is maximized when the insurer is able to effi-ciently and effectively balance higher returns from riskierinvestments against the increased investment risk and theneed for capital.

Factors Affecting Insurer CapitalDecisionsWhen assets have greater value to one firm, when comparedto other firms, these assets are said to be specific assets.

Insurers retain capital to preserve the value of their specificassets, referred to as the insurer’s franchise value.

Reductions in a firm’s value, resulting from the failure ofmanagement to act in the best interest of stockholders, arecalled agency cost (Figure 1).

Lesson 2 33



FIGURE 1—Agency Theory

Self-Check 5


______ 1. Economic capital = Market value of assets – Market value of liabilities

______ 2. A mutual insurer is an incorporated insurance company, owned by investors who have

purchased the stock or equity of the company.

______ 3. Reductions in a firm’s value, resulting from the failure of management to act in the

best interest of stockholders, are called agency cost.

(Continued)

Risk Management34

Self-Check 5


______ 4. Underwriting risk is the risk that an average claim cost will differ from the amount

expected when a policy is sold.

______ 5. The reinsurer pays the ceding insurer a premium.

______ 6. A reinsurance treaty covers multiple policies written by the ceding insurer.


7. The difference between an insurer’s market value of assets and its market value of liabilities iscalled

a. economic capital. c. reported capital.b. economic profit. d. expected losses.

8. An insurance company which is owned by its policyholders is called a

a. stock insurer. c. mutual insurer.b. life insurer. d. Lloyd’s association.

9. Which one of the following is not a reason for insurers to hold “adequate” economic capital?

a. To protect against the loss of franchise valueb. To provide a cushion for meeting unexpected claims costsc. To achieve higher premium volumed. To eliminate any chance of insolvency

10. Lloyd’s of London is a/an

a. stock insurance company.b. mutual insurance company.c. marketplace for transacting insurance business.d. unincorporated mutual.


Answer Questions 1 and 7 on page 96 in the textbook.


Lesson 2 35


Scope and Operation of StateInsurance RegulationEach state has a state insurance department or commissionand a state insurance commissioner. A voluntary organizationof state commissioners, the National Association of Insurance

Commissioners (NAIC), conducts regular meetings to discussinsurance regulatory issues and develop model laws.

Objectives of Regulation: The Public Interest ViewThe public interest view of regulation suggests that regulationexists when the characteristics of a market differ significantlyfrom those of a competitive market, characterized by

1. Large numbers of sellers with relatively low marketshares and low cost of entry by new firms

2. Low-cost information to firms with respect to the cost ofproduction and to consumers concerning prices andquality

3. An absence of spillovers (i.e., all costs are internalized tosellers or buyers)

Regulation and Political PressureAn alternative to the public interest view is the theory of

economic regulation, suggesting that regulators seek to servetheir own interest by maximizing political support. Movementwithin and between industry and the regulatory structuresuggests that regulators may fail to act in the best interestsof the consuming public. This is known as capture theory,

regulatory capture theory, the capture hypothesis, or the producer protection hypothesis.

Risk Management36



Self-Check 6Indicate whether each of the following statements is True or False.

______ 1. Few states have a state insurance department or commission and a state insurance

commissioner.

______ 2. A voluntary organization of state commissioners has been recommended, but doesn’t

presently exist.

______ 3. A competitive market is characterized by a small numbers of sellers with relatively high

market shares and high cost of entry by new firms.

______ 4. The theory of economic regulation suggests that regulators seek to serve their own

interest by maximizing political support.

______ 5. The following are equivalent or comparable terms: capture theory, regulatory capture

theory, the capture hypothesis, and/or the producer protection hypothesis.


6. The main criticism of the McCarran-Ferguson Act is that it

a. causes heterogeneity in prices.b. makes it more difficult for insurers to adequately price policies.c. increases the cost of entry into a particular market or line of business.d. facilitates collusion among insurers to increase prices.

7. In most states, insurance regulation covers all of the following areas except

a. “free riders.” c. insurer sales practices.b. policy forms. d. compulsory insurance.


Answer Questions 2, 7, and 9 on pages 113–114 in the textbook.


Lesson 2 37


Solvency Ratings and RegulationFinancial rating agencies provide solvency ratings of insur-ance companies. Examples include A.M. Best Company,Moody’s, Standard and Poor’s, and Duff and Phelps.

Regulatory monitoring of insolvency risk is a form of delegated monitoring. The NAIC Insurance Regulatory

Information System (IRIS) has been used by state regulatorssince the 1970s. Historically, insurers have been required tomeet or exceed fixed minimum capital requirements to continue to operate in a state. The NAIC has developed risk-based capital requirements for adoption by states.

All states have guaranty funds or guaranty associations.

These guaranty systems provide substantial protection toconsumers covered by an insolvent insurer.

Generally, post-insolvency assessments are levied or imposedon surviving insurers, to acquire the necessary economicresources to pay claims against insolvent insurers.



Risk Management38

Self-Check 7


______ 1. Financial rating agencies provide solvency ratings of insurance companies.

______ 2. Regulatory monitoring of insolvency risk is a form of delegated monitoring.

______ 3. There are no requirements that insurers meet or exceed fixed minimum capital

requirements.

______ 4. The NAIC hasn’t yet, but is considering, the development of risk-based capital

requirements for adoption by states.

______ 5. Very few states have guaranty funds or guaranty associations.

______ 6. Generally, post-insolvency assessments are never levied or imposed on surviving

insurers.


7. All of the following factors have contributed to insurance company insolvencies except

a. catastrophe losses. c. general business cycle factors.b. inadequate rates. d. inadequate capital.

8. What is meant by a “flight to quality” in insurance markets?

a. Policyholders withdraw funds from insurance companies and invest in low-risk securities.b. Policyholders cancel policies with high-risk insurers and buy insurance from better-rated

companies.c. Low-risk policyholders decide to go uninsured because rates are too high.d. Insurers decide to invest funds only in low-risk assets.

(Continued)

Lesson 2 39


Insurance Costs and Fair PremiumsA fair premium is one that’s sufficient to fund the insurer’scosts and provide a fair return on invested capital, as follows:

Fair premium = Cost + Fair return

Expected Claim CostsAdverse selection is defined as the tendency of buyers withhigh expected losses to buy more coverage than buyers withlow expected losses when charged the same premium (Figure 2).

Self-Check 79. Suppose that Quality-Is-Us Insurance Company (QIU) has been evaluated against risk-based

capital (RBC) standards and has too little capital. Which of the following choices is not amethod that QIU could use to reduce its ratio of capital to RBC?

a. Sell more insuranceb. Reinsure more of its businessc. Raise more capitald. Move its investments from stocks to bonds


Complete Questions 1, 2, 3, and 6 on pages 130–131 in the textbook.


Risk Management40

Competition between insurance providers leads to cost-based

prices, based on the insured’s risk classification. When low-risk and high-risk buyers are forced to pay the sameinsurance rates, a cross-subsidy is said to have taken place,benefiting high-risk buyers and penalizing low-risk buyers.

Insurers employ selection standards to determine whether anapplicant in a given class will be offered coverage at theinsurer’s class rate. The overall process of assessing expectedclaim costs for buyers, determining the applicant rate, anddeciding whether to offer coverage is known as underwriting.

Class rates may be modified by experience ratings (or merit

ratings) to reflect the prior loss experience of the applicant.Some may qualify for a bonus-malus or no-claims discount.

A fair premium must include a recovery of cost, known asexpense loading.

Investment Income and the Timing of Claim PaymentsInsurers must plan cash flows for claims costs and coordi-nate these cash flows with investment activities. The amountof money needed to fund expected claim costs after takinginto consideration investment income earned by the insurermight be referred to as discounted expected claim costs.

FIGURE 2—Adverse Selection

Lesson 2 41

Price RegulationHistorically, insurance rates were subject to prior approval

laws by rating bureaus. Beginning in the late 1960s, manystates began replacing these with competitive rating laws.

When regulation of rate changes or risk classification lowersrates below levels required to cover expected costs and provide a reasonable profit, insurers won’t voluntarily sellcoverage. Supply shortages may occur, but are prevented bystate residual market systems. These systems force insurersto participate in the residual market if they wish to sell cover-age in the voluntary market.



Self-Check 8


______ 1. Fair premium = Cost + Fair return

______ 2. Adverse selection is defined as the tendency of buyers with low expected losses to buy

more coverage than buyers with low expected losses when charged the same premium.

______ 3. When low-risk and high-risk buyers are forced to pay different insurance rates, a

cross-subsidy is said to have taken place.

(Continued)

Risk Management42

Self-Check 8


______ 4. The overall process of assessing expected claim costs for buyers, determining the

applicant rate, and deciding whether to offer coverage is known as underwriting.

______ 5. A fair premium must include a recovery of cost, known as profit loading.

______ 6. Supply shortages may occur due to state residual market systems.


7. A hard insurance market is characterized by

a. increasing prices. c. falling prices.b. stable prices. d. readily available coverage.

8. Which of the following is not a common (short-term) outcome of temporary rate suppression?

a. Insurers suffer losses c. Insurers curtail investmentsb. Insurers reduce supply d. Insurers raise premiums

9. Which of the following types of insurance will have the longest claim tail?

a. Homeowner’sb. Automobile physical damage (collision)c. Auto liabilityd. Employee medical coverage


Answer Questions 1, 2, 7, and 9 on page 159 in the textbook.


Lesson 2 43


Risk Aversion and Demand for InsuranceA person who is risk averse prefers certainty to a risky oruncertain alternative. A person who is risk neutral cares onlyabout expected wealth and wouldn’t expect a risk premium toaccept risk.

Diversification reduces risk to individuals (see Chapter 4).The same may be said for individual shareholders, in wayssimilar to the application of insurance pools. If business own-ers aren’t well-diversified, the purchase of businessinsurance will reduce the business owners’ risk. Businessinsurance coverage will preserve capital in the event of abusiness loss.



Risk Management44

Self-Check 9Indicate whether each of the following statements is True or False.

______ 1. A person who is risk averse cares only about expected wealth and wouldn’t expect a

risk premium to accept risk.

______ 2. A person who is risk neutral prefers certainty to a risky or uncertain alternative.

______ 3. Nonmonetary losses include pain, suffering, and grief.

______ 4. Diversification reduces risk to individuals.

______ 5. If business owners aren’t well-diversified, the purchase of business insurance will

reduce the business owners’ risk.

______ 6. Business insurance coverage will preserve capital in the event of a business loss.


7. An individual’s demand for insurance depends on all of the following factors except

a. income. c. premium loading.b. wealth. d. portfolio return.

(Continued)

Lesson 2 45

Self-Check 9


8. Suppose that you have $20,000 in wealth and face a 20% chance of losing $10,000. What isthe expected value of your wealth without insurance?

a. $10,000 c. $18,000b. $16,000 d. $20,000

9. The main reason that diversified shareholders might not want their corporate managers topurchase insurance is that

a. they like risk.b. they’ve already diversified away the risk that’s being insured.c. they’re risk averse.d. cash flow variability increases their return on investment.


Answer Questions 2, 3, and 5a on page 174 in the textbook.


Risk Management46


Factors That Limit the Insurability of RiskParameter uncertainty exists when insurers are uncertainabout the true expected losses of those insured. Moral hazard

refers to the effect of insurance on the insured’s incentives toreduce expected losses. Adverse selection refers to that situa-tion in which consumers have different expected losses, butthe insurer is unable to distinguish between the two types ofconsumers and charge them different premiums (Figure 3).

Contractual Provisions That Limit CoverageContractual provisions that limit coverage include deductibles,coinsurance, policy limits, and policy exclusions. Deductibles

eliminate coverage for relatively small losses by making theinsured pay the first several hundred dollars, for example, ofa claim. Coinsurance requires an insured to pay a specified

FIGURE 3—AsymmetricInformation

Lesson 2 47

portion of the loss, often a percentage. An upper limit orceiling on a policy is referred to as a policy limit. If an insur-ance policy contains exclusions, these items are excluded fromcoverage. Pro rata clauses and excess clauses may alsoinvolve the coordination of benefits and/or reduce the risk ofrecovery in excess of loss.

There are two types of insurance policies: (1) indemnity

contracts require that the insurer pay the claim after a lossand (2) valued contracts establish the amount at the time ofinsurance contract initiation. Insurance-to-value (coinsurance)

clauses specify the percentage of the property’s value that theinsurer requires to be purchased to receive a full reimburse-ment in the event of loss.

Legal DoctrineThe indemnity principle states that an insurance policy can’tpay more than the financial loss suffered. Furthermore, theinsurance policyholder must have an insurable interest—forexample, you can’t insure your neighbor’s house, because it’snot yours. Both the insurer and the policyholder must dis-close all relevant information and negotiate with utmost goodfaith. Failure to do so may constitute a misrepresentation orconcealment of a material or significant, relevant variablethat could have led to very different terms in the agreement.

When disputes arise, rules pertaining to contracts of adhesion

(a policy offered for acceptance or rejection but not negotia-tion) apply. Some courts have adopted what’s known as adoctrine of reasonable expectations, which holds that policieswill be interpreted in a fashion consistent with the expecta-tions of a reasonable person without legal training. Bad-faith

suits arise in cases where insurers have failed to act in amanner consistent with reasonable policyholder expectations.


Check 10. Check your answers with those provided at theback of this study guide. When you’re sure that you com-pletely understand the material from Assignment 10, moveon to the examination for Lesson 2.

Risk Management48

Self-Check 10


______ 1. Parameter uncertainty exists when insurers are certain about the true expected losses

of those insured.

______ 2. Moral hazard refers to the effect of insurance on the insured’s incentives to reduce

expected losses.

______ 3. Adverse selection refers to that situation in which consumers have different expected

losses, but the insurer is unable to distinguish between the two types of consumers

and charge them different premiums.

______ 4. Contractual provisions that limit coverage include deductibles, coinsurance, policy

limits, and policy exclusions.

______ 5. The indemnity principle states that an insurance policy can pay more than the financial

loss suffered.

______ 6. The doctrine of reasonable expectations holds that policies will be interpreted in a

fashion consistent with the expectations of a reasonable person with legal training.


7. The reason that higher premium loadings generally lead to lower demand for insurance coverage is that

a. the fair premium becomes too large relative to the expected cost of not purchasing insurance.

b. people don’t like insurers to make too much profit.c. exposures with low severity always have high administrative costs.d. exposures with high frequency are less likely to be insurable.

(Continued)

Lesson 2 49

Self-Check 10

8. The primary limiting factor on the insurability of highly correlated loss exposures is

a. high administrative costs. c. the moral hazard problem.b. high capital costs. d. adverse selection.

9. Tom and Judy, a married couple, are employed at different companies, and both of theiremployers provide complete family health insurance with pro rata clauses, no deductibles, and no coinsurance. If Tom has knee surgery that costs $5,000, he can recover

a. $5,000 from each insurer since the full premium has been paid for that coverage.b. $5,000 from his own insurer only.c. $2,500 from each insurer.d. $5,000 from his own insurer, who will then try to collect $2,500 from Judy’s insurer.


Answer Question 1 on page 198 in the textbook.


Risk Management50

NOTES

51

1. Which of the following is incorrect?

A. Higher risk = Higher varianceB. Higher variance = Higher standard deviationC. Higher standard deviation = Higher uncertaintyD. Higher uncertainty = Lower risk

2. Which of the following represents a correct definition forunderwriting?

A. The costs associated with marketing and specifying theterms of agreements for risk pooling arrangements

B. The procedures associated with estimating a potential riskpooling participant’s expected loss

C. The cost associated with monitoring claims by membersof the risk pool

D. The process of writing an insurance contract

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Lesson 2General Theory of Insurance Markets








EXAMINATION NUMBER








3. Which of the following statements is true of pooling arrangements?

A. They result in overall risk reduction for each individual participant in the pool.B. They increase the risk for each individual participant in the pool.C. They result in overall risk reduction for selected participants in the pool.D. They increase the risk for selected participants in the pool.

4. Complete the following equation:Economic capital =

A. Historical cost of assets – Historical cost of liabilitiesB. Replacement cost of assets – Replacement cost of liabilitiesC. Market value of assets – Market value of liabilitiesD. Depreciated cost of assets – Historical cost of liabilities

5. Reduction of a firm’s value resulting from the failure of management to act in the bestinterest of stockholders is called

A. agency cost. C. monitoring cost.B. adverse selection. D. moral hazard.

6. The major underlying force that motivates individuals to purchase insurance eventhough insurance premiums exceed expected claim costs is

A. profit. C. expected losses.B. risk aversion. D. premium loadings.

7. The public interest view of regulation suggests that regulation exists when the characteristics of a market differ significantly from those of a competitive market, characterized by all of the following except

A. an absence of spillovers (i.e., all costs are internalized to sellers or buyers).B. large numbers of sellers with relatively low market shares and low cost of entry by

new firms.C. low-cost information to firms with respect to the cost of production and to

consumers concerning prices and quality.D. small numbers of sellers with relatively high market shares and high cost of entry

by new firms.

8. Which area of insurance regulation includes risk-based capital requirements, guarantyfunds, and financial reporting requirements?

A. Licensing regulation C. Solvency regulationB. Rate regulation D. Regulation of sales practices

9. Regulatory monitoring of insolvency risk is a form of

A. fixed minimum capital requirements.B. delegated monitoring.C. guaranty funds or guaranty associations.D. post-insolvency assessments.


10. The tendency of buyers with high expected losses to buy more coverage than buyerswith low expected losses when charged the same premium is referred to as

A. principal cost. C. moral hazard.B. agency cost. D. adverse selection.

11. Risk-based capital formulas for property-liability insurers encompass which of the following main risk categories?

A. Asset risk, credit risk, underwriting risk, and off-balance sheet riskB. Asset risk, credit risk, and underwriting riskC. Asset risk, interest rate risk, credit risk, and off-balance sheet riskD. Credit risk, interest rate risk, underwriting risk, and off-balance sheet risk

12. The legal principle which states that an insurance policy can’t pay more than the financial loss suffered is called the principle of

A. insurable interest. C. indemnity.B. moral hazard. D. adhesion.

13. A cross-subsidy in insurance occurs in which situation?

A. When different lines of insurance (e.g., auto and homeowner’s) are priced so thatthose with higher administrative costs subsidize those with lower administrativecosts

B. When each risk class pays a premium that’s appropriate for their level of riskC. When buyers in different risk groups pay the same premium, so that lower-risk

buyers subsidize the higher-risk buyersD. When insurance is designed to encourage a change in behavior of risky buyers

14. Nonmonetary losses include

A. pain and suffering. C. agency cost.B. lost income. D. principal cost.

15. The doctrine of reasonable expectations holds that insurance policies will be interpretedin a fashion

A. consistent with the expectations of a reasonable person with legal training.B. consistent with the expectations of a reasonable person without legal training.C. consistent with the expectations of a reasonable person with at least a sixth grade

reading level.D. that provides the greatest benefit to the insurance company.


