McGraw-Hill/Irwin Copyright © 2004 by the McGraw-Hill Companies, Inc. All rights reserved.

Chapter 2

Objective and Risk Management

T2.2H&N, Ch. 2

Need for a RM Objective• Risk imposes costs on businesses and individuals

• Risk Management (e.g., loss control and insurance) also is costly

Tradeoffs must be made

• Need a criteria for making choices about how much risk management should be undertaken

• Appropriate Criteria: Minimize Cost of Risk

T2.3H&N, Ch. 2

Components of the Cost of Risk

T2.4H&N, Ch. 2

Tradeoffs in the Cost of Risk• Decreasing one component of the cost of risk usually is

associated with an increase in another component

• Examples:

• Decreasing expected direct losses (worker injury costs) by increasing loss control costs (increased workplace safety)

• Decreasing expected indirect losses (bankruptcy costs) by increasing loss financing costs (insurance costs)

• Decreasing cost of residual uncertainty by increasing loss financing costs (insurance costs)

T2.5H&N, Ch. 2

Cost of Risk Example• Firm value in ideal world of no risk = $100,000.

• Issues to be examined:

• What is firm value with risk of worker injuries?

• What is relation between firm value and cost of risk?

T2.6H&N, Ch. 2

Cost of Risk Example• Business is faced with one source of risk:

Probability of worker injury = 1/10

Losses from a worker injury:

medical expenses $10,000lost pay $50,000total $60,000

Expected loss = $_________

T2.7H&N, Ch. 2

Cost of Risk ExampleOption 1: Do Nothing

• Cost of risk:

Expected loss = $________Cost of residual uncertainty = $4,000 (assumed)Cost of loss control = $0Cost of loss financing = $0Cost of internal risk reduction = $0

• Total cost of risk = $__________

• Firm value = $100,000 - $________ = $_________

T2.8H&N, Ch. 2

Cost of Risk ExampleOption 2: Loss control

• Spend $2,000 to reduce probability of loss to 1/20

• Cost of risk:

Expected loss = $_________Cost of residual uncertainty = $3,000 (assumed)Cost of loss control = $2,000Cost of loss financing = $0Cost of internal risk reduction = $0

• Total cost of risk = $_________

• Firm value = $100,000 - $________ = $_________

T2.9H&N, Ch. 2

Cost of Risk ExampleOption 3: Additional Loss control

• Spend an additional $2,000 to reduce probability of loss to 1/40

• Cost of risk:

Expected loss = $________Cost of residual uncertainty = $2,700 (assumed)Cost of loss control = $4,000Cost of loss financing = $0Cost of internal risk reduction = $0

• Total cost of risk = $__________

• Firm value = $100,000 - $_________= $___________

T2.10H&N, Ch. 2

Cost of Risk Example

Option 4: No loss control, but full insurance

• Premium = $7,500

• Loading = premium - expected loss = $7,500 - $6,000 = $1,500

• Cost of risk:

Expected loss = $6,000Cost of residual uncertainty = $0Cost of loss control = $0Cost of loss financing = $1,500Cost of internal risk reduction = $0

• Total cost of risk = $7,500• Firm value = $100,000 -$7,500 = $92,500

T2.11H&N, Ch. 2

Cost of Risk Example• Key points from example:

• Do NOT minimize risk, Minimize cost of risk

• There are cost tradeoffs:

• Increase insurance coverage ==> • Increase loading paid• Decrease residual uncertainty

• Additional loss control ==>• Decrease expected losses• Increase loss control costs

T2.12H&N, Ch. 2

Determinants of Value• Firm Value depends on

• Magnitude of expected net cash flows

• Timing of expected net cash flows

• Risk of expected net cash flows

• Net cash flows = cash inflows – cash outflows

T2.13H&N, Ch. 2

Firm Value Maximization & the Cost of Risk• Maximizing Value by Minimizing Cost of Risk

• Define:

• Cost of risk = Value without risk – Value with risk

• Rearrange:

• Value with risk = Value without risk – Cost of risk

• Implication:

• Maximize Value Minimize Cost of Risk

Hypothetical construct

T2.14H&N, Ch. 2

Do Managers Maximize Shareholder Value?

• In practice, there are several factors that motivate managers to maximize shareholder value

• Management compensation contracts (e.g., bonuses)

• Market for corporate control (e.g., hostile takeovers)

• Product market competition

• Monitoring by shareholders with large stakes

• Legal duty of managers

T2.15H&N, Ch. 2

Individual RM and the Cost of Risk

• Cost of risk concept applies to individual RM

• An individual’s cost of residual uncertainty depends on the person’s degree of risk aversion

• Risk aversion

• Pay extra to reduce risk (buy insurance even though premium exceeds expected claim costs)

• Require higher expected returns to take on more risk (demand higher expected returns on riskier stocks)

T2.16H&N, Ch. 2

Risk Management & Societal Welfare

• Minimizing the cost of risk is also an appropriate objective for society, because doing so generally results in an efficient level of risk for society

• Efficiency ==> risky activities are pursued until the marginal costs exceed the marginal benefits

• Implication: public policies should consider the cost tradeoffs

• Example: greater safety regulation lower expected losses, but higher loss control costs

T2.17H&N, Ch. 2

Conflict between Private & Societal Objectives

• Issue:

• Will individuals and businesses acting to minimize their own cost of risk result in the minimization of society’s cost of risk?

• Observe:

• For a business to maximize value (minimize its own cost of risk), the business must consider the effect of its decisions on other parties (even in the absence of regulation and legal liability)

• Why – b/c decisions affect the terms at which other parties contract with the firm

• Example: riskier workplace higher wages

T2.18H&N, Ch. 2

• What if business cost of risk < societal cost of risk?

• Example: workers are uninformed about injury risk

• Then, a business might engage in excessively risky behavior (they may not consider the effects of risk on other claimants)

• Thus, there is a potential role for regulation and legal liability.

• Regulation and legal liability should induce managers to make decisions that minimize society’s cost of risk

Conflict between Private & Societal Objectives