NOTES

Loss Control and LegalLiability

INTRODUCTIONLesson 3 will introduce terminology relating to loss controland basic legal liability rules.


� Define and describe the various types of loss control

� Derive optimal levels of loss control using information onthe costs and benefits

� Discuss the rationale for government safety programs

� Provide background on the general structure of U.S. law

� Describe basic legal liability rules and procedures,including negligence law

� Describe the economic functions of the legal liability system

� Explain the circumstances in which the assignment oflegal liability affects safety incentives and discuss rela-tionships between liability law and safety regulation

� Briefly describe various proposals for tort reform

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Risk Management56


Types of Loss Control� Loss control refers to strategies used to reduce expected

losses.

� Loss prevention is associated with the reduction of thefrequency of losses.

� Loss reduction is associated with the reduction of themagnitude of a loss.

� Loss avoidance is a form of loss prevention, reducing theprobability of loss to zero.

� Pre-loss activities precede a loss and are designed toreduce the magnitude of the loss.

� Post-loss activities follow a loss and are, typically,designed to prevent additional losses.

� Segregation (separation) of exposure units describes theprocess of risk diversification through the segregation ofloss exposures into smaller exposure units.

Examples of Identification of Benefits and CostsExamples of costs and benefits associated with loss controlare included in your text on pages 207–209, and includeinstallation of automatic sprinkler systems, installation ofsafety guards, and child-resistant packaging of nonprescrip-tion drugs.

Lesson 3 57

Cost-Benefit Analysis of SafetyRegulationGovernment regulation is costly and may not be able tooperationalize adequate incentives to effectively implementsafety programs.

Pages 210–212 of your text illustrate how the value of a life can be computed. Table 11.3 on page 213 of your textsummarizes some examples of the costs associated with esti-mates of the number of lives saved from a variety of safetyregulations.


Check 11. Check your answers with those provided at theback of this study guide. When you’re sure that you com-pletely understand the material from Assignment 11, moveon to Assignment 12.

Self-Check 11


______ 1. Loss prevention is associated with the reduction of the magnitude of a loss.

______ 2. Loss reduction is associated with the reduction of the frequency of a loss.

______ 3. Post-loss activities precede a loss; they’re designed to reduce the magnitude of a loss.

______ 4. Pre-loss activities follow a loss; they’re typically designed to prevent additional losses.

______ 5. Loss avoidance is a form of loss prevention, reducing the probability of loss to zero.

______ 6. Segregation of exposure units describes the process of risk diversification through the

segregation of loss exposures into smaller exposure units

(Continued)

Risk Management58

Self-Check 11


7. A particular loss control effort will be undertaken if

a. the expected frequency of losses is reduced.b. the expected severity of losses is reduced.c. expected losses are reduced by an amount greater than the cost of the loss control effort.d. All of the above

8. Loss prevention activities are aimed at reducing the

a. frequency of losses.b. size of a loss, if and when a loss occurs.c. probability of loss to zero.d. None of the above


Answer Question 5 on page 214 in the textbook.


Lesson 3 59


Tort Liability RulesDamages take a variety of forms:

� Compensatory damages are meant to compensate theplaintiff for some injury or loss he or she has suffered.

➢ Special damages—compensation for economic losses

➢ General damages—compensation for noneconomiclosses (i.e., pain and suffering)

� Punitive damages aren’t compensatory, but are designedto punish the defendant and deter future injuriousbehavior.

Joint and several liability refers to cases (e.g., partnerships)where each defendant can be separately held responsible forthe entire amount of damages.

Liability from NegligenceGenerally, negligence is proved when there’s a

� Legal duty by the defendant

� Breach of that duty (firms must take cost-justified

precautions to prevent harm)

� Proximate cause

� Injury to the plaintiff

Defenses to negligence include the following:

� Assumption of risk defense—the plaintiff knew the risksand proceeded anyway.

� Contributory negligence—the plaintiff’s own negligencecontributed to his or her injury, and the defendantdoesn’t have to pay anything.

Risk Management60

� Comparative negligence—the plaintiff’s own negligencecontributed to his or her injury, and the defendant hasto pay an amount in proportion to his or her contribu-tion to the injury.

Economic Objectives of the Tort Liability SystemThe U.S. tort system attempts to compensate victims fully fortheir losses. The collateral source rule precludes courts fromreducing damages awarded by the amount of coverage pro-vided by a plaintiff’s first-party life, health, or propertyinsurance.

A defendant who has a judgment imposed on him or her, buthas insufficient wealth to pay the entire judgment, is said tobe judgment proof for damages in excess of his or her wealth.

Proposals for Tort ReformContemporary tort reform proposals include

1. Modifying incentives to bring suits

2. Limits on contingency fees

3. Reducing damages by placing caps or ceilings on painand suffering awards and punitive damages

4. Limits on punitive damages

5. Limiting the application of joint and several liability



Lesson 3 61

Self-Check 12


______ 1. Common law has evolved over time and includes judicial precedent.

______ 2. Statutory law refers to laws passed by legislative bodies.

______ 3. Criminal law is usually the result of common law.

______ 4. Damages take a variety of forms, including compensatory damages and punitive

damages.

______ 5. Compensatory damages include special damages and general damages.


6. From an economic perspective, the tort system would not be necessary if consumers were

a. uninformed about a product’s risk and transaction costs were low.b. fully informed about a product’s risk and transaction costs were low.c. fully informed about a product’s risk and transaction costs were high.d. partially informed about a product’s risk and transaction costs were high.

7. John was speeding into an intersection when Mary negligently was making a left turn. Their cars collided, and Mary sued John for her injuries. The jury determined that John wasnegligent and that Mary was 30% responsible for her own injuries. Mary’s actual damageswere $25,000. If the comparative negligence rule applies in that jurisdiction, how much willMary get?

a. Nothing c. $17,500b. $7,500 d. $25,000

8. When the U.S. legal system assigns a liability rule for a general type of loss, the system isessentially

a. assessing fault. c. allocating risk.b. protecting consumers. d. measuring damages.


Complete Questions 1, 2, 6, 8, and 9 on pages 234–235 in the textbook.


Risk Management62

NOTES

63

1. Which of the following best defines strategies used to reduceexpected losses?

A. Loss control C. Loss reductionB. Loss prevention D. Loss avoidance

2. Which of the following is associated with the reduction of thefrequency of losses?

A. Loss control C. Loss preventionB. Loss reduction D. Loss avoidance

3. Insurance coverage can reduce the incentives to undertakeloss control activities if insurers

A. help pay for the loss control.B. pay for losses anyway.C. reduce insurance premiums after loss control is

implemented.D. don’t reduce insurance premiums after loss control is

implemented.

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Lesson 3Loss Control and Legal Liability








EXAMINATION NUMBER








4. Segregation of exposure units can reduce

A. the expected frequency of losses.B. the expected severity of losses.C. both the expected frequency and expected severity of losses.D. only those losses that result from natural disasters.

5. Billy Bob earns $45,000 and faces a .007 probability of dying in a workplace accident.Jim Bob earns $41,000 and faces a .0038 probability of dying in a workplace accident.The two require the same level of skill and training. From this information, what is theimplicit value of a person’s life?

A. $315,000 C. $1,052,631B. $571,428 D. $1,250,000

6. Which one of the following is not a potential benefit of loss control efforts to improveworkplace safety?

A. Reduced expected lossesB. Increased worker productivityC. Improved marginal cost of safetyD. Reduced insurance premiums

7. In business liability cases, courts may apply an economic standard for negligencecalled cost-justified precautions. This standard is met if the business

A. spent at least 10% of its revenue on safety efforts.B. undertook safety costs whenever the marginal benefit of the safety effort was

greater than the marginal cost.C. undertook safety costs whenever the marginal benefit of the safety effort was less

than the marginal cost.D. has purchased adequate insurance.

8. Which of the following refers to laws passed by legislative bodies?

A. Statutory law C. Criminal lawB. Common law D. Tort law

9. Which one of the following liability rules frequently applies to products liability cases?

A. No liability C. Strict liabilityB. Negligence D. Absolute liability

10. Under joint and several liability,

A. a defendant’s spouse is equally liable for the defendant’s negligence.B. a defendant has no defenses against the charge of negligence.C. a defendant can’t be held fully responsible for losses he or she only partially

caused.D. a defendant can be held fully responsible for losses he or she only partially caused.


11. Which one of the following is not a potential source of limited liability (or beingjudgment proof)?

A. Bankruptcy lawsB. Being elderlyC. Lack of wealthD. Being incorporated (as a business)

12. Ted was injured in an accident that was caused by Judy’s negligence. As a result of theaccident, Ted incurred $8,000 in medical bills. He filed and won a lawsuit against Linda,and the medical bills were paid by the judgment. These medical bills are what type ofdamages?

A. Special compensatory damagesB. General compensatory damagesC. Special punitive damagesD. General punitive damages

13. The conditions necessary for a plaintiff to show that a defendant was negligent includeall of the following except which one?

A. The defendant had a duty to the plaintiff and breached the duty.B. The defendant’s breach of duty was the proximate cause of the plaintiff’s injury.C. The defendant intended to cause harm to the plaintiff.D. The plaintiff suffered a loss.

14. In which of the following cases is the defendant always liable?

A. No liability C. Strict liabilityB. Absolute liability D. Negligence

15. John was speeding into an intersection when Mary negligently was making a left turn.Their cars collided, and Mary sued John for her injuries. The jury determined that Johnwas negligent and that Mary was 30% responsible for her own injuries. Mary’s actualdamages were $25,000. If the contributory negligence rule applies in that jurisdiction,how much will Mary get?

A. $25,000 C. $7,500B. $17,500 D. Nothing


NOTES

Personal Insurance Issues

INTRODUCTIONLesson 4 has great potential for applicability in your personalinsurance planning needs. The assignments and chapters inthis lesson will provide you with insights into automobile,homeowner’s, and life insurance and annuities.


� Describe personal auto insurance coverage (and expo-sure to loss) arising from automobile ownership and useand explain major features of pricing and underwriting

� Explain compulsory and no-fault automobile insurancelaws and their rationale and effect

� Describe homeowner’s insurance and personal umbrellaliability insurance policies, as well as property insurancearrangements for catastrophic perils, including FAIRplans and National Flood Insurance Program

� Analyze the impact of catastrophes on property insur-ance and the market’s response to large catastrophes

� Provide a brief overview of major life insurance andannuity products

� Describe key features and uses of term, endowment,whole life (compared to universal and variable) life insurance policies and annuity products

� Describe the tax benefits associated with life insuranceand annuity products

� Analyze the pricing of basic life insurance policies andannuities

� Describe methods for comparing the cost of life insur-ance policies across insurers

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Overview of Auto Loss Exposures and InsuranceYour personal auto policy provides auto liability coverage. Itconsists of predetermined coverage based on state compulsory

liability insurance laws, which require drivers to be insuredfor minimum amounts. All states have financial responsibility

laws that penalize those found to have negligently causedaccidents, if they’re unable to pay for certain minimumamounts of damages. Some of the acronyms used in theinsurance industry, and likely to be detailed on your personalauto insurance policy billing statement, include

� PDL—property damage liability

� BIL—bodily injury liability

� PIP—personal injury protection

� UM—uninsured motorist

� UIM—underinsured motorist

� FR—financial responsibility law

Your personal auto policy may include auto medical payments

coverage, which acts independently from health insurance. Instates with no-fault or related laws, your personal auto policyincludes personal injury protection coverage instead. Yourpolicy may also include uninsured and/or underinsured

motorist coverage. This covers you if the cause of the accidentis someone who can’t pay and has no insurance. There aretwo optional types of coverage for vehicle damage and theft:collision coverage and other-than-collision (also calledcomprehensive) coverage.

Lesson 4 69

Auto Insurance Pricing andUnderwritingDifferent insurance rates are charged to different groups ofconsumers, depending on

� Driver class (for example, age group)

� Territorial ratings (for example, city or rural area)

Driver classes include those based on age, gender, automobileuse, number of automobiles and accompanying homeowner’scoverage, and other factors. The insured’s driving record inalso an important factor. The nonstandard insurance market isthe specialty insurance market, which exists to serve driverswith characteristics that suggest significantly above-averageexpected claim and/or administrative costs.



Self-Check 13Match the abbreviations on the left with the terms on the right.

______ 1. PDL

______ 2. BIL

______ 3. PIP

______ 4. UM

______ 5. UIM

______ 6. FR

(Continued)

a. ____Bodily insured liability

b. ____Underinsured motorist

c. ____Personal damage liability

d. ____Financial responsibility law

e. ____Uninsured motorist

f. ____Personal insurance protection

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Self-Check 13


7. Jodi, age 25, is single, lives by herself, and drives a Subaru. Which one of the following statements most completely describes persons insured under her personal automobile policy?

a. Only her, when she is driving her carb. Only her, when she is driving her car or a rental carc. Her and anyone else who is driving her car with her permissiond. Her, when she is driving any car with permission, and anyone else who is driving her car

with her permission

8. Which of the following is the most common type of residual market mechanism for auto liability insurance?

a. Assigned risk plan c. Reinsurance facilityb. Joint underwriting association d. ARC plan

9. If a person’s past accidents and driving violations didn’t result in higher auto insurance premiums, what impact would this have on incentives?

a. Increased incentive for insurers to provide low-priced coverageb. Decreased incentive for people to buy insurancec. Decreased incentive to drive safelyd. Increased incentive for excessive coverage


Answer Questions 2, 3, 6, 7, and 11 on pages 273–274 in the textbook.


Lesson 4 71


Homeowner’s InsuranceThe basic contents from Tables 14.2 and 14.3 on pages 278and 282, respectively, have been merged below. The mostcommon form of homeowner’s policy is HO3:

Homeowner’s insurance dwelling coverage (A) covers the mainresidence and attached structures. Coverage for medical

payments to others pays medical expenses for nonresidentsinjured while on the premises. Guaranteed replacement cost

will pay the like-kind replacement cost even if it exceeds thepolicy limit. The majority of homeowner policies cover

Policy

Form

Perils Covered Type of Settlement

Percent of

Homeowner’s Policies

A & B & D

Dwelling &

Other

Structures

C

Personal

Property

A & B

Dwelling &

Other

Structures

C

Personal

Property

1977 1995

HO1 Basic Basic LKRC ACV 14% <1%

HO2 Expanded Expanded LKRC ACV orLKRC 41% 6%

HO3 Open peril Expanded LKRC orGRC

ACV orLKRC 45% 93%

HO4 (Renter)NA Expanded NA ACV or

LKRC NA NA

HO5 Open peril Open peril GRC LKRC NA NA

HO6 (Condo)Expanded Expanded ACV ACV or

LKRC NA NA

HO8 Basic Basic FRC or ACV ACV 0% <1%

LK = like-kind, GRC = guaranteed replacement cost, RC = replacement cost, ACV = actual cashvalue, and NA = not applicable.

Risk Management72

dwellings and other structures up to their like-kind replace-ment cost. The actual cash value is defined as replacementcost less depreciation:

ACV = RC – Depreciation

Policies that pay functional replacement cost (FRC) pay thecost of replacement for damaged property using the samefunctional materials, but not necessarily the same exactmaterials.

Personal umbrella policies usually provide excess coverage ofat least $1 million for liabilities arising from multiple sources.

Coverage of High Risk/Catastrophic PerilsInsurance against flood losses can be purchased through thegovernment-subsidized National Flood Insurance Program

(NFIP). The program attempts a delicate balancing act—covering flood losses while not encouraging excessivedevelopment (and therefore repeat losses) in flood-proneareas. In some cases, the government purchases and con-demns properties that are flooded multiple times.

Following large losses caused by urban riots in 1967 and1968, many insurers withdrew or raised premiums signifi-cantly, so a number of states created fair access to insurance

requirements (FAIR) plans to provide coverage in these areas.Seven states on the East and Gulf costs of the United Stateshave beach and windstorm insurance plans to cover hurri-cane losses. Even with this plan, Florida residents havefound it increasingly difficult to purchase insurance becauseof the severe hurricanes that have hit the state in recentyears. Increased development in the state has caused hurri-cane losses to increase each year, leading many insurers tostop writing homeowner’s insurance in Florida, or to exclude certain types of damage from their coverage.



Lesson 4 73

Self-Check 14


______ 1. The most common form of homeowner’s policy is HO7.

______ 2. Homeowner insurance dwelling coverage covers the main residence and attached

structures.

______ 3. Coverage for medical payments to others pays medical expenses for nonresidents

injured while on the premises.

______ 4. ACV = annual cost value

______ 5. RC = repair cash


6. Which of the following losses is normally included in homeowner’s insurance coverage?

a. Normal wear and tear on the dwellingb. Property loss caused by a petc. Damage to motor vehiclesd. Loss or damage to the homeowner’s personal property while staying at a hotel in Las

Vegas

7. Under most homeowner’s insurance policies, if the coverage meets the coinsurance requirement, dwellings and other structures will be insured up to

a. their actual cash value.b. their like-kind replacement cost.c. their replacement cost less accumulated depreciation.d. 80% of their actual cash value.

8. The primary reason for the low profitability of homeowner’s insurance companies in the 1990swas

a. losses from catastrophes. c. mismanagement.b. poor underwriting. d. unexpected inflation.

(Continued)

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Life Insurance Product OverviewTerm insurance provides pure insurance or death protectionwithout a savings plan. Cash value policies contain a terminsurance component plus a savings plan:

Cash value policies = Term insurance + Savings plan

In the case of a cash value policy, the amount of savingsaccumulated at any point in time is referred to as the cash

value of the policy.

If a policyholder terminates or surrenders the policy, he orshe is entitled to at least a portion of the policy’s cash value.Early policy surrenders are referred to as lapses. The cash

Self-Check 14

9. Governmental entities (such as the CAT Fund in Florida) may have an advantage at insuringcorrelated loss exposures because

a. correlated loss exposures affect a large number of people.b. pooling across time requires consideration of the time value of money.c. governments are in a better position than private insurers to enforce intertemporal pooling

contracts.d. governments are better at determining the price of correlated risks.


Answer Questions 1 and 3 on page 295 in the textbook.


Lesson 4 75

surrender value is less than the cash value with universal lifeand variable life policies, as a surrender charge is oftenapplied.

The death benefit is the amount of money received by thebeneficiary when the insured dies, and equals the policy’sface amount. Death protection is the amount of the deathbenefit less the cash value, as follows:

Death protection = Death benefit – Cash value

Traditional Products: Term, Endowment, and Whole LifeNearly all term policies are guaranteed renewable—that is,although they may last only five years, they can be renewedafter that time, and then renewed again and again. Anendowment policy is insurance where the insurer pays theface amount of the policy either at the insured’s death or atthe end of the policy. This type of insurance is uncommon inthe United States, because it doesn’t get favorable tax treat-ment. A whole life policy is an endowment policy with a verylong term. The fundamental aspect of a whole life policy canbe summarized, as follows:

Death protection = Death benefit (or Face amount) – Cashvalue

Illustrated dividends for whole life policies, which salesmenuse to sell the policies, tend to reflect what the insurer iscurrently paying, which isn’t guaranteed for the future. Thiscan lead to claims of deceptive marketing when the interestrates have been particularly high and assumptions aboutfuture rates are based on that anomaly.

Extended term insurance uses a single premium to purchasea paid-up term policy. Usually this large premium comesfrom the cash value of a whole life policy that’s converted to aterm policy.

Most whole life policies allow the policyholder to obtain alarge portion of the cash value of the policy without surren-dering the policy (policy loan). This amount then decreasesthe amount of the death benefit if the insured dies beforerepaying the loan.

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Product Innovation: Universal and Variable LifeUniversal life policies, like whole life policies, provide perma-nent death protection and savings accumulation. However,these policies offer greater flexibility with respect to premiumpayments, and the cash value varies explicitly over time. Thecash value is based on premium payments, less expense andmortality charges, plus credited interest.

A variable life policy generates a return earned on a portfolio of assets—usually stocks or bonds—chosen by the policyholder.

Tax Benefits from Life Insurance PoliciesCash value life insurance policies may represent a tax-advantaged financial vehicle, when compared to alternatives.

� Death benefits aren’t taxable (but they may be subject toestate tax).

� No income tax is paid on increases in cash value whilethe policy remains in force, unlike a savings accountwhere the interest is taxed every year.

� If surrendered, the policyholder pays income tax on thesurrender value minus the premiums paid (even thoughonly part of those premiums went to the cash value).

Annuity ContractsAn annuity is associated with an accumulation period—

when the insurance company receives payments from theannuitant, or policyholder—and a payout period—when theinsurance company makes payments to the annuitant. Anannuity that pays only until the annuitant dies is called astraight life annuity. A deferred annuity (about 95 percent ofall annuities purchased) is usually purchased before retire-ment, to be used as income after retirement. A fixed annuity

usually guarantees some minimum rate of return, whereas avariable annuity doesn’t.

Lesson 4 77

Life Insurance Pricing and Cost ComparisonsNet premiums and mortality tables are examined in pages 314through 323 of your text, where the authors compare asequence of one-year life insurance policies to a two-yearterm policy. Term insurance policies are commonly comparedusing the interest adjusted cost index. Whole life policies arecommonly compared using the estimated implicit rate of

return.

Rules of thumb suggest that insurance coverage should equal 6 to 10 times annual income.



Self-Check 15


______ 1. Term insurance provides an insurance component plus a savings plan.

______ 2. Cash value policies provide pure insurance or death protection without a savings plan.

______ 3. Death protection = Death benefit – Cash value

______ 4. Whole life insurance policies are commonly compared using the interest adjusted cost

index. Term life policies are commonly compared using the estimated implicit rate of

return.

______ 5. Term life insurance provides a death benefit equal to the face amount of the policy if

the insured dies during the policy period.

(Continued)

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Self-Check 15


6. Which of the following types of life insurance policies were sold the most in the United Statesduring 2000?

a. Term life insurance c. Universal life insuranceb. Whole life insurance d. Variable life insurance

7. In pricing a life insurance contract, which of the following is not necessary to determine theprice per thousand dollars of coverage?

a. The age of the insuredb. The time value of moneyc. The face amount of the policyd. The insurer’s expense and profit loading

8. Over the life of the policyholder, the face amount of a whole life policy remains fixed, but thedeath protection component _______ and the cash value component _______.

a. increases; decreases c. decreases; decreasesb. increases; increases d. decreases; increases


Answer Questions 1, 2, 3, and 4 on page 329 in the textbook.


79

1. The market for auto insurance that provides coverage todrivers who would otherwise not be able to buy insurance iscalled the _______ market.

A. residual C. prior approvalB. voluntary D. reinsurance

2. Which of the following is not one of the main types ofcoverage provided under the personal auto policy?

A. Liability coverage for injuries caused by the negligence ofthe insured driver

B. Coverage for physical damage to the personal property ofthe negligent driver

C. Coverage for losses caused to the insured by a driverwithout liability insurance

D. Coverage for theft of the insured vehicle

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Lesson 4Personal Insurance Issues








EXAMINATION NUMBER








3. Which one of the following is not an argument favoring no-fault personal injury protection (PIP) coverage?

A. Loss payments are generally made more quickly.B. Dispute resolution costs are lower.C. It provides increased incentives for auto safety.D. When fault is unclear, more people will still have first-party coverage.

4. Henry is driving Lisa’s automobile. He runs a stop sign and causes an accident. Henryand Lisa both have a personal automobile insurance policy. How will the liability cover-age between these two policies most likely be coordinated?

A. Henry’s policy is primary, while Lisa’s policy is excess.B. Lisa’s policy is primary, while Henry’s policy is excess.C. Henry’s and Lisa’s policy pay equal shares.D. Only Henry’s policy is obligated to provide liability coverage, since he is the at-fault

driver.

5. Insurance coverage for flood damage is available through the National Flood InsuranceProgram. How does the program operate?

A. Private insurers sell and service the policies, with the federal government bearingthe risk.

B. Private insurers sell and service the policies while sharing the risk with the federalgovernment.

C. Private insurers underwrite the risk, with the federal government acting as a reinsurer only in the event of a bad loss experience.

D. All polices are sold and serviced by the federal government, which also bears therisk.

6. Which of the following statements is true of compulsory automobile insurance?

A. It’s unconstitutional.B. It enjoys strong enforcement.C. It’s similar to a flat or sales tax in its impact on policyholders.D. It has a regressive impact on the distribution of income.

7. Driver classes may be based on which of the following factors?

A. Age C. Sexual orientationB. Race D. Religion

8. Which of the following losses is most likely to be excluded from coverage in a homeowner’s insurance policy?

A. Theft of personal propertyB. Damage from lightning strikeC. Property loss due to an intentional actD. Fire loss


9. What is the main reason that homeowner’s insurance policies commonly exclude coverage for earthquake and flood?

A. Not many people need this coverage.B. The losses tend to be correlated across policyholders.C. Moral hazardD. The government can provide this coverage more cost effectively.

10. When Kathy buys a single-premium whole life policy, she

A. makes the same premium payment each year of the policy period.B. makes the same premium payment each year for a limited number of years and is

then covered for her whole life.C. makes the same premium payment each year for her whole life and is covered for

her whole life.D. pays the entire premium in a lump sum when the policy is issued and is then

covered for her whole life.

11. In the context of life insurance policies, which of the following equations is incorrect?

A. Cash value policies = Term insurance + Savings planB. Potentially taxable = Receipt – Net costC. Death protection = Death benefit – Cash valueD. Death protection = Death benefit

12. Which of the following is not a tax benefit of cash value life insurance?

A. Death benefits aren’t taxable income.B. Life insurance premiums paid are tax deductible in the United States.C. The annual increase in the cash value while the policy is in force isn’t taxed.D. Returns earned on the savings component are tax deferred until surrender.

13. As a rule of thumb, insurance coverage should equal

A. 6 to 10 times annual income.B. 6 to 10 times net worth.C. 6 to 10 times monthly income.D. 6% to 10% of expected annual retirement income.

14. An annuity that pays only until the annuitant dies is called a _______ annuity.

A. straight life C. whole lifeB. term D. universal

15. A policy that pays the face amount of the policy if the insured dies and also pays theface amount if the insured survives the policy term is called a/an _______ policy.

A. whole life C. endowmentB. universal life D. term life


NOTES

Employer-EmployeeRelationships

INTRODUCTIONIn Lesson 5 we’ll review a variety of employee benefits. Groupmedical and health care and retirement plans are covered inthe first two assignments. These represent employer-providedplans to attract and retain employees. We’ll also reviewworkers’ compensation and Social Security, which are requiredby state and/or federal law. Assignment 19 will form thefoundation for your course project.


� Explain major types of employee benefits and why firmsprovide them

� Describe, analyze, and summarize group medicalexpense coverage provisions and pricing issues, including HMOs and other forms of managed care

� Discuss the causes of high health care costs, why manyremain uninsured, and proposals to control costs andincrease the number of those insured

� Describe major types and features of employment-relatedretirement plans and their tax incentives, growth indefined contribution plans, and related government regulation and insurance

� Define IRAs, Roth IRAs, SEP, and Keogh plans

� Describe the basic history, features, and economicrationale of workers’ compensation laws and liabilityinsurance

� Describe Social Security retirement, survivor, and disability and Medicare programs, benefits and theirfinancing

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Major Types of Employee BenefitsThe most common types of voluntary benefits offered byemployers include

� Medical insurance

� Life insurance

� Disability insurance

� Dental insurance

� Retirement plans

Cafeteria benefit plans (also known as flexible benefit plans

or, more formally, Section 125 plans, after the InternalRevenue Code section addressing them) provide some corebenefits to all employees, while allowing them to select from amenu of optional benefits. Tax advantaged benefits includeflexible spending accounts, which may be used to pay formedical, dental, or child care expenses using pre-tax dollars.The amount of money in this account must be decided aheadof time, and any unused portion is forfeited at the end of theperiod. Therefore, it’s important for employees to be some-what conservative in their estimated costs.

Why Firms Provide Employee BenefitsThree reasons are commonly suggested to explain why firmsprovide employee benefits instead of simply paying highercash wages:

1. Tax savings for both employer and employee (Employeebenefits plans that receive preferential income tax treatment are called qualified plans.)

Lesson 5 85

2. Administrative expenses in group insurance premiumsare lower as a percentage than for individual insurance(economies of scale lower the per-individual cost).

3. Employers sometimes find that employer-provided bene-fits promote employee productivity or retention. (Howmany times have your heard someone refer, favorably, totheir employer’s superior benefits?)

Overview of Group Medical Expense CoverageOne of the most common and important types of employeebenefits is group medical expense coverage. With traditionalfee-for-service arrangements, employees receive basic benefits

(hospitalization, surgery, physician services, and specifieddiagnostic tests), and, typically, additional protection in theform of supplementary major medical coverage. Many planscontain a stop loss clause or place a ceiling on the out-of-pocket maximum costs to be incurred by the employee. Theinsurance company pays all qualifying expenses above thisceiling. Under this system, some basic services—such asroutine checkups—may not be paid for by the insurance.

Some insurers play an active role in patient health care man-agement. This is called managed care. Health maintenance

organizations (HMOs) represent one form of managed care, inwhich insureds must use doctors within the network or theinsurance company won’t pay for the care. HMOs usuallyplace a lot of emphasis on preventive care, providing morecoverage for routine screenings than for specialist care.Efforts to control costs have led to requirements thatparticipants select a primary care physician, who serves agatekeeper function. The requirement that insureds see a pri-mary doctor first, to get permission to see a specialist, meansthat specialist utilization is lower under this type of plan.

Some providers have contracted with employers/insurers forprice discounts. These arrangements are called preferred

provider organizations.

Risk Management86

Group Medical Plan Provisions and Pricing IssuesFee-for-service group medical plans usually contain apreexisting conditions clause, excluding coverage for newemployees for ailments for which the person received medicaltreatment during some period of time, often the prior 12months. Preexisting clauses are relatively uncommon inHMOs.

Title I of the Health Insurance Portability and Accountability

Act (HIPAA), enacted in 1996, limits preexisting conditionexclusions to 12 months after enrollment (18 months in thecase of those who don’t enroll as soon as they’re eligible).This means that preexisting conditions can’t be excludedforever; rather, they’re subject to a waiting period. Individualsmay reduce or eliminate this exclusion period if they hadhealth insurance (“creditable coverage”) prior to enrolling inthe plan, without any “significant breaks” in coverage—defined as 63 days or more without creditable coverage. So, aperson changing jobs that provide health insurance isn’t sub-ject to the exclusion. Insurance companies are required toprovide a “certificate of creditable coverage” upon terminationof coverage.

“Creditable coverage” includes nearly all group and individualhealth plans, Medicare, and Medicaid. To determine howmuch coverage can be credited against the exclusion periodin the new plan, start at the enrollment date and count back-wards until you reach a significant break in coverage, or the12-month period is exhausted. Essentially, the 12-monthexclusion period is applied retroactively to the previousinsurance the person had, so that someone who had insur-ance continuously for 13 months before enrolling in newemployment coverage has no exclusion period; someone whohad insurance for only 6 months faces a 6-month exclusionperiod; and someone who had no previous insurance facesthe full 12-month exclusion period.

If the insurance has a waiting period before employees areeligible for health coverage, the “enrollment date” in thedefinition is the beginning of the waiting period. Any waitingperiod that applies to enrollment in the plan runs concur-

A preexisting conditionis defined by HIPAA asa condition for which“medical advice, diagno-sis, care or treatmentwas recommended orreceived within the six-month period beforethe enrollment date.”For a person who had amedical condition inthe past, but hasn’treceived any medicaladvice, diagnosis, careor treatment for itwithin the six monthsprior to enrollment inthe new plan, the oldcondition is not a pre-existing condition towhich an exclusion canbe applied.

Lesson 5 87

rently with the exclusion period, so that a 6-month waitingperiod can’t be added to a 12-month exclusion period tobecome an 18-month exclusion period. The waiting periodalso doesn’t count as a “significant break” in coverage.

Genetic information can’t be counted as a preexisting condition—so, for example, a woman who carries the breastcancer gene, but who has never had breast cancer, can’t bedenied coverage if she develops breast cancer. Pregnancy alsocan’t be treated as a preexisting condition.

Health Care ReformThe Health Insurance Accountability and Portability Act of1996 permitted medical savings accounts (MSAs) (nowreferred to as health savings accounts, or HSAs) on an experi-mental basis. Congress later extended the program past theexperimental stage. The original MSAs were limited to theself-employed and employers of 50 or fewer people; HSAsaren’t subject to these restrictions. These accounts accom-pany high-deductible health insurance plans ($1,100 or morefor a single person) and, unlike flexible spending plans, aren’ta “use it or lose it” proposition—if the money in the accountisn’t spent in one year, it can be rolled over and continue togrow and accumulate.

Note: Not all health plans with high deductibles meet therequirements for association with an HSA. By law, an HSAplan can’t include pre-deductible co-pays for routine care ortreatment, except that optional co-pays may be included forpreventive care. There are also maximum out-of-pocket coststhat change annually.

A health savings account is funded with pre-tax dollars, andif withdrawals are made for the purposes of qualified medicalexpenditures, the withdrawals aren’t subject to federalincome tax (many states also exempt this money from taxa-tion). If withdrawals aren’t used for medical expenses, they’resubject to a penalty tax, unless the person is of retirementage or disabled. Earnings in the account accumulate tax-deferred. The law limits how much can be contributed eachyear to the account—for 2008, those limits are $2,900/indi-vidual and $5,800/family.

Risk Management88

During the 2008 presidential election campaign, candidatesClinton and Obama proposed similar, one-provider plans toprovide medical insurance at a lower cost to all Americans,and John McCain proposed a $5,000 per year refundable taxcredit for medical insurance, to allow market forces to enterinto the provider selection process.



Self-Check 16


______ 1. The most common types of voluntary benefits offered by employers include medical

insurance, life insurance, disability insurance, dental insurance, and retirement plans.

______ 2. Firms provide employee benefits instead of simply paying higher cash wages, in part,

to achieve tax savings for both employer and employee.

______ 3. One of the most common and important types of employee benefits is group medical

expense coverage.

______ 4. The Health Insurance Accountability and Portability Act of 1996 permitted medical

savings accounts (MSAs) on an experimental basis.

______ 5. Causes of increasing medical and health care costs include excessive utilization,

increased quality, higher costs associated with improved technologies and treatments,

and an aging population.

(Continued)

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Self-Check 16


6. Employee benefit plans that do not require workers to pay part of the cost of the benefits areknown as

a. defined benefit plans. c. contributory plans.b. noncontributory plans. d. cafeteria plans.

7. Group insurance is usually cheaper than individual insurance for all of the following reasonsexcept

a. lower claims cost. c. lower expense loading.b. reduced adverse selection. d. better predictability of losses.

8. Which of the following statements about medical savings accounts (MSAs) is true?

a. Healthier employees will opt for traditional insurance plans, thus causing the MSAs to losemoney.

b. If a person has losses less than the deductible in a given year, he or she gets no benefitfrom the insurance.

c. MSAs will have no effect on the incentives for utilization of health care.d. The MSA provides catastrophic coverage.


Risk Management90


Overview of Retirement PlansThere are three ways to provide for retirement income:

1. Defined benefit plans—An employer promises employeesa monthly retirement benefit (called a pension) defined bya benefit formula. The retirement benefit as a percentageof the employee’s final salary is called the replacement

rate. The replacement rate increases as the employee’syears of service increase.

Assuming that the employer honors its pension commit-ments, in this type of plan the employer assumes theinvestment risk—if the investments in the pension funddo poorly, the employer must make up the difference byincreasing its contributions. In the long bull market ofthe late 1990s, many large companies didn’t make anypension fund contributions at all because of the growthin the pension funds’ investments. Then, when themarket crashed in 1999–2000, suddenly the funds’assets crashed also and they became badly underfunded.Many companies terminated their pension plans and leftit to the government to pay the benefits, so the risk tothe employee of this sort of plan has increased.

2. Defined contribution plans—An employer (and, often, theemployee) makes a specific (defined) contribution to afund up to a certain allowable amount. A 401(k) is anexample of a defined contribution plan; the annualcontribution limit for 2008 is $15,500. The employeegenerally has a choice of several funds to allocate themoney to (commonly stock and bond mutual funds). Theemployee’s retirement benefit depends on the investmentreturn. In this type of fund, the employee bears the riskof investment return. If the investments do poorly, theemployer won’t add any money to the account, and theemployee’s ability to cover costs in retirement will becompromised. The employee is always vested in his or

Lesson 5 91

her own contributions to the plan, while vesting in theemployer’s portion works in much the same way as withpension plans.

3. Cash balance plans—During the 1990s, hybrid planscalled cash balance plans evolved. Like defined benefitplans from a sponsor’s perspective and classified asdefined benefit plans for regulatory purposes, cash bal-ance plans are similar to defined contribution plans froman employee’s perspective. The employer contributesmoney on behalf of each employee according to a formula;all the money is invested into an aggregate fund thatisn’t directed by the employee. The employee, however,can roll over the funds in a lump sum to anotheraccount when he or she changes jobs. Increases anddecreases in the value of the plan’s investments don’tdirectly affect the benefit amounts promised to partici-pants. Thus, the investment risks and rewards on planassets are borne solely by the employer.

While both traditional defined benefit plans and cash balanceplans are required to offer payment of an employee’s benefitin the form of a series of payments for life, traditional definedbenefit plans define an employee’s benefit as a series ofmonthly payments for life to begin at retirement, but cashbalance plans define the benefit in terms of a stated accountbalance. (These accounts are often referred to as “hypotheti-cal accounts” because they don’t reflect actual contributionsto an account or actual gains and losses allocable to theaccount.) In addition, many cash balance plans allow theparticipant to choose (with consent from his or her spouse)instead to take a lump sum benefit equal to the accountbalance at retirement.

Companies are allowed to change their traditional pensionplan formula to a cash balance plan formula. Federal lawdoes place restrictions on plan changes of this type. Forexample, a plan amendment can’t reduce benefits that partic-ipants have already earned. Advance notification to planparticipants is required if, as a result of the amendment, therate that plan participants may earn benefits in the future issignificantly reduced. There are other legal requirements thathave to be satisfied, including prohibitions against agediscrimination.

Risk Management92

Tax Advantages of Retirement PlansThe widespread use of employment-related retirement plansis due to the preferential tax treatment granted through thesequalified retirement plans. Generally, the tax deferral allowsthese monies to grow, without reduction by annual tax pay-ments. Even greater tax savings are enjoyed if the individualreceives a tax deduction for the contribution during peakearnings years while in a relatively high tax bracket, andwithdraws and pays the tax while in a lower tax bracketduring retirement years.

Incentive Effects of Employer-Sponsored Pension PlansRetirement plans are used to

1. Increase employee productivity, effort, and retention

2. Promote retirement at an age when employee productivity declines

Many of these plans have participation requirements andvesting requirements. Vesting requirements may result in theforfeiture of all or a portion of the component contributed bythe employer if the employee terminates employment with theemployer on or before a predetermined vesting date. Vestingmay take the form of cliff vesting (e.g., full benefits after acertain number of years, but none before then) or graded

vesting (e.g., 20 percent after 2 years, 40 percent after 4 years,and so on). A plan’s normal retirement age determines the ageat which a retiree receives full retirement benefits, and mayused to induce retirement.

Retirement Plan Provisions and RegulationsRegulation of retirement plans expanded with the Employee

Retirement Income Security Act (ERISA) of 1974. To retaintheir tax-favored status, qualified plans must meetnondiscrimination rules, which means in essence that the

Lesson 5 93

retirement plan can’t be used as a disguised tax shelter forthe CEO while the rank-and-file employees are discouragedfrom participating. The law also prohibits excessively longvesting periods.

ERISA requires minimum funding requirements for defined-benefit plans, and created the Pension Benefit Guaranty

Corporation (PBGC) to ensure that some benefits are given toemployees when a company’s pension fund is terminatedwhile less than adequately funded. Companies with pensionplans are charged an annual premium for this insurance. Inrecent years, due in part to gyrations in the stock and bondmarkets, many company pension plans have become under-funded and been turned over to the PBGC, whose ability tocover all the obligations is becoming more and more strained.



Risk Management94

Self-Check 17


______ 1. In a defined benefit plan, an employer promises employees a monthly retirement

benefit defined by a benefit formula.

______ 2. In a defined contribution plan, the employer and/or employee makes a specific

contribution to a fund.

______ 3. Vesting may take the form of cliff vesting or graded vesting.

______ 4. In a money purchase plan, the employer makes a contribution to the employee’s

account, but only if the firm profits.

______ 5. Only employees can establish Keogh plans.


6. The tax advantages of qualified retirement plans include all of the following except

a. contributions to the plan aren’t subject to income tax until received as benefits.b. contributions paid by employers are tax deductible in the year they’re made.c. earnings on assets in qualified retirement plans are subject to lower capital gains tax

rates.d. dividend and interest earnings in the retirement plan aren’t subject to income tax until

received as benefits.

7. Which of the following investments makes the least sense for a qualified pension plan?

a. Tax-free municipal bonds c. Corporate bondsb. Dividend-paying stocks d. Growth stocks

8. A defined contribution plan that’s invested entirely in the sponsoring firm’s stock

a. is violating the law because employer stock is limited to no more than 10% of plan assets.b. has been shown to increase employee productivity by 10%.c. makes a firm more likely to be a takeover target.d. may be bad for participants because it forces them to have a relatively undiversified

portfolio.


Lesson 5 95


Overview of Workers’ CompensationLawsWorkers’ compensation laws have two important features:

1. Employers pay benefits without regard to employer faultor negligence.

2. Employees aren’t allowed to sue employers for injuriesunder tort law.

The economic rationale for workers’ compensation rests onwhether it can minimize the cost of risk by maximizing thewelfare of workers when compared to alternatives.

Employers are required by law to either purchase workers’compensation insurance or prove that they have the ability to self-insure and pay claims. Some states run their owninsurance companies for workers’ compensation; all statesregulate insurance prices to some extent. Workers’ compen-sation payments may be made for temporary total disability,permanent total disability, or permanent partial disability.

Workers’ Compensation Insurance and Self-InsuranceWorkers’ compensation insurance has two main coverageparts:

1. Workers’ compensation insurance

2. Employers’ liability insurance

Generally, employees are classified based on their position inthe firm for purposes of workers’ compensation. Somepositions embody greater risk and some are less risky. Forexample, a white-collar worker in an office has little risk ofharm in the normal course of his or her duties, while ademolition expert is placed at great risk during the ordinary

Risk Management96

course of a day’s activities. For this reason, the prospective

loss cost and therefore the advisory rate (cost of insuranceper $100 of gross salary) for the latter is far greater than thatfor the former. The advisory rate is adjusted, up or down,based on a firm’s experience rating (costs of claims in theprevious three years) and schedule rating (rating based on theinsurer’s estimate of future claim costs, based on things likesafety programs). Therefore, a firm with few accidents result-ing in claims is likely to reduce their workers’ compensationcosts, which provides an economic incentive to improveworker safety.

Adverse selection and moral hazard can occur in an employ-ment setting as well as in an insurance setting (Figure 4).

Government Safety RegulationThe most significant government safety regulations includethe Occupational Safety and Health Act (OSHA), whichbecame effective in 1971, and the Americans with Disabilities

Act (ADA), which became effective in 1992. OSHA providessafety requirements for employers and allows employees toanonymously report violations. Employers can be fined forviolations, and managers can even be subject to criminalpenalties in extreme cases. The ADA made it illegal to

FIGURE 4—Moral Hazard and Employment

Lesson 5 97

discriminate against disabled workers, and requires employersto make “reasonable accommodations” to help disabledworkers perform their jobs.



Self-Check 18


______ 1. Workers’ compensation payments may be made for temporary total disability,

permanent total disability, or permanent partial disability.

______ 2. The economic rationale for workers’ compensation rests on whether it can minimize the

cost of risk by maximizing the welfare of workers when compared to alternatives.

______ 3. Workers’ compensation insurance has two main coverage parts: workers’ dental

insurance and employers’ litigation insurance.

______ 4. The advisory rate can be adjusted up or down based on a firm’s experience rating and

schedule rating.

______ 5. One of the most significant government safety regulations is the Occupational Safety

and Health Act.


6. If the 2002 prospective loss cost per $100 of payroll for Colorado restaurants is $.80 and theABC Insurance Company’s loading for expenses and profit is 20% of the class rate, what is theABC class rate for a Colorado restaurant in 2002?

a. $0.16 per $100 payroll c. $0.96 per $100 payrollb. $0.80 per $100 payroll d. $1.00 per $100 payroll

(Continued)

Risk Management98


Overview of Social SecurityThe U.S. Social Security program, enacted in 1935, is moreformally known as the Old-Age, Survivors, Disability, and

Health Insurance (OASDHI) program. As shown in Figure 5, itincludes

1. Old-Age, Survivors, and Disability Insurance (OASDI)

2. Medicare (the health insurance component)

Self-Check 18

7. Yasmina works as an accountant for MyTown Medical clinic. One of the clinic’s physician/owners has given Yasmina some medical advice that she feels has severely exacerbated anold work-related back injury. As a result of this situation, what kind of lawsuit might Yasminabe able to file against her employer?

a. Employment practices lawsuitb. Dual capacity lawsuitc. Employee compensation lawsuitd. Yasmina won’t be able to file any lawsuit because the injury is work related.

8. The original rationale for second injury funds was to

a. increase employment opportunities for workers who have sustained some type of permanent injury.

b. hold a worker’s employer responsible for funding second-injury costs.c. eliminate second-injury lawsuits.d. reduce the incentive of insurers to investigate questionable claims.


Lesson 5 99

Generally, OASDI represents 6.2 percent (12.4 percent,combined) and Medicare represents 1.45 percent (2.9 per-cent, combined) of the 7.65 percent of salary or wages thatthe employer and employee each contribute to the U.S. SocialSecurity system (7.65 + 7.65 = 15.3 percent, in total).

FIGURE 5—The FICA Tax

Tax Wage Year Base

Tax Wage Year Base

Tax Wage Year Base

Tax Wage Year Base

1937–50 $3,000

1951–54 $3,600

1955–58 $4,200

1959–65 $4,800

1966–67 $6,600

1968–71 $7,800

1972 $9,000

1973 $10,800

1974 $13,200

1975 $14,100

1976 $15,300

1977 $16,500

1978 $17,700

1979 $22,900

1980 $25,900

1981 $29,700

1982 $32,400

1983 $35,700

1984 $37,800

1985 $39,600

1986 $42,000

1987 $43,800

1988 $45,000

1989 $48,000

1990 $51,300

1991 $53,400

1992 $55,500

1993 $57,600

1994 $60,600

1995 $61,200

1996 $62,700

1997 $65,400

1998 $68,400

1999 $72,600

2000 $76,200

2001 $80,400

2002 $84,900

2003 $87,000

2004 $87,900

2005 $90,000

2006 $94,200

2007 $97,500

2008 $102,000

2009 $106,500

Social Security Wage Base through the Years

Risk Management100

OASDI BenefitsOld-Age, Survivors, and Disability Insurance (OASDI) benefitsinclude retirement, survivors, and disability benefits. Thesebenefits are summarized in Table 19.1 on page 416 of yourtext.

OASDI benefits provide monthly benefits to a worker retiringat normal retirement age, known as the primary insurance

amount (PIA). This is calculated in two steps, including thecomputation of the worker’s average indexed monthly

earnings (AIME). OASDI benefits are adjusted to keep up withinflation through annual cost-of-living adjustments (COLA).

Social Security benefits aren’t subject to a means test, butare subject to an earnings test. This means that people don’thave to prove they have few assets to collect Social Security;benefits are reduced, however, if wage income (not investmentincome) exceeds a certain level after retirement.

Tax FICA SECAYear(s)


1937–49 1.00% NA

1950 1.50% NA

1951–53 1.50% 2.25%

1954–56 2.00% 3.00%

1957–58 2.25% 3.38%

1959 2.50% 3.75%

1960–61 3.00% 4.50%

1962 3.13% 4.70%

1963–65 3.63% 5.40%

1966 4.20% 6.15%

1967–68 4.40% 6.40%

1969–70 4.80% 6.90%

1971–72 5.20% 7.50%

1973 5.85% 8.00%

1974–77 5.85% 7.90%

1978 6.05% 8.10%

1979-80 6.13% 8.10%

1981 6.65% 9.30%

1982–83 6.70% 9.35%

1984 6.70% 11.30%

1985 7.05% 11.80%

1986–87 7.15% 12.30%

1988–89 7.51% 13.02%

1990– 7.65% 15.30%

FICA Tax (1937– ), SECA Tax (1951– ), SECA tax subsidy phase-out completed & SECA taxesadjusted & partially deductible (1990– )

Social Security Taxes through the Years

Lesson 5 101

OASDI FinancingOASDI benefits are financed almost exclusively from payroll(also called Federal Insurance Contribution Act, or FICA) taxes.

The OASDI tax rate, as previously discussed, is 6.2 percent ofan annually inflation-adjusted maximum taxable wage base

($102,000 for 2008). The tax for Medicare doesn’t have amaximum wage base.

Social Security is largely financed using what’s called pay-as-

you-go financing. This means that payroll taxes on current

workers fund payment of benefits to current retirees. Workers’contributions aren’t set aside in a fund to pay their laterbenefits—which is why the demographic trend of increasingaverage age of the population is worrisome from the perspec-tive of Social Security. The number of workers supportingeach beneficiary has declined dramatically since the programbegan. In addition, as lifespans have increased, people havebeen collecting benefits for longer, which of course costs more.

The pay-as-you-go system is often referred to by legislatorsand politicians as PAYGO. Average benefits are expressed asfollows:

Average benefit = Tax rate ✕ Average taxable wage ✕Ratio of workers to beneficiaries

Alternatively:

Tax rate = Average benefits ÷ (Average taxable wage ✕Ratio of workers to beneficiaries)

While a worker’s payroll taxes aren’t invested to fund his orher future benefits, an implicit rate of return on payroll taxes

can be calculated.

Why Have Social Security?Social Security represents what economists refer to as anintergenerational contract. The younger generation fundsSocial Security for older generations, with the expectationthat the same will be done for them, and so on.

Risk Management102

Presently, we face a crisis in the United States as the popula-tion ages. There will continue to be a smaller base of youngerworkers to fund the Social Security benefits for older benefici-aries under the PAYGO system. Unless a change is made, thesystem is projected to become insolvent by around 2040.

Proposed Changes and Alternatives to Social SecurityDuring the 2008 Presidential campaign, Senators Obama andClinton recommend lifting the wage base ceiling, at variouslevels, to ensure adequate funding for Social Security, wellinto the future. Other proposals, including those made byPresident George W. Bush, included a partial privatization ofSocial Security, both to generate higher returns from stocksand to prevent politicians from spending Social Security netcash inflows. This privatization component represents adeparture from the PAYGO system.

MedicareSince your textbook was published, the Medicare law hasbeen modified to include prescription drugs. Medicare nowhas three main parts:

� Part A: Hospital Insurance (abbreviated as HI in yourtextbook)

� Part B: Supplementary Medical Insurance (abbreviatedas SMI in your textbook)

� Part D: Prescription drug plan

There’s also a Part C, the Medicare Advantage plan. Parts Aand B are often referred to as the Original Medicare plan.

Most people get their coverage through the Original Medicareplan, which is a fee-for-service plan. Beneficiaries are alwaysfree to get noncovered services on their own if they choose topay for the service. For people with other insurance besidesMedicare, sometimes that other insurance pays health carebills first, and Medicare pays what’s left. Examples includeliability insurance (including automobile insurance), black-lung benefits, and workers’ compensation.

Lesson 5 103

Medicare Part A

Medicare Part A covers hospitalization and inpatient care inskilled nursing facilities, hospice, and also home health careunder certain conditions. People usually don’t pay a monthlypremium for Part A coverage if they or their spouse paidMedicare taxes while working.

Medicare Part B

Medicare Part B helps cover medically necessary services likedoctors’ services and outpatient care. It also helps cover somepreventive services to help maintain patients’ health and tokeep certain illnesses from getting worse. Part B is subject toa monthly premium (the standard amount is $96.40 in 2008;higher-income people pay more). There’s also a deductible.For anyone who doesn’t sign up for Part B when first eligible,the cost may go up 10% for each full 12-month period thathe or she could have had Part B, but didn’t sign up for it. Ifthe delay in taking Part B is because the person is covered bygroup health plan coverage based on employment, the higherpremium may not apply.

Medigap (Medicare SupplementInsurance) Policies

The Original Medicare Plan pays for many, but not all, healthcare services and supplies. To help pay out-of-pocket costs,many people buy a Medigap policy sold by private insurancecompanies. A Medigap policy is private health insurancedesigned to supplement the Original Medicare Plan. Thismeans it helps pay some of the health care costs (“gaps”) thatthe Original Medicare Plan doesn’t cover, like copayments,coinsurance, and deductibles. Some Medigap policies coverextra benefits for an extra cost. For people in the OriginalMedicare Plan who buy a Medigap policy, both plans will paytheir share of Medicare-approved amounts for covered healthcare costs.

Medicare doesn’t pay any of the costs for a Medigap policy.Medigap policies work only with the Original Medicare Plan,and they can’t be used to pay copayments or deductibles forMedicare Advantage Plans. In fact, it’s illegal for anyone to

Risk Management104

sell a Medigap policy to someone who has a MedicareAdvantage Plan. Every Medigap policy must be clearlyidentified as “Medicare Supplement Insurance.”

Medigap insurance companies can sell only a “standardized”Medigap policy. Standardized Medigap policies are identifiedby letters (Medigap plans A through L). In Massachusetts,Minnesota, and Wisconsin, Medigap policies are standardizedin a different way. Some states have another type of Medigappolicy called Medicare SELECT, which requires beneficiariesto use specific hospitals and in some cases, specific doctors,to get full benefits. Each standardized Medigap policy mustoffer the same basic benefits, no matter which insurancecompany sells it. Usually the only difference between Medigappolicies sold by different insurance companies is the cost.

Medicare Part C

With the passage of the Balanced Budget Act of 1997,Medicare beneficiaries were given the option to receive theirMedicare benefits through private health insurance plans(HMOs or PPOs), instead of through the Original Medicareplan. These programs were known as Medicare+Choice

or Part C plans. With the Medicare Prescription Drug,

Improvement, and Modernization Act of 2003, the compensa-tion and business practices changed for insurers that offerthese plans, and they became known as Medicare Advantage

(MA) plans.

Medicare has a standard benefit package for care that mem-bers can receive from nearly any hospital or doctor in thecountry. Medicare Advantage plans must cover at least all ofthe medically necessary services that the Original Medicareplan provides. For people who choose to enroll in a Medicareprivate health plan, Medicare pays the private health plan aset amount every month for each member. Members mayhave to pay a monthly premium in addition to the MedicarePart B premium, and generally pay a fixed amount (a copay-ment of $20, for example) every time they see a doctor.Medicare Advantage Plans may offer extra benefits, such asvision, hearing, dental, and/or health and wellness programs.They generally have provider networks, meaning beneficiaries

Lesson 5 105

must go to certain providers to get covered services. Onlyduring certain times of the year is it possible to join or switchplans.

Medicare Part D

Medicare Part D was created by the Medicare PrescriptionDrug, Improvement, and Modernization Act, and went intoeffect on January 1, 2006. Anyone with Part A or B is eligiblefor Part D; in fact, anyone on the Original Medicare planmust also choose a Part D plan. To receive this benefit, a per-son with Medicare must enroll in a stand-alone Prescription

Drug Plan (PDP) or Medicare Advantage plan with prescription

drug coverage (MA-PD). These plans are approved and regu-lated by the Medicare program, but are actually designed andadministered by private health insurance companies. Peoplewho decide not to join a Medicare drug plan when they arefirst eligible may pay a late-enrollment penalty if they chooseto join later.

Unlike Original Medicare, Part D coverage isn’t standardized.Plans choose which drugs they wish to cover, at what levelthey wish to cover them, and may choose not to cover somedrugs at all. The plan has been criticized for being overlycomplicated, especially relating to the “Donut Hole,” officiallyknown as the Coverage Gap. Here’s a rough example of howit works:

In 2008, the standard benefit requires payment of a$275 deductible. The beneficiary then pays 25% of thecost of a covered prescription drug up to an initialcoverage limit of $2,510. (Only 10 percent of plans for2008 offer the defined standard benefit. Most eliminatethe deductible and use tiered drug co-payments ratherthan coinsurance.) Once the initial coverage limit isreached, the beneficiary is subject to anotherdeductible, referred to commonly as the “Donut Hole,”in which he or she must pay the full cost of medicine.When total out-of-pocket expenses on formulary drugsfor the year, including the deductible and initial coin-surance, reach $4,050, the beneficiary then reaches“catastrophic coverage,” and pays $2.25 for a genericor preferred drug and $5.65 for other drugs, or 5%

Risk Management106

coinsurance, whichever is greater. The $4,050 amountis calculated on a yearly basis, so a beneficiary whoamasses $4,050 in out-of-pocket costs by December 31of one year will start a new deductible on January 1.

In some cases, people who have prescription drug coveragefrom a former or current employer or union who join aMedicare drug plan might lose all of their employer or unioncoverage (along with their dependents). In other cases, theymay still be able to use the employer or union coverage alongwith the plan they join. Employers and unions that provideprescription drug coverage must notify beneficiaries eachyear about how their current coverage compares toMedicare’s basic prescription drug coverage. These noticesmay be used later as proof of creditable prescription drugcoverage if the beneficiary joins a Medicare drug plan.



The Part D Late-Enrollment Penalty

If you don’t join a Medicare drug plan when you’re first eligible for

Medicare Part A and/or B and you go without creditable prescription

drug coverage (prescription drug coverage that’s at least as good as

Medicare’s drug coverage) for 63 continuous days or more, you may

have to pay a late-enrollment penalty to join a plan later. This penalty

amount changes every year, and you’ll have to pay it as long as you

have Medicare prescription drug coverage. Your late-enrollment

penalty is calculated when you join a Medicare drug plan. To estimate

your penalty amount, multiply 1% of the national base beneficiary

premium ($27.93 ✕ 1% = $.28 in 2008) by the number of full

months you were eligible to join a Medicare drug plan but didn’t.

Round this to the nearest ten cents. This penalty amount is added

each month to your Medicare drug plan’s premium for as long as you

have a plan.

Lesson 5 107

Self-Check 19


______ 1. The U.S. Social Security program is more formally known as the Old-Age, Survivors,

Disability, and Health Insurance (OASDHI) program.

______ 2. Generally, OASDI represents 6.2 percent and Medicare represents 1.45 percent

of the 7.65 percent of salary or wages that employer and employee each contribute to

the U.S. Social Security system (7.65 + 7.65 = 15.3 percent, in total).

______ 3. OASDI benefits include retirement, survivors, and disability benefits.

______ 4. OASDI benefits provide monthly benefits to a worker retiring above normal retirement

age, known as the primary insurance amount (PIA).

______ 5. Average benefits are expressed as follows: Maximum benefit = Tax rate ✕ Minimum

taxable wage ✕ Ratio of workers to beneficiaries

______ 6. Presently, a worker’s payroll taxes are invested in the stock market to fund his or her

future benefits.


7. The basic monthly Social Security retirement benefit payable to a worker who retires at normal retirement age is called the

a. AIME. c. replacement rate.b. PIA. d. earnings test.

8. Implicit rates of return on Social Security payroll taxes are highest for

a. the lowest-paid workers.b. the highest-paid workers.c. workers who have fewer than 40 quarters of coverage.d. workers who entered the system after 1985.

(Continued)

Risk Management108

Self-Check 19

9. Blanche was a stay-at-home mother and homemaker for nearly her entire adult life. Her SocialSecurity retirement benefit (when she reaches the normal retirement age and assuming herhusband is alive) will be ________ of her husband’s primary insurance amount.

a. 50% c. 75%b. 60% d. 100%


Graded Project

BACKGROUNDSocial Security solvency has been a topic of significant debatein recent years. As the population ages, life expectancyincreases, and fewer workers fund the PAYGO system, thistopic is likely to remain important until it’s solved. Thisproject is designed to increase the depth of your understand-ing of how Social Security taxes are imposed and how toresearch Social Security insurance and retirement benefits.

Take a moment to review the tables below, which you studiedin Assignment 19. These are the wage bases to which theOASDI component of Social Security applies—for the 2009calendar and tax year, 6.2% of $106,500 (7.65%, up to thiswage base ceiling, for both OASDI and Medicare).

109

Tax Wage Year Base

Tax Wage Year Base

Tax Wage Year Base

Tax Wage Year Base

1937–50 $3,000

1951–54 $3,600

1955–58 $4,200

1959–65 $4,800

1966–67 $6,600

1968–71 $7,800

1972 $9,000

1973 $10,800

1974 $13,200

1975 $14,100

1976 $15,300

1977 $16,500

1978 $17,700

1979 $22,900

1980 $25,900

1981 $29,700

1982 $32,400

1983 $35,700

1984 $37,800

1985 $39,600

1986 $42,000

1987 $43,800

1988 $45,000

1989 $48,000

1990 $51,300

1991 $53,400

1992 $55,500

1993 $57,600

1994 $60,600

1995 $61,200

1996 $62,700

1997 $65,400

1998 $68,400

1999 $72,600

2000 $76,200

2001 $80,400

2002 $84,900

2003 $87,000

2004 $87,900

2005 $90,000

2006 $94,200

2007 $97,500

2008 $102,000

2009 $106,500

Social Security Wage Base through the Years

Remember, the 7.65% for 1990– represents the 6.2 percentOASDI plus the 1.45 percent Medicare tax.

PROCEDURE

Step 1Combine the wage base and FICA tax rates applied to thesewage bases into a single Excel file. In the process, computethe maximum employee (and employer) contribution to SocialSecurity, based only on the maximum wage base. Here’s anexample of a portion of the table:

Graded Project110



1937–49 1.00% NA

1950 1.50% NA

1951–53 1.50% 2.25%

1954–56 2.00% 3.00%

1957–58 2.25% 3.38%

1959 2.50% 3.75%

1960–61 3.00% 4.50%

1962 3.13% 4.70%

1963–65 3.63% 5.40%

1966 4.20% 6.15%

1967–68 4.40% 6.40%

1969–70 4.80% 6.90%

1971–72 5.20% 7.50%

1973 5.85% 8.00%

1974–77 5.85% 7.90%

1978 6.05% 8.10%

1979-80 6.13% 8.10%

1981 6.65% 9.30%

1982–83 6.70% 9.35%

1984 6.70% 11.30%

1985 7.05% 11.80%

1986–87 7.15% 12.30%

1988–89 7.51% 13.02%

1990– 7.65% 15.30%

FICA Tax (1937– ), SECA Tax (1951– ), SECA tax subsidy phase-out completed & SECA taxesadjusted & partially deductible (1990– )

Tax Wage Percent Maximum Year Base FICA

1937 $3,000 1.00% $30.00

1938 $3,000 1.00% $30.00

——BREAK IN SEQUENCE——

2008 $102,000 7.65% $7,803.00

2009 $106,500 7.65% $8,147.25

Social Security Taxes

Step 2

Introduction

FICA (Federal Insurance Contributions Act) and SECA (Self-Employment Contributions Act) represent the employer/employee contributions to OASDI and Medicare and contribu-tions for the self-employed or sole proprietor. Notice that aself-employed individual didn’t have to contribute to SocialSecurity from 1937 through 1950.

Before the 1980s, self-employed taxpayers made a contribu-tion to Social Security that was less than the employee’s andemployer’s contributions, combined. However, one of thesolutions to the Social Security shortfall at that time was tophase in a catch-up provision, where, starting in 1990, theemployer (7.65%) and employee (7.65%) and the self-employed (15.3%) make equivalent contributions. Effectively,the self-employed taxpayer makes both employer andemployee contributions.

Procedure

Into the Excel file you completed in Step 1, add columns forthe SECA tax rates applied to these wage bases. In theprocess, compute the maximum self-employed taxpayer’s con-tribution to Social Security, based only on the maximum wagebase. Also add a column for both employer and employee FICAcomponents, so that we can compare the combined employerand employee contributions to FICA to the SECA contribu-tions. Here’s an example of a portion of the table:

Graded Project 111

Tax Wage FICA Maximum 2 Times SECA Maximum Year Base Percent FICA Maximum Percent SECA

FICA

1937 $3,000 1.00% $30.00 $60.00 0.00% $ — 1938 $3,000 1.00% $30.00 $60.00 0.00% $ — 1939 $3,000 1.00% $30.00 $60.00 0.00% $ —

—————BREAK IN SEQUENCE————— 1989 $48,000 7.51% $3,604.80 $7,209.60 13.02% $ 6,249.60 1990 $51,300 7.65% $3,924.45 $7,848.90 15.30% $ 7,848.90

—————BREAK IN SEQUENCE————— 2008 $102,000 7.65% $7,803.00 $15,606.00 15.30% $15,606.00 2009 $106,500 7.65% $8,147.25 $16,294.50 15.30% $16,294.50

Notice that the employee and employer contributions to FICAbecame equivalent to the self-employed taxpayer’s contribu-tion to SECA in 1990.

Step 3Prepare a simple Excel graphic to illustrate the combineddollar contributions of employee and employer to FICAcompared to those for the self-employed taxpayer to SECAfrom 1937 through 2009.

Step 4Under current law, a taxpayer with a salary of $110,000 for2009 would pay only 7.65% on the first $106,500. The samewould be said for the employer. However, also under currentlaw, any amount in excess of the $106,500 wage base andearned income amount for 2009 would continue to be subjectto the 1.45% Medicare contribution by both employer andemployee, for a total of 2.9%.

Separately compute the amounts, in addition to the$16,294.50 from the above table, that the employee andemployer would have to pay for Medicare, assuming a salarylevel of $110,000 for the 2009 calendar and tax year. Showyour calculations.

SUBMITTING YOUR ASSIGNMENTFollow this procedure to submit your assignment:

1. On your computer, save a revised and corrected versionof your assignment. Be sure it includes all of the infor-mation listed in your assignment.

2. Go to http://www.takeexamsonline.com and log ontothe site.

3. At your homepage, click on Take an Exam.

4. In the box provided, enter the project number:50082900.

Graded Project112


Graded Project 113

5. Click on Submit.

6. On the next screen, enter your e-mail address.

7. If you wish to tell your instructor anything specificregarding this assignment, enter it in the Commentsbox.

8. Attach your file or files as follows:

� Click on the first Browse box.

� Locate the file you wish to attach.

� Double-click on the file.

� If you have more than one file to attach, click on thenext Browse box and repeat the above steps for eachfile.

9. Click on Submit.

Important

After you submit the assignment for evaluation, you should receive a

confirmation e-mail with a tracking number. If you don’t receive this

number within 24 hours, you must resubmit the assignment.

NOTES

Graded Project114

115

1. The most common types of voluntary benefits offered byemployers include all of the following, except

A. medical insurance.B. life insurance.C. disability insurance.D. automobile insurance.

2. Cafeteria benefit plans are also known as

A. flexible spending accounts.B. Section 125 plans.C. noncontributory plans.D. “free lunch” plans.

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3. Which of the following is not one of the reasons commonly suggested explaining whyfirms provide employee benefits instead of simply paying higher cash wages?

A. Employers don’t have enough cash to pay higher wages.B. Employer-provided benefits promote employee productivity.C. Percentage loadings for administrative expenses in group insurance premiums are

lower than for individual insurance.D. They provide tax savings for both employer and employee.

4. The cost of employee benefits represents, on average, _______ of private employers’total compensation costs.

A. 5%–10% C. 20%–25%B. 10%–15% D. 35%–40%

5. Many group medical expense coverage and medical plans contain a stop loss clause,which places a ceiling on the

A. amount a hospital or physician can charge the insurance provider.B. amount the provider will pay for any given medical problem or condition.C. out-of-pocket maximum costs to be incurred by the employee.D. out-of-pocket maximum costs to be incurred by the employer.

6. Monica works for a firm that has a pension plan. Her employer’s contributions varyfrom year to year depending on how well the firm is doing. For example, in 2007 whenthe firm had net income of $1,000,000, it contributed $2,000 to her pension. In 2008when the firm had net income of $2,000,000, they contributed $4,000 to her pension.What kind of plan does Monica have?

A. Profit sharing plan C. 401(k) planB. Money purchase plan D. ESOP

7. A retirement plan in which the employer promises to pay the employees a retirementbenefit equal to 2% of their final salary for every year of service is an example of a

A. defined contribution plan. C. contributory plan.B. 401(k) plan. D. defined benefit plan.

8. Workers’ compensation laws have which two important features?

A. (1) Employers pay benefits unless there was employer fault or negligence, and (2) employees aren’t allowed to sue employers for injuries under tort law.

B. (1) Employers pay benefits without regard to employer fault or negligence, and (2) employees are required to sue employers for injuries under tort law.

C. (1) Employers pay benefits unless there was employer fault or negligence, and (2) employees can choose to sue employers for injuries under tort law.

D. (1) Employers pay benefits without regard to employer fault or negligence, and (2) employees aren’t allowed to sue employers for injuries under tort law.


9. If an employer decides to use cliff vesting, what is the maximum length of service thatcan be required of an employee before vesting occurs?

A. 3 years C. 7 yearsB. 5 years D. 10 years

10. Which of the following categories of workers is not eligible for Social Security (OASDI)benefits?

A. Retired persons age 62 and over who have 40 quarters of coverageB. Unmarried children age 18 and under of deceased participants who had at least 6

quarters of coverage during the 13 quarters preceding deathC. Spouses, under age 60, of deceased, fully insured workers with no dependent

childrenD. Disabled workers with at least 20 quarters of coverage during the 40 quarters

preceding the onset of disability

11. Medicare Part A provides which of the following benefits?

A. Inpatient hospital services C. Pharmaceutical expensesB. Physicians’ services D. Free homeopathic remedies

12. Due in large part to _______, workers’ compensation costs continue to increase.

A. undocumented workersB. rising medical costsC. inflationD. the declining value of the U.S. dollar

13. Which of the following is not one of the main types of workers’ compensation benefits?

A. Pain and suffering compensationB. Payment of medical expensesC. Payment for lost income due to disabilityD. Death benefits

14. Under workers’ compensation laws, injured workers who are unable to work can typically receive benefits equal to

A. 100% of their pre-injury wage.B. 100% of the state’s average weekly wage.C. 2/3 of their pre-injury wage, capped at 100% of the state’s average wage.D. 3/4 of their pre-injury wage, capped at 100% of the state’s average wage.

15. Which one of the following programs is not financed with OASDHI payroll taxes?

A. Social Security disability benefits C. Medicare Part AB. Social Security survivor benefits D. Medicare Part B


NOTES

Business RiskManagement—Theory

INTRODUCTIONLesson 6 includes three chapters on business risk manage-ment and theory. The first two of the three will representreview material typically covered in corporate financecourses.


� Analyze corporate risk management using modernaccounting rules and financial management tools

� Explain firm valuation, using expected cash flows andcost of capital

� Describe how investor diversification affects cost of capital, why corporate risk reduction doesn’t affect costof capital, and how corporate risk reduction affectsexpected cash flows

� Show how progressive tax rates induce firms to reducerisk, provide tax benefits to insurance, tax benefits fromdepreciation, and debt financing

� Describe how insurance premium taxes and excise taxesincrease premium loadings

� Describe government regulation that requires businessinsurance

� Identify firm characteristics that influence risk retention/reduction decisions and where firms should focus theirrisk reduction activities

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Principles of Business ValuationGenerally, businesses are valued based on the present valueof net cash inflows. Therefore, the same concepts andmechanics relating to discounted cash flow (DCF), net pres-ent value (NPV), and internal rate of return (IRR) would applywhen establishing the fair market value of a firm, where thediscount rate is referred to as the opportunity cost of capital

and includes a profit component, and risk-free rates and risk

premiums are included for consideration and in the computa-tional formulas.

Recall that there are two types of risk:

1. Diversifiable risk, which has no effect on the opportunitycost of capital

2. Nondiversifiable risk, which increases the opportunitycost of capital as follows:

Total risk = Diversifiable risk + Nondiversifiable risk

Diversifiable risk can be eliminated in a carefully constructedportfolio; nondiversifiable risk can’t be eliminated. Just as amutual fund or investor might seek to diversify the compo-nents of a portfolio to eliminate diversifiable risk, and insurercan construct a diversified portfolio of insureds or policyholders to achieve a comparable objective.

Risk Management and the Opportunity Cost of CapitalThe discount rate equals the risk-free rate plus a risk premium.Risk management must focus on a reduction of the riskpremium component of the discount rate. The risk premiumis dependent only on nondiversifiable risk.

Lesson 6 121

Risk Management and Expected Cash FlowsNet present value (NPV) is the present value of a project’s netcash flow. The cost of issuing securities to finance a projectreduces the NPV of the project, resulting in an adjusted NPV,

as follows:

Adjusted NPV = NPV – Cost of issuing securities



Self-Check 20


______ 1. Generally, businesses are valued based on the present value of net cash inflows.

______ 2. Diversifiable risk increases the opportunity cost of capital.

______ 3. Nondiversifiable risk decreases the opportunity cost of capital.

______ 4. Total risk = Diversifiable risk + Nondiversifiable risk

______ 5. Discount rate = Risk-free rate + Risk premium

______ 6. Adjusted NPV = NPV + Cost of issuing securities

(Continued)

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7. Which of the following is not an advantage of purchasing insurance as compared to retainingthe risk?

a. Insurers can provide cheaper claim processing and loss control services.b. The price of the insurance is often less than the expected claim cost.c. Insurance reduces the likelihood of financial distress.d. Insurance can reduce a firm’s expected tax payments.

8. In estimating the net present value of a firm’s cash flows, the appropriate discount rate will bethe risk-free rate plus a risk premium that takes into account

a. all the risk that the firm is subject to.b. firm-specific and market risk that the firm is subject to.c. diversifiable risk only.d. nondiversifiable risk only.

9. When deciding how much insurance to purchase, a firm must compare the insurance premiumloading to the

a. cost of capital.b. expected loss.c. expected cost of raising new funds following a loss.d. costs of financial distress.


Complete Questions 1, 2, and 5 on pages 456–457 in the textbook.


Lesson 6 123


TaxesA transaction provides a tax benefit if it lowers the aggregatepresent value of tax payments for all parties involved in thetransaction. Tax rate progressivity simply means that taxrates rise as taxable income rises.

Tax Treatment of Insurers versusNoninsurance CompaniesInsurance companies can deduct the discounted value ofincurred losses, which equals losses paid during the yearplus the change during the year in the discounted value of itsliability for unpaid claims (loss reserve), as follows:

Tax deductible losses = Losses paid + Discounted change in losses expected

A tax shield is the amount by which tax payments arereduced by an expense when computing taxable income. Forexample, for a firm in a 34 percent federal income taxbracket (T = 34%), the tax shield for an additional $100 indeductions is $34, as follows:

Tax shield = 1 ✕ T

Tax shield = $100 ✕ 34% = $34

Insurance and Interest Tax Shields on DebtA firm’s capital structure refers to the composition and typesof debt and equity used to finance its assets. Recall that A = L + OE. Dividends must be paid from after-tax dollars,but interest expense is tax deductible. Deductible interest,therefore, represents an interest tax shield.

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All states impose premium taxes on insurance transactions.These approximate 2 percent, on average. The federal govern-ment imposes excise taxes on insurance purchased frominsurers domiciled outside of the United States (known asalien insurers).

Regulatory Effects on Loss FinancingAdmitted insurers are licensed and providing insurance in aparticular state. A nonadmitted insurer can also sell insur-ance covering a risk in a state in which it’s not licensed, solong as it’s licensed in some state and uses an approvedinsurance agent. Nonadmitted insurance coverage oftenrepresents excess coverage. The market for nonadmittedinsurance is called the excess and surplus (E&S) lines market.



Self-Check 21


______ 1. A transaction provides a tax benefit if it lowers the aggregate present value of tax

payments for all parties involved in the transaction.

______ 2. Tax rate progressivity simply means that tax rates rise as taxable income rises.

______ 3. Interest expense must be paid from after-tax dollars, but dividends are tax deductible.

(Continued)

Lesson 6 125

Self-Check 21


______ 4. Insurance companies can deduct the discounted value of incurred losses, which equals

losses paid during the year plus the change during the year in the discounted value of

its liability for unpaid claims (loss reserve).

______ 5. All states impose excise taxes on insurance transactions approximating 2 percent, on

average. The federal government imposes premium taxes on insurance purchased from

an insurer domiciled outside of the United States (known as an alien insurer).

______ 6. A tax shield is the amount by which tax payments are reduced by an expense when

computing taxable income.


7. Premium taxes and excise taxes

a. increase the premium loading on insurance.b. decrease the present value of expected losses.c. can’t be passed on to insurance buyers in the form of higher premiums.d. don’t affect the choice between insurance and retention.

8. A tax benefit should be defined (or stated) in terms of

a. actual tax payments. c. expected tax payments.b. actual tax deductions. d. expected loss financing.

9. This year’s deduction for incurred losses for CPT Insurance Company is equal to the

a. present value of losses that were incurred this year.b. value of losses that were paid this year.c. dollar value of losses that incurred this year, no matter when they’re expected to be paid.d. value of losses that were paid this year plus any change in the discounted value of

incurred losses that will be paid in the future.


Complete Questions 1, 2, and 7 on pages 481–482 in the textbook.


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Firm Characteristics Affecting RiskRetention (Reduction) DecisionsRisk retention refers to the decision to accept the uncertainty(variability) associated with a particular risk exposure. Risk

reduction refers to the decision to reduce uncertainty andvariability.

Increasing risk retention may potentially lead to

� Savings on premium loadings

� Reduced exposure to insurance market volatility

� Reducing moral hazard

� Avoiding high premiums that may accompany asymmetric information

� Avoiding implicit taxes arising from insurance price regulation

Aggregated or Disaggregated RiskManagementA policy that bundles multiple exposures is referred to as abundled policy. Advantages of purchasing a bundled policyinclude the reduction in fixed costs of arranging multipleinsurance contracts and the reduction in proportional load-ing costs on policies as a result of reducing the purchase ofunnecessary coverage. Disadvantages include greater com-plexity and, therefore, greater costs associated with arrangingthe policy.



Lesson 6 127

Self-Check 22


______ 1. Risk retention refers to the decision to reduce uncertainty (variability).

______ 2. Risk reduction refers to the decision to accept the uncertainty (variability) associated

with a particular risk exposure.

______ 3. Increasing risk retention may lead to potential savings on premium loadings.

______ 4. Increasing risk retention may lead to potential savings through reduced exposure to

insurance market volatility.

______ 5. Increasing risk retention may lead to potential savings from reduced moral hazard.

______ 6. A policy that bundles multiple exposures is referred to as a bundled policy.


7. Bilbo Industries is a technology company that prides itself on the ability to react quickly tonew product developments. It maintains a significant research and development budget.Regarding risk-reducing activities, Bilbo Industries is

a. more likely to retain risks thereby retaining use of more funds.b. more likely to retain risk because of their ability to react to changing developments.c. less likely to retain risks to concentrate on what they do best.d. less likely to retain risk to help ensure they have a steady supply of investment funds.

8. Residual markets regulation can create an incentive to self-insure

a. when residual premiums are higher than those in the voluntary market.b. because firms that self-insure don’t participate in residual market financing.c. because self-insured firms are subsidized by the residual markets.d. whenever residual markets provide coverage for compulsory coverages.

9. A basic guideline for the retain/insure decision is “Insure those exposures that . . .

a. are measurable.”b. have high frequency and high severity.”c. can potentially result in large, disruptive losses.”d. have reasonably predictable losses.” (This makes for stable premiums.)


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1. Which of the following statements is true of diversifiable risk?

A. It can be eliminated in a carefully constructed portfolio.B. It can’t be eliminated.C. It affects the opportunity cost of capital.D. It increases the opportunity cost of capital.

2. Which of the following risks faced by a business is most likelyto be nondiversifiable?

A. An explosion at the firm’s plantB. Worker injuryC. Reduced earnings due to poor economic conditionsD. A class-action product liability claim

3. Which of the following equations is correct?

A. Discount rate = Risk-free rate – Risk premiumB. Discount rate = Risk-free rate ✕ Risk premiumC. Discount rate = Risk-free rate ÷ Risk premiumD. Discount rate = Risk-free rate + Risk premium

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4. Which of the following equations is correct?

A. Adjusted NPV = NPV + Cost of issuing securitiesB. Adjusted NPV = NPV – Cost of issuing securitiesC. Adjusted NPV = NPV ÷ Cost of issuing securitiesD. Adjusted NPV = NPV ✕ Cost of issuing securities

5. Corporate risk reduction increases shareholder wealth by

A. increasing expected net cash flows.B. decreasing expected net cash flows.C. decreasing the corporate cost of capital.D. increasing the corporate cost of capital.

6. Which of the following statements is true of the tax treatment of uninsured losses?

A. It’s the same as the financial reporting of uninsured losses.B. It allows for a firm to choose when the loss will be deducted.C. It’s the same for insurance companies and non-insurance companies.D. It requires that the loss be deducted in the year it’s paid.

7. The main advantage of using debt financing is the

A. effect on cost of capital.B. availability of interest tax shields.C. lower probability of financial distress.D. reduced variability of earnings.

8. The federal government imposes _______ taxes on insurance purchased from insurersdomiciled outside of the United States.

A. sin C. exciseB. premium D. non-patriot

9. U.S. corporations can carry losses _______ years forward and 2 years backwards.

A. 10 C. 22B. 20 D. 25

10. An admitted insurer in a particular state

A. can be domestic, foreign, or alien.B. is always a domestic insurer.C. isn’t always licensed to sell insurance in the state.D. faces stricter regulation than nonadmitted insurers.

11. Which of the following refers to the decision to accept the uncertainty (variability)associated with a particular risk exposure?

A. Risk retention C. Risk sharingB. Risk reduction D. Risk mitigation


12. Which one of the following firms is more likely to use retention?

A. A closely held firmB. A firm with a high level of financial leverageC. A publicly traded and widely held firmD. A small firm

13. Which one of the following is an example of an aggregated approach to risk management?

A. Hedging exchange rate riskB. Hedging interest rate riskC. Purchasing a high level of liability insuranceD. Using derivatives to stabilize fluctuations in revenue

14. A bundled insurance policy with a single overall retention limit can help a firm

A. avoid the problem of two contracts providing duplicate coverage.B. develop simpler contracts.C. avoid purchasing unnecessary coverage.D. understand the disaggregated loss distributions.

15. A disaggregated risk management approach will generally result in

A. higher transaction costs. C. lower expected losses.B. lower transaction costs. D. higher expected losses.


NOTES

Business RiskManagement—Types of Contracts

INTRODUCTIONLesson 7 includes three chapters on business risk manage-ment and types of contracts. Chapter 24 is a review of basiccorporate finance concepts.


� Identify major types of property-casualty insurance contracts purchased by businesses and describe thenegotiation of commercial insurance programs

� Explain the operation of deductibles and self-insuredretentions, policy limits, primary coverage, excess coverage, and umbrella liability coverage in commercialinsurance programs

� Describe key provisions of insurance coverage for damage to business property, including associated lossof income and extraordinary operating expenses

� Describe key provisions of commercial general liabilityinsurance, including occurrences and claims-made coverage

� Highlight differences between commercial and personalinsurance pricing and underwriting

� Explain basic derivative contracts (options, forwards,futures, and swaps) commonly used for hedging, anddistinctions between insurance and derivatives contracts

� Distinguish between exchange-traded and over-the-counter derivative markets

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� Describe major types of risk typically hedged using derivatives

� Define alternative risk transfer, provide examples ofproducts (finite risk plans and captive insurancecompanies), and explain why these products are used


Overview of Contracts and MarketsThere are four major types of property-casualty insurancecontracts sold to business buyers:

1. First-party coverage for policyholders’ losses fromproperty damage and associated loss of income

2. Liability and related coverage for injury to third parties

3. Multiple-peril contracts, which, analogous to home-owner’s insurance, cover both property and liabilitylosses in a single contract

4. Surety bonds and financial guarantees

Deductibles and Self-InsuredRetentionsAn exposure diagram is a tool useful in displaying how aninsurance contract apportions insurance between the insurerand the insured. With a per occurrence deductible, theinsurance buyer or customer pays up to the deductibleamount on each covered loss. With an aggregate deductible,

the insurance buyer or customer pays until the aggregateamount paid equals the aggregate deductible, and the insur-ance company pays all amounts in excess of the aggregatedeductible. The deductible amount may be referred to as aself-insured retention (SIR).

Lesson 7 135

Policy Limits andPrimary/Excess/Umbrella PoliciesBoth property and liability policies typically have per

occurrence limits. Liability policies also have an annual

aggregate limit. Excess policies provide coverage if losses arein excess of some relatively large threshold, referred to as theattachment point. A policy attaching immediately above thefirm’s retention is commonly referred to as primary coverage.

Some firms purchase insurance coverage in layers fromdifferent insurers. This is referred to as layering coverage.

An umbrella policy is similar to excess coverage in that thepolicy provides excess coverage over other policies or self-insured retentions, and covers liability losses from multipleexposures or perils. A coverage chart, like that provided inFigure 23.6 on page 511 of your text, may be used to sum-marize and depict layers and participating insurers.

Property InsuranceLoss of income associated with a curtailment or cessation ofoperations following physical damage to property can beinsured with business interruption coverage, and may becombined with or provided separately from extra expense

coverage, which insures the buyer against extraordinaryexpenses that might be incurred to maintain operation fol-lowing damage to facilities. A causes of loss form is used tospecify causes of loss (perils) in business property insurancecontracts.

Commercial General Liability InsuranceThe standard commercial general liability (CGL) insurance

policy places a duty to defend the policyholder and paydefense costs on the insurer. Business risk exclusions excludethe insurer from liability for damage to the insured’s product,work, and impaired property. CGL buyers may choose cover-age that’s triggered by an occurrence of injury (occurrences

coverage) or coverage that’s triggered by a claim being made(claims-made coverage).

Risk Management136

For personal injury applications, if the date of injury can’t bereasonably determined, the date that the injury manifestsitself to the plaintiff triggers coverage (manifestation trigger).

Alternatively, the court (fact-finder) attempts to estimatewhen the injury actually occurred based on expert testimonyand other evidence (injury-in-fact trigger).



Self-Check 23


______ 1. Surety bonds and financial guarantees are a type of property-casualty insurance

contracts sold to business buyers.

______ 2. With a per occurrence deductible, the insurance buyer pays up to the deductible

amount on each covered loss.

______ 3. CGL buyers may choose coverage that’s triggered by an occurrence of injury, referred

to as claims-made coverage.

______ 4. For personal injury applications, if the date of injury can’t be reasonably determined,

the date that the injury manifests itself to the plaintiff triggers coverage and is referred

to as the injury-in-fact trigger.

______ 5. With an aggregate deductible, the insurance buyer pays until the aggregate amount

paid equals the aggregate deductible, and the insurance company pays all amounts in

excess of the aggregate deductible.

(Continued)

Lesson 7 137

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6. Large businesses often purchase highly customized insurance contracts. These contracts arefrequently called

a. personal policies. c. manuscript policies.b. special needs policies. d. commercial forms.

7. Your commercial liability policy has the following terms: $10,000 per occurrence deductible;$50,000 stop loss provision; and $200,000 policy limit. How much will you pay if the coveredlosses during the policy period are as follows: $10,000; $25,000, $50,000, $5,000, $8,000;$20,000; and $100,000?

a. $10,000 c. $168,000b. $50,000 d. $218,000

8. An occurrence policy

a. covers claims that are filed during the policy period.b. is the least common type of commercial property and liability insurance policy.c. covers claims for losses that occurred during the policy period if the claim is also made

during the policy period.d. covers claims for losses that happened during the policy period regardless of when the

claim is filed.


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Introduction to Derivatives and HedgingCall and put option contracts, often covered in corporatefinance courses, are covered again in this course, as theseoptions are derived from underlying financial assets andrepresent a relatively simple hedging strategy that firms ofany size might employ to reduce risk.

A derivative contract has a payoff or value derived from thevalue of some underlying asset, as follows:

� The buyer of a call option contract receives a positive pay-off only if their cost for the option (option price) for theunderlying asset value exceeds some threshold, orexercise price.

� The buyer of a put option contract receives a positive pay-off only if the cost for the option for the underlying assetvalue falls below the exercise price.

Cash-settled derivative contacts are purely financial and don’tinvolve physical delivery of the underlying asset.

Hedging with Forward/Futures ContractsA forward contract or a futures contract generates a payoffequal to the difference between the actual price of the under-lying asset and some predetermined price called the forward

price or the futures price. The cost of carry relationship isillustrated on page 538 of your text, as follows:

Forward (future) price = Spot price at time t + Cost ofcarry

Lesson 7 139

Markets for DerivativesAn over-the-counter (OTC) derivative contract is tailor-made tothe needs of the contract participants. An exchange-traded

derivative is standardized. Performance bonds, called amargin, must be posted by those taking futures positions.

An entertaining way to learn about derivatives and themagnitude of the risks associated with these financial instru-ments is to watch the film Trading Places, where the Dukesare faced with a margin call.



Self-Check 24


______ 1. A derivative contract has a payoff or value derived from the value of some underlying

asset.

______ 2. The buyer of a call option contract receives a positive payoff only if the option price

falls below the exercise price.

______ 3. The buyer of a put option contract receives a positive payoff only if the cost for the

option for the underlying asset value exceeds the exercise price.

______ 4. Determinants of call option prices include the price of the underlying asset, the

exercise price, the volatility in the return of the underlying asset, the time to maturity

for the underlying asset, and interest rates.

______ 5. An over-the-counter (OTC) derivative contract is standardized.

(Continued)

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Self-Check 24


6. Which of the following is not a factor that influences the price of a call option at a given pointin time (t)?

a. The date that the option was first createdb. The price of the underlying asset at time tc. The exercise price of the optiond. The interest rate on government bonds (risk free rate)

7. Option X and Option Y have the same underlying security and the same exercise price. IfOption X has three months to maturity and Option Y has six months to maturity, which optionwill have a higher price?

a. Option X will have a higher price.b. Option Y will have a higher price.c. Since Options X and Y are on the same underlying security, they must have the same

price.d. The answer can’t be determined from the information given.

8. The current spot price of oil is $12 per barrel, the interest rate is 8%, and the cost of storingand insuring oil for one year is 1% of the value of the oil. What would be the no-arbitragefutures price today on a contract that expires one year from now?

a. $12 c. $13.09b. $12.96 d. $13.20


Lesson 7 141


Description of Alternative RiskTransfer (ART)Although alternative risk transfer (ART) transactions doesn’thave a generally accepted definition, characteristics includethe following:

1. They involve a high level of retention.

2. They span multiple years.

3. They include multiple sources of cash.

4. They cover sources of risk not normally covered byinsurance contracts.

5. They involve capital market institutions and securities.

Generally, ART transactions have increased in recentdecades.

Loss Sensitive ContractsLoss sensitive insurance contracts involve premium adjust-ments dependent on the losses that occur or are paid during

the policy period. Large-deductible policies involve the reten-tion of a significant amount of the risk by the policyholder,with the insurer temporarily financing the losses.

A retrospectively rated policy (retro) is a loss sensitive contractwith an up-front premium and an additional premium that’spaid after the loss (or, if losses were less than expected, partof the up-front premium may be refunded). As with largedeductible policies, the insurer settles all claims.

An investment credit program is one where the insured paysthe insurer an amount expected to cover loss payments up tothe desired deductible amount and the insurer, after deduct-ing for expenses, places the remaining funds in a trustaccount to earn interest while awaiting a claim. A premium

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financing arrangement is one where a policyholder borrowsthe funds deposited with the insurer, for tax purposes. A loss

portfolio transfer occurs when a firm transfers a loss to aninsurer by paying the present value of expected future claimsin one lump sum or installments. The insurer takes on therisk of the future claims being different than expected, andthe insured can write off its loss all at once for tax and finan-cial statement purposes.

Finite Risk ContractsInsurers (and reinsurers) offer multiple-year loss sensitiveplans referred to as finite risk insurance or financial insurance.

These plans don’t transfer much of the risk of loss to theinsurer from the insured, but rather allow for smoothing ofthe loss payments over the policy period.

Captive InsurersCaptive insurers are wholly owned subsidiaries. They’re called a pure captive if they insure only their parent or itssubsidiaries. Brother-sister transactions may occur betweensubsidiaries with the same parent as the captive. Manycaptives have unrelated business, selling insurance to non-insurance corporations not owned by the captive parent.Others are group captives, where the insurance corporationhas multiple parents. These relations are shown in Figure 25.3on page 558 in your text. Captives are usually formed for taxpurposes. Risk retention groups are similar to group captives.

Multiline/Multitrigger InsurancePoliciesMultiline insurance policies provide coverage against anaggregate measure of losses from different risk exposures.Multitrigger insurance policies specify multiple conditions orcontingencies that must occur before payments are made.

Lesson 7 143

Contingent Financing ArrangementsContingent debt and contingent equity (or new stock) is debtor equity contingent upon an event or events. The benefit tothe company of this sort of arrangement is that its financerate, or the price it will get for new equity shares, is knownup-front. The risk taken on by the bank or investors is thatinterest rates will be higher than the agreed rate (thus thebank is forgoing profits), or the company’s stock price will belower (thus the investors are overpaying). Because all assetsare financed with debt and/or equity, these represent contin-gent financing arrangements. In addition, many largeinsurance companies have lines of credit with banks orfinancial institutions.



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Self-Check 25


______ 1. Alternative risk transfer (ART) transactions typically involve a high level of retention.

______ 2. Loss sensitive insurance contracts involve premium adjustments dependent on the

losses that occur or are paid after the policy period.

______ 3. Large-deductible policies involve the retention of a significant amount of the risk by the

policyholder, with the insurer temporarily financing the losses.

______ 4. A retrospectively rated policy is a loss sensitive contract with an up-front premium.

______ 5. Captive insurers are wholly owned subsidiaries.

______ 6. Multiline insurance policies specify multiple conditions or contingencies that must occur

before payments are made.


7. All of the following are examples of loss sensitive policies except

a. retrospectively rated policies. c. investment credit programs.b. experience rated policies. d. excess policies.

8. A multitrigger insurance policy

a. provides coverage for losses generated from different risk exposures.b. is triggered by multiple conditions or contingencies.c. is triggered only when two losses of the same type occur.d. requires two insurers provide payment of large losses.

9. Regarding captives, what does “unrelated business” refer to?

a. Selling insurance coverage to entities not related to the parent corporationb. Insurance lines outside the captive’s scopec. Independent loss exposuresd. Noninsurance activities


145

1. An insurance contract provision that stipulates the policy-holder will pay the first $100,000 of each loss is an exampleof a/an

A. aggregate deductible.B. stop loss provision.C. per occurrence deductible.D. loss cap.

2. Which of the following is a tool useful in displaying how aparticular insurance contract apportions losses between theinsurer and the insured?

A. Exposure diagram C. Aggregation graphB. Coverage chart D. Occurrence diagram

3. Both property and liability policies typically have

A. annual aggregate limits. C. layering coverage.B. per occurrence limits. D. excess policies.

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Lesson 7Business Risk Management—Types

of Contracts








EXAMINATION NUMBER








4. The portion of a property insurance policy that summarizes the types and locations ofcovered property, policy limits, and premiums rates is called the

A. coverage form. C. policy conditions.B. policy package. D. policy declarations.

5. Loss of income associated with a curtailment or cessation of operations followingphysical damage to property can be insured with which of the following?

A. Extra expense coverage C. Business interruption coverageB. Causes of loss form D. Umbrella policy

6. LT properties has four excess policies covering a large building it owns. Each policy isfrom a different insurer and has a policy limit of $10 million. The first policy has anattachment point of $5 million, the second policy attachment point of $15 million, thethird policy has an attachment point of $25 million, and the fourth policy has anattachment point of $35 million. This type of insurance purchasing is referred to as_______ coverage.

A. attachment C. blanketB. layering D. umbrella

7. Call option A has an exercise price of $20. Call option B has an exercise price of $15. If all other characteristics of these options are identical and they are on the sameunderlying asset, which option will have a higher price?

A. Call option A will have a higher price.B. Call option B will have a higher price.C. Call option A and call option B will have the same price.D. It’s impossible for two options on the same underlying asset to have different

exercise prices.

8. Which of the following statements is true about a futures contract?

A. The payoff is equal to the difference between the price of the underlying asset andthe futures price.

B. The payoff is the same as that of a call option.C. Futures contracts always require delivery of the underlying asset to complete the

contract.D. The futures price is paid by the buyer at the outset of the contract.

9. Basis risk exists when the hedging instrument

A. is likely to increase in value over time.B. is likely to decrease in value over time.C. has a high level of volatility.D. differs in value from the item being hedged.


10. When there’s an increase in a put option price, the

A. price of the underlying asset increases.B. volatility in return of the underlying asset increases.C. time to maturity decreases.D. interest rates decrease.

11. Which of the following statements is true about the notional principal for swap contracts?

A. It’s an accurate measure of the amount of money at risk.B. It’s usually double the amount of money at risk.C. It’s usually an inaccurate measure of the amount of money at risk.D. It’s the expected value of the payout of the contract.

12. The cost of carry relationship is illustrated by which of the following equations?

A. Forward price = Spot price at time t + Cost of carryB. Forward price + Spot price at time t = Cost of carryC. Forward price ✕ Spot price at time t = Cost of carryD. Forward price = Spot price at time t ✕ Cost of carry

13. A.J. Manufacturing has an agreement with the Bank of St. Croix whereby A.J. canborrow up $3.5 million should the manufacturing plant suffer a severe fire or wind-storm. The interest rate on the loan is guaranteed to not be greater than 7 percent.This is an example of

A. contingent debt. C. a letter of credit.B. contingent equity. D. a line of credit.

14. Experience-rated policies are beneficial to the insurer because they help to reduce

A. adverse selection. C. fraud.B. moral hazard. D. insurer insolvency.

15. An oil refinery has recently suffered an explosion. The refinery has estimated its costfrom this explosion to be approximately $50 million. Uncertainty still exists, though,regarding the actual amount and timing of the loss payments. An insurer has agreed,for a price, to assume all responsibility for the payment of this loss. This is an exampleof a/an

A. retrospectively rated policy. C. incurred loss retro policy.B. premium financing arrangement. D. loss portfolio transfer.


NOTES

Business RiskManagement—Additional Topics

INTRODUCTIONLesson 8 begins with Chapter 26. The majority of the materialcontained in Chapter 26 is a review of business statisticsconcepts. Chapter 27 is devoted to a case study: UnitedGrain Growers is a case that integrates many of the conceptsand tools presented in previous chapters. Chapters 28 and 29introduce and provide coverage of additional terms and con-cepts, completing the textbook coverage of this course in RiskManagement.


� Explain how historical data is used to compute a proba-bility distribution of future losses and how correlationcoefficients and regression is applied in the context ofrisk management

� Define enterprise risk management

� Describe legal liability rules, insurance coverage, andpublic policy issues as they relate to product, environ-mental, and directors and officers’ (D&O) liability

� Explain how limited liability assists businesses in limitedtort liability risk reduction, and how businesses areliable for the actions of agents, employees, and independent contractors

� Define hold harmless and indemnity agreements andtheir impact on the cost of risk

149

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Risk Management150


Risk Management ToolsThis material is a review of business statistics and corporatefinance. Use this chapter as an opportunity to review thismaterial, but as applied to risk management.

Calculating Frequency and Severity ofLosses from Historical DataRecall, from earlier coursework, that regression seeks todevelop a cost equation, where total cost is a function of fixedcosts and variable costs, as follows:

Y = αα + ββX

or

Total cost = Fixed cost + Variable cost

or

Dependent variable = Y-axis intercept + Slope

Using Entire Probability DistributionsThe risk of loss can be estimated using the normal distribu-tion. Frequently, a computer simulation of loss distribution willprove useful for risk estimation. The Poisson distribution isfrequently used for these applications, as is the lognormal

distribution. Both of these are complicated statisticalcalculations that you don’t need to delve into further for ourpurposes.



Lesson 8 151

Self-Check 26


______ 1. Regression seeks to develop a cost equation, where

Dependent variable = Y-axis intercept – Slope

______ 2. The risk of loss can be estimated using the normal distribution.

______ 3. Discounted cash flow analysis and the net present value method are applied with

projections of cash flows to compute risk estimates.


4. A probability distribution that is often used to approximate the severity of property and liability losses is the _______ distribution.

a. Poisson c. gammab. normal d. lognormal

The following table contains loss data from Smith Corporation. Use this data to answer

questions 5–8.

5. What is the average loss severity in Year 1?

a. $6,588 c. $8,137b. $7,714 d. $9,450

(Continued)

Year 1 Year 2 Year 3

Loss Severity Loss Severity Loss Severity

#1 $ 4,000 #1 $ 7,000 #1 $ 3,000

#2 2,000 #2 27,000 #2 9,500

#3 8,000 #3 5,000 #3 17,000

#4 5,500 #4 14,000 #4 12,000

#5 19,000 #5 3,500 #5 5,000

#6 11,000 #6 31,000

#7 4,500 #7 21,000

#8 6,000

#9 8,500

Risk Management152


Enterprise Risk ManagementEnterprise risk management (ERM) refers to the identificationand measurement of all risk exposures and their manage-ment within a unified framework. This chapter is dedicated toa real-life case study of a company and its risk managementstrategies. The United Grain Growers case integrates many ofthe concepts and tools presented in previous chapters.



Self-Check 26

6. What is the average loss severity over the three years?

a. $8,137 c. $11,300b. $10,643 d. $11,751

7. Using the three-year average frequency and average severity, what is the expected total lossamount for the next year (Year 4)?

a. $81,951 c. $74,501b. $79,261 d. $65,891

8. In Year 3, Smith Corporation had an insurance policy to help finance its losses. The policy hada $5,000 per occurrence deductible, a $25,000 stop-loss provision, and a $75,000 policy limit.What amount did Smith Corporation pay for these losses?

a. $25,000 c. $38,000b. $35,000 d. $42,000


Lesson 8 153

Self-Check 27


1. Which risk exposure was identified as United Grain Growers’ main source of unmanaged risk?

a. Counterparty risk c. Environmental liabilityb. Commodity price and basis risk d. Weather effects on grain volume

2. Why was it appropriate for the UGG analysts to use a time trend variable in a regressionequation modeling crop yields?

a. Because crop yields vary from year-to-yearb. To capture productivity increases over timec. To measure the length of the growing seasond. To adjust for annual crop quality

3. Analysts for UGG performed regression analysis with assorted dependent variables, e.g. wheatfrom Alberta. In addition to a time trend variable, what other two variables were used asexplanatory variables?

a. Average June temperature and average July precipitationb. Average June temperature and average fertilizer application in Mayc. Average July precipitation and average fertilizer application in Mayd. Average fertilizer application in May and average length of the growing season

4. If average temperature and average precipitation variables in Alberta are highly correlatedwith the respective variables in Saskatchewan, geographic diversification will

a. do little to reduce the exposure to weather risk.b. provide some reduction in the exposure to weather risk.c. effectively eliminate the exposure to weather risk.d. Correlation doesn’t impact the effects of diversification.


Complete Questions 1–2 on page 603 in the textbook.


Risk Management154


Products LiabilityThere are three general types of product defects:

1. Manufacturing defect—a product deviates from what themanufacturer intended.

2. Design defect—foreseeable risks of harm presented bythe product could have been prevented.

3. Warning defect—the product hasn’t been properly labeledor risks associated with use haven’t been previouslyexplained.

Defenses against the above include

1. Assumed risk

2. Engaging in unforeseeable misuse

In addition to the above, contract law provides for thefollowing warranties:

1. Express warranty—an explicit statement or promise ofperformance

2. Implied warranty—the product is reasonably designed forits intended use

Environmental LiabilityThe Comprehensive Environmental Response, Compensation,

and Liability Act (CERCLA) of 1980, also known as theSuperfund law, was passed, in part, because of the LoveCanal incident described on page 614 of your text.

Although your text makes light of the environmentalimpact of the Love Canal toxins, there was a signifi-cant number of children with birth defects in the townbefore the population was evacuated. Pictures ofchemicals bubbling up to the surface, and decayed

Lesson 8 155

chemical drums emerging from the ground inresidents’ backyards, shocked people into demandinggovernment action. The site was officially declared“closed” (cleanup completed) in 2004, 21 years after itwas declared an environmental disaster. For acontemporary account of the site by then–EPAAdministrator Eckardt C. Beck, go tohttp://www.epa.gov/history/topics/lovecanal/01.htm

Beginning in 1973, many commercial general liability (CGL)

policies included a sudden and accidental clause, offering aseparate policy to cover other environmental areas, includinggradual pollution.

Frequently, disputes over environmental claims arise fromthe trigger of coverage—which insurance policies are triggeredby the event and how claim costs are to be divided amongand covered by multiple policies. In 1986, insurers respondedto tendencies by some courts to require coverage by changingthe exclusion in the standard CGL policy from all but suddenand accidental pollution to absolute pollution exclusion.

Directors’ and Officers’ LiabilityCorporate directors and officers (abbreviated D&O) arerequired to make informed decisions (called the duty of care).Generally, courts apply the business judgment rule, wherethey won’t question informed decisions, even if they turnedout poorly. However, the post-Enron era has led to manylawsuits against directors and officers when publicly tradedstock prices decline, and dramatic increases in the pricecharged to these corporations for D&O insurance. Corporateindemnification of officers and directors refers to reimburse-ment by the corporation for director and officer legal costsand losses from settlements, judgments, and fines.

Shareholder suits fall into two classes:

� Derivative suits are brought by shareholders on behalf ofthe corporation, where damages awarded are received bythe corporation.

http://www.epa.gov/history/topics/lovecanal/

Risk Management156

� Direct action suits against directors and/or officers areinitiated by shareholders, where damages awarded arereceived by the plaintiffs and their attorneys.

The duty of loyalty means that the directors must act in thebest interests of the shareholders when a corporate decisioninvolves a potentially material conflict of interest betweenshareholders, officers, and directors.



Self-Check 28


______ 1. There are three general types of product defects: manufacturing defect, design defect,

and warning defect.

______ 2. Contract law provides for express warranties, but not implied warranties.

______ 3. Direct action suits are brought by shareholders on behalf of the corporation, and

damages awarded are received by the corporation.

______ 4. Corporate directors and officers are bound by a duty of loyalty.

______ 5. A strike suit is a frivolous lawsuit.

(Continued)

Lesson 8 157


Risk Shifting through Limited LiabilityOne of the advantages of incorporating is to limit liability tocorporate assets. However, there have been cases wherecourts have forced shareholders to pay claims that thecorporation can’t pay (known as piercing the corporate veil),

Self-Check 28


6. The court case MacPherson v. Buick (1916) established which one of the following legalprecedents?

a. Negligence needed to be proved in product liability casesb. A contractual relationship between the injured party and the manufacturer is not needed

to recover damages.c. The strict liability standard for products liability cases.d. The “unreasonably dangerous” standard for products liability

7. Strict liability for all consumer losses due to product-related injuries

a. provides inadequate incentives for manufacturers to invest in safety.b. provides inadequate compensation for victims.c. provides appropriate incentives for consumers to take safety precautions.d. helps correct the problem of uninformed consumers who overconsume risky products in

the absence of such a liability rule.

8. A manufacturer is subject to liability resulting from express and implied warranties. This is anexample of what kind of liability?

a. Tort c. Strictb. Contractual d. Imputed


Risk Management158

effectively nullifying the risk shifting intended through use ofthese limited liability provisions. These cases are rare,however, and almost always involve either closely heldcorporations or parent-subsidiary situations.

Liability for Actions of Employees and Other PartiesVicarious liability (also known as imputed negligence) repre-sents a fundamental provision of tort law, where the principal

(usually the employer) is responsible for the actions of theagent (usually the employee) and his or her related torts (e.g.,any strict liability). This may be applied in employee-employerarrangements, but may not apply in independent contractorcases, because they’re supposed to be “independent” and notunder the company’s direct control. However, protecting thepublic safety constitutes a nondelegable duty—one that can’tbe delegated to an independent contractor. In such cases, thebusiness hiring the contractor may be held to be vicariouslyliable.

Hold Harmless and IndemnityAgreementsA hold harmless agreement is a contract between two partiesin which one party agrees to hold the other party harmless(in other words, pay any damages) for losses arising fromsome specified activity. An indemnity agreement is one whereone party (the indemnitee) pays an injured party and is thenreimbursed by the other party (the indemnitor). One type ofevidence of indemnity is a certificate of insurance, issued bythe insurer.

Lesson 8 159

Claims Management andAdministrationInsurance payments are often accompanied or combined withthe signing of a release, which releases the payer from futureclaims. In other words, the plaintiff can’t decide to sue againfor some other injury arising from the incident. Advance

payments may also be made by an insurer (defendant) in acase involving litigation. While the vast majority of liabilitysuits are settled with lump sum settlements, a structured

settlement represents an alternative, where the settlement ispaid in installments, usually through an annuity.


Check 29. Check your answers with those provided at theback of this study guide. When you’re sure that you com-pletely understand the material from Assignment 29, moveon to your last lesson examination.

Self-Check 29


______ 1. One of the advantages of incorporating is to limit liability to corporate assets and

protect personal assets.

______ 2. There have been no cases where courts have allowed the corporate veil to be pierced.

______ 3. Vicarious liability represents a fundamental provision of tort law, where the principal is

responsible for the actions of the agent and his or her related torts.

______ 4. The vast majority of liability suits are settled with structured settlements.

(Continued)

Risk Management160

Self-Check 29


5. Under a system of limited liability, corporations do not bear all of the costs of tort liabilityclaims. This might cause firms to

a. fail to provide optimal safety incentives.b. take excessive risk.c. fail to consider all of the costs that they impose on others.d. All of the above

6. Under common law, a worker will be deemed to be an employee (as opposed to anindependent contractor) if the

a. hiring firm doesn’t control hours worked.b. hiring firm supervises and directs the worker in how the work should be done.c. worker provides his or her own tools and equipment.d. worker has complete control over how and when the work is completed.

7. A lawsuit in which the plaintiff’s case is known by both parties to be weak is called a

a. nuisance suit. c. judgment-proof suit.b. test case. d. subsidiary suit.

8. Vicarious liability is also known as

a. strict liability. c. imputed negligence.b. contractual liability. d. acquired negligence.


161

1. Regression seeks to develop a cost equation. Which of thefollowing represents a cost equation based on linear regression?

A. Y = α + βX C. Y = α ✕ βXB. Y = α – βX D. Y = α ÷ βX

2. The _______ distribution is often used to approximate thefrequency of accident losses.

A. normal C. PoissonB. gamma D. lognormal

3. If the normal distribution is used to estimate losses when thetrue loss distribution is in fact positively skewed, which of thefollowing errors will occur?

A. The maximum probable loss will be overestimated.B. The maximum probable loss will be underestimated.C. The standard deviation will be underestimated.D. The standard deviation will be overestimated.

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Lesson 8Business Risk Management—Additional

Topics








EXAMINATION NUMBER








4. The correlation coefficient is always within the range between

A. –2.0 and +1.0. C. 0 and +1.0.B. –1.0 and 0. D. –1.0 and +1.0.

5. When a risk manager is choosing between two alternative, mutually exclusive methodsof financing losses that have different patterns of expenditures, but don’t materiallyaffect the variability of any of the firm’s cash flows, the appropriate cost of capital fordiscounting these expenditures is the

A. risk free rate.B. opportunity cost.C. opportunity cost of capital, adjusted upward to reflect additional risk.D. opportunity cost of capital, adjusted downward to reflect reduced risk.

6. A hold harmless agreement is a contract between two parties in which

A. both parties agree to indemnify each other for any losses incurred.B. both parties agree to buy insurance against any potential losses that might arise

out of the activity they are engaged in.C. one party agrees not to make the other party pay for any losses that might arise

out of some activity.D. one party agrees to reimburse the other party for any losses that might arise out of

some activity.

7. If a group of shareholders file a lawsuit on behalf of the corporation against the directors and officers of the corporation, it’s called a/an _______ lawsuit.

A. direct action C. indemnityB. nuisance D. derivative

8. Roaster Coaster Inc. manufactures rolling hotdog vending stands. One of the hotdogvending stands comes off the production line defective. It eventually starts a fire at anamusement park. The fire causes a minor panic that results in a few children beinginjured as the crowd runs away from the fire. This is an example of a _______ defect.

A. hidden C. manufacturingB. design D. warning

9. When foreseeable risks of harm presented by a product could easily have been prevented, it’s said to have a _______ defect.

A. design C. warningB. manufacturing D. strict


10. Under the most recent commercial general liability policies, environmental damage is

A. covered only if it was “sudden and intentional.”B. excluded from coverage under the policy.C. covered if the pollution was gradual.D. covered if the policyholder was unaware that it was occurring.

11. The principle that product liability suits must be brought within a certain number ofyears is called

A. assumed risk. C. regressivity.B. unforeseeable misuse. D. the statute of repose.

12. If the directors and officers of a corporation cause the shareholders to suffer a loss,

A. they’re personally liable for the total amount of the losses.B. they aren’t liable if they can show that they acted with reasonable business

judgment.C. they can never be held personally liable because of the limited liability rule.D. they can be liable only up to the limit of their investment in the corporation.

13. When a corporation has debt financing and limited liability, a liability claim in excess ofthe equity value of the firm will

A. expose shareholders to claims on their personal assets.B. result in shareholders losing only part of their investment in the firm, since

bondholders will pay some of the cost.C. result in shareholders losing all of their investment in the firm.D. be paid only after the shareholders have paid back their debt to the bondholders.

14. Which of the following statements about the liability of businesses for actions of independent contractors is true?

A. A business that hires an independent contractor can always be held vicariouslyliable for the negligent actions of the contractor.

B. A business that hires an independent contractor will never be held vicariously liablefor the negligent actions of the contractor.

C. A business that hires an independent contractor can be held liable for the actions ofthe contractor if the contractor is acting as an employee.

D. A business can avoid liability by delegating to an independent contractor the dutyto keep the public safe.

15. Protecting the public safety constitutes a/an

A. hold harmless agreement. C. indemnity agreement.B. certificate of insurance. D. nondelegable duty.


NOTES

Self-Check 1

1. True

2. False

3. True

4. a

5. b

6. d

Self-Check 2

1. True

2. False

3. True

4. False

5. False

6. c

7. b

8. a

Answers to Textbook Problems

1. The cost of achieving zero risk is too high.

Self-Check 3

1. True

2. True

3. True

4. True

5. True

6. False

7. a

165

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8. c

9. d


1. Expected Value of Losses = ($90,000 ✕ 0.02) + ($10,000 ✕ 0.06) + ($0 ✕ 0.92) = $2,400

2. Expected Value of Profits = ($70,000 ✕ 0.05) + ($50,000 ✕ 0.25) + ($30,000 ✕ 0.35) + ($10,000 ✕ 0.2) +(–$10,000 ✕ 0.15) = $27,000

3. Expected Value = ($3,000,000 ✕ 0.004) + ($1,500,000 ✕0.01) + ($800,000 ✕ 0.026) = $47,800

4. Expected Value = ($5,000,000 ✕ 0.004) + ($1,500,000 ✕0.025) + ($500,000 ✕ 0.03) = $72,500

Self-Check 4

1. False

2. False

3. True

4. True

5. True

6. True

7. c

8. b

9. c

Self-Check 5

1. True

2. False

3. True

4. True

5. False

6. True

Self-Check Answers166

Self-Check Answers

7. a

8. c

9. d

10. c


1. $200 – $175 = $25 million

7. The major investments held by property-liability insurersare municipal bonds, corporate bonds, governmentbonds, and common stock. The major investment held bylife-health insurers is corporate bonds.

Self-Check 6

1. False

2. False

3. False

4. True

5. True

6. d

7. a


2. See pages 105–106 of the text.

7. To the extent that consumers can interpret informationand that the Internet information is trustworthy, then acase might be made for less regulation.

9. The NAIC is an association of state insurance commis-sioners. Its role is to facilitate and coordinate stateregulation of insurance.

Self-Check 7

1. True

2. True

3. False

167

4. False

5. False

6. False

7. c

8. b

9. a


1. In some cases (although it’s difficult to identify when),insurers may simply have had really bad luck.

2. Insurer insolvencies can occur as a result of suddenunexpected events. In addition, insurers can sometimeshide their financial difficulties for some time from out-side observers. Thus, insolvency doesn’t necessarilyimply that regulators failed to perform their jobs.

3. Businesses are more likely to use solvency ratings ofinsurers because of the larger amount of insurance cov-erage they typically purchase and because guarantyfunds typically won’t provide complete coverage if theirinsurer becomes insolvent.

6. Insurers might be reluctant to reduce their capitalbecause the insurer has significant franchise value,which would be lost if the insurer failed.

Self-Check 8

1. True

2. False

3. False

4. True

5. False

6. False

7. a

8. d

9. c



1. Expected claim cost = ($100,000 ✕ 0.005) + ($60,000 ✕0.01) + ($20,000 ✕ 0.02) + ($10,000 ✕ 0.05) = $500 +$600 + $400 + 500 = $2,000

b. Present value of expected claim cost = $2,000 ÷ 1.06= $1,886.79

c. Fair premium = $1,886.79 + $100 + $50 = $2,036.79

2. Expected loss adjustment expenses = 0.12 ✕ $2,000 =$240

Present value of expected loss adjustment expenses =$240 ÷ 1.06 = $226.42

Fair premium = $2,036.79 + 226.42 = $2,263.21

7. When interest rates increase, insurance premiumsshould decrease, all else equal. The farther into thefuture that claims are paid, the lower are insurancepremiums, all else equal.

9. If capital shocks cause insurance prices to increaseabove the present value of expected costs, then policy-holders implicitly bear part of the risk associated withlosses that deplete insurers’ capital.

Self-Check 9

1. False

2. False

3. True

4. True

5. True

6. True

7. d

8. c

9. b

Self-Check Answers 169


2. A risk-averse person would purchase policy c becausethe premium is equal to the expected claim cost, i.e.,there’s no premium loading. A risk-averse personwouldn’t necessarily purchase policy d.

3. Poor people may simply not have sufficient income topurchase insurance. In addition, poor people havelimited wealth to protect from lawsuits. Therefore, they’lllikely purchase little liability insurance coverage.

5 Expected claim cost = (0.02 ✕ $20,000) + (0.04 ✕ $5,000)+ (0.01 ✕ $1,000) = $400 + $200 + $100 = $700

Fair premium = $700 ✕ 1.15 = $805

Loading from the insurer’s perspective = $105

Self-Check 10

1. False

2. True

3. True

4. True

5. False

6. False

7. a

8. b

9. c


1. a. As legal costs increase, the premium loading willincrease, which will likely lead to a decrease in theamount of insurance coverage purchase by risk-aversepeople.

b. As regulatory compliance costs decrease, the premiumloading will decrease, which will likely lead to anincrease in the amount of insurance coveragepurchased by risk-averse people.


c. As the tax on investment earnings increase, thepremium loading will increase, which will likely leadto a decrease in the amount of insurance coveragepurchased by risk-averse people.

d. As the variability of claim costs increase, the insurerwill likely need to hold more capital to keep its likeli-hood of insolvency constant. Capital costs will causethe premium loading to increase, which will likely leadto a decrease in the amount of insurance coveragepurchased by risk-averse people.

e. As the criminal penalties for fraud increase, insurerswill need to spend less to verify that claims are legiti-mate. Therefore the premium loading will decrease,which will likely lead to an increase in the amount ofinsurance coverage purchased by risk-averse people.

Self-Check 11

1. False

2. False

3. False

4. False

5. True

6. True

7. c

8. a


5. Generally, the cost of eliminating the possibility of adeath at a worksite is too costly.

Self-Check 12

1. True

2. True

3. False


4. True

5. True

6. b

7. c

8. c


1. a. If the automobile driver is found negligent, then he orshe would be liable for Ms. Schmit’s medical expensesand noneconomic losses.

b. If the automobile driver is found negligent, but suc-cessfully argues that Ms. Schmit also was negligentfor crossing the street between intersections, thenunder a contributory negligence standard, Ms. Schmitwould have to pay her own medical expenses and shewouldn’t be reimbursed for her noneconomic losses.

c. If the automobile driver is found negligent, butsuccessfully argues that Ms. Schmit also was negli-gent for crossing the street between intersections,then under a comparative negligence standard, thedriver might be liable for only a portion (correspon-ding to how the responsibility for the accident wasapportioned by the court) of Ms. Schmit’s medicalexpenses and noneconomic losses. Under some states’comparative negligence rules, if the defendant is lessthan 50 percent responsible, however, the defendantcould escape liability completely.

d. Under an absolute liability standard, the driver wouldbe liable even if Ms. Schmit was largely responsiblefor the accident.

2. a. If physicians were always liable, then they wouldprobably exercise more care in the delivery of medicalservices. An absolute liability standard could providephysicians with excessive incentives for safety, i.e.,they might practice defensive medicine that increasedthe cost and safety of medical care beyond the pointthat consumers would be willing to pay for (if con-sumers paid the full cost of services). The expected


liability cost associated with providing care also couldlead some physicians to stop practicing or switching tospecialties with less liability risk.

b. Victims would receive more compensation since theywould receive compensation for injuries even whenthe physician wasn’t negligent. From a compensation(insurance) perspective, this might be advantageousas people would bear less risk, although the impor-tance of this effect is reduced to the extent peoplehave medical expense insurance that would coveradditional medical costs due to injuries from previousmedical treatments.

c. Legal costs would likely decrease because courtswouldn’t have to incur the costs of determiningwhether physicians were negligent.

6. A profit-maximizing producer would spend the optimalamount ($4,000).

8. The producer would spend $2,000.

9. Each additional level of safety expenditures lowers thefirm’s insurance premium by the amount of expectedconsumer losses. Therefore, the profit-maximizing firmwill spend the optimal amount ($4,000).

Self-Check 13

1. c

2. a

3. f

4. e

5. b

6. d

7. d

8. a

9. c



2. Underinsured and uninsured motorist coverage might beimproved by eliminating any mandatory coverage forpain and suffering. Many people would prefer not topurchase insurance against noneconomic losses, andthus the mandatory coverage forces some people to pur-chase insurance they don’t desire.

3. The main rating factors are driving record, location ofresidence (territory), and characteristics of the driver,such as age and gender.

5. Insurers will be willing to sell coverage provided they can cover their costs, including their cost of capital.Consequently, the people that are insured in residualmarkets are typically people who have higher expectedcosts than the premium that insurers are allowed tocharge. Not surprisingly, residual markets typically losemoney.

6. People who violate compulsory insurance laws and drivewithout insurance may have greater incentives to avoidaccidents so as not to incur the penalties associated withviolating the compulsory insurance law.

7. Repeal of compulsory liability insurance and limits ontort liability would likely decrease drivers’ incentives forsafety. The government could counteract this effect byincreasing fines for traffic violations and accidents andby increasing enforcement efforts.

11. Personal injury lawyers benefit from lawsuits and there-fore generally would be hurt by the limitations on legalliability of no-fault laws. To the extent that legislators arestill practicing law or plan to practice law after their termin office, voting on no-fault legislation could represent aconflict of interest.

Self-Check 14

1. False

2. True

3. True


4. False

5. False

6. d

7. b

8. a

9. c


1. Assuming the homeowner is determined to be liable,then the insurer would pay all of the damages. If thehomeowner isn’t negligent, then the insurer would pay$1,000 of medical payments.

b. Since all of these items would be covered up to$10,000 under the other structures coverage, theinsurer would pay $10,000.

c. The insurer would pay the entire damage of $75,000.

3. Premium = 0.005 ✕ $100,000 ✕ 1.2 = $600.

Self-Check 15

1. False

2. False

3. True

4. False

5. True

6. b

7. c

8. d


1. It would probably be a good idea for Jane to purchaseterm insurance. In this way, she can purchase a rela-tively large amount of coverage. In contrast, a whole lifepolicy with the same premium would provide much lowercoverage.


2. The curve would shift down.

3.

4. People who expect to die early are more likely to buy lifeinsurance, and people who expect to live longer than theaverage person tend to buy annuities.

Self-Check 16

1. True

2. True

3. True

4. True

5. True

6. b

7. a

8. d

Self-Check 17

1. True

2. True

3. True

4. False


Year 1 Year 2 Year 3

Cash Value at beginning of year $10,000 $10,971 $11,887

Premium payments made at beginning of year $1,000 $1,000 $1,500

Mortality cost $550 $600 $675

Expense cost $100 $50 $50

Interest rate used for crediting cash value 6.0% 5.0% 5.0%

Credited interest* 621 566 633

Cash Value at end of year 10,971 11,887 13,295

* (Cash value at beginning of year + premium payments – mortality cost – expense cost ) ✕Interest rate.

5. False

6. c

7. a

8. d

Self-Check 18

1. True

2. True

3. False

4. True

5. True

6. d

7. b

8. a

Self-Check 19

1. True

2. True

3. True

4. False

5. False

6. False

7. b

8. a

9. a


Self-Check 20

1. True

2. False

3. False

4. True

5. True

6. False

7. b

8. d

9. c


1. Price = $20 ÷ 1.08 + $20 ÷ 1.082 = $18.52 + $17.15 =$35.66.

2.

5. Opportunity cost of capital = 0.07 + 0.05 = 0.12 = 12%.Since investors can diversify this risk on their own,Thistle’s risk premium won’t change if it purchasesinsurance.


Year 1 Year 2

Revenue $100.00 $100.00

Costs $85.00 with prob. 0.1 $85.00 with prob. 0.1

$79.445 with prob. 0.9 $79.445 with prob. 0.9

Net Cash Flow $15.00 with prob. 0.1 $15.00 with prob. 0.1

$20.56 with prob. 0.9 $20.56 with prob. 0.9

(a) Expected net cash flow = $15 ✕ 0.1 + $20.56 ✕ 0.9 = $20

(b) $35.66

(c) The opportunity cost of capital shouldn’t change as a result of introducing the risk of workplace injuries, because this risk is firm specific and should be readily diversified byshareholders.

Self-Check 21

1. True

2. True

3. False

4. True

5. False

6. True

7. a

8. c

9. d


1. False—transactions might reduce expected tax payments, but they also reduce expected cash flows toshareholders.

2. False—the definition of a tax benefit considers the taxpayments of all the parties involved in a transaction. Thepolicyholder could receive the benefits of the tax breakthrough a lower insurance premium.

3. Under tax accounting, a loss is recorded when it’s paid.Under financial reporting accounting, a loss is recordedwhen it becomes probable and can be reasonablyestimated.

Self-Check 22

1. False

2. False

3. True

4. True

5. True

6. True


7. d

8. b

9. c

Self-Check 23

1. True

2. True

3. False

4. False

5. True

6. c

7. b

8. d

Self-Check 24

1. True

2. False

3. False

4. True

5. False

6. a

7. b

8. c

Self-Check 25

1. True

2. False

3. True

4. True


5. True

6. False

7. d

8. b

9. a

Self-Check 26

1. False

2. True

3. True

4. d

5. b

6. b

7. c

8. c

Self-Check 27

1. d

2. b

3. a

4. a


1. Correlation coefficient = 0.94

2. Correlation coefficient = 0.88

Self-Check 28

1. True

2. False

3. False


4. True

5. True

6. b

7. d

8. b

Self-Check 29

1. True

2. False

3. True

4. False

5. d

6. b

7. a

8. c


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