Chapter 1 1.

(Direct and indirect cost) (damage manufactory plant) The direct losses are the
property damage and liability costs. The indirect losses include lost profits from the interruption
of the business, additional operating expenses, higher cost of raising additional capital, the value
of foregone investment opportunities because the cost of raising external funds reduces the value
of investment opportunities, and in the extreme bankruptcy costs. (Lasuit) The direct losses are
the legal costs and the costs associated ith !udgments or settlements of claims. The indirect
costs include disruption of daily operations as employees deal ith lasuits, damaged reputation
ith the community and consumers hich could in turn increase labor costs and reduce demand
for the product. The liability loss also could increase the cost of raising additional capital, cause
the firm to forego investment opportunities because the cost of raising external funds reduces the
value of investment opportunities, and in the extreme bankruptcy costs. ".(reduce risk loss of la
suit)#ne ay to reduce the risk of product liability lasuits is to reduce the amount of the product
that is produced, but not change its design or marketing. $n the extreme, the manufacturer could
stop production all together. %nother ay is to make the product safer for consumers either by
design changes, greater &uality control in the manufacturing process, or by providing arning
labels or safety instructions ith the product. '. (Loss control automobil) The risk of being
in!ured in an automobile could be reduced by driving (a) less often, (b) more safely, (c) during
times that have a loer likelihood of accidents (daytime during non(rush hour period), (d) less
often on dangerous roads, (e) a safer car, (f) at loer speeds, (g) using seat belts, (h) ithout
distractions ) not using a phone.*. (+inancial loss, differ from internal risk reduction) The main
methods of financing losses are paying losses out of internal funds (retention or self(insurance),
purchasing insurance contracts, using derivative contracts, or non(insurance risk transfers. Loss
financing refers to the methods used to finance potential losses. ,ith the exception of retention,
other loss financing methods (insurance contracts, derivative contracts, and other contractual risk
transfers) shift some of the uncertainty about losses to another party. $nternal risk reduction
refers to the internal activities, such as diversification and investments in information, hich
reduce uncertainty about losses. Chapter 2 1. (%chieve -ero risk, effiency)The cost of achieving
-ero risk is too high. (orker $n!uries. /ost of 0isk /omponent, 1pecific 2xamples ) 2xpected
losses3 2xpected orkers4 compensation benefits (medical expenses, lost ages), expected
employee replacement costs, expected lost productivity. 0esidual 5ncertainty3 0eduction in value
due to oners4 risk aversion6 higher ages demanded by employees for the uncertainty
associated ith having uninsured losses from in!uries3 Loss /ontrol, 1afety expenditures3 Loss
+inancing, Loading on orkers4 compensation insurance premiums3 $nternal 0isk 0eduction,
$nvestments in information concerning the likelihood and severity of accidents.3 (Loss from
expropriation) 2xpected Loss, 2xpected property losses, expected lost profits3 0esidual
5ncertainty, 0eduction in value due to oners4 risk aversion3 Loss /ontrol, /osts due to
designing operations to reduce the probability of expropriation (e.g., having the facility produce
an incomplete product, here completion re&uires expertise that the foreign country ill find
costly to obtain)6 costs of lobbying government officials3 Loss +inancing, Loading on political
risk insurance premiums3 $nternal 0isk 0eduction, /osts due to inefficiencies associated ith
spreading facilities across different geographical areas. (preference changes) 2xpected Losses,
2xpected lost profits, expected severance pay, expected unemployment insurance costs, expected
losses on sale of idle capacity3 0esidual 5ncertainty, 0eduction in value due to oners4 risk
aversion6 higher compensation demanded by employees for the risk of losing their !obs3 Loss
/ontrol %dvertising costs to reduce preference changes3 Loss +inancing, $nternal 0isk 0eduction,
/osts of establishing production facilities in ine and soda. '. ($ncentive make product)
7usinesses have incentives to make safe products if consumers are informed about the product8s risk.
9rovided consumers are informed, the terms of sale ill reflect the risk imposed on consumers, i.e.,
consumers ill pay less for more risky products. /onse&uently, reducing risk ill increase product prices,
all else e&ual. (0educe orker in!ury risk) 7usinesses have incentives to reduce the fre&uency and severity
of orker in!uries if employees are informed about the risk. 0educing risk on employees ill alter the
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terms of contract, i.e., labor costs ill be loer, all else e&ual. %lso, orker in!uries often disrupt
operations. (%void polluting) 7usinesses have incentives to care for the environment to the extent that
people ho transact ith the firm care about the environment and alter the terms at hich they are illing
to transact if the firm harms the environment. +or example, if consumers are illing to pay higher prices
for products produced by firms that take care of the environment or if potential employees are illing to
ork at loer salaries at firms that take care of the environment, then firms ill have an incentives not to
pollute then environment. 4 :r. +atcat ill be motivated to operate the firm in the best interests of
shareholders (as opposed to his on interests) because of the folloing forces. The market for
corporate control (( if :r. +atcat fails to maximi-e shareholder ealth then the firm ill more
likely be sub!ect to a hostile takeover and the ac&uirer ill likely replace :r. +atcat ith a ne
manager. The managerial labor market (( if :r. +atcat fails to maximi-e shareholder ealth, then
he ill likely have feer opportunities for higher paying, more prestigious managerial positions.
$ncentive contracts (( the firm most likely ill have incentive contracts that make :r. +atcat8s
compensation depend on the firm8s performance and therefore motivate him to act to maximi-e
shareholder ealth. Legal duty to shareholders (( under all state incorporation las, managers
have a legal duty to act in shareholders interests. $f they violate these duties, shareholders can sue
them. :onitoring by shareholders (( some shareholders (typically those ith large stakes) have
an incentive to monitor managers and to remove managers via the board of directors if managers
do not act in shareholders8 interests. #f course, these forces do not operate costlessly and
perfectly. Thus, managers ill not alays act in shareholders4 interest. ; (Legal system) ,ithout
a legal system that holds firms liable for the damage they impose on the environment, ,e(Dump($t may
take too fe precautions in disposing toxic substances. $n other ords, the cost to society of dumping
substances in a river could exceed the cost to ,e(Dump($t if the legal system did not impose liability.
<. (risk of in!ure) 1ince consumers prefer safer products, consumers are illing to pay higher
prices for safer !et skis. =oever, because of limited resources, the amount that consumers are
illing to pay for additional safety is likely to diminish as safety increases. +or example,
consumers might be illing to pay an extra >1?? for a safety feature that reduces the likelihood of
an accident from ?.???; to ?.???', but they might not be illing to pay an extra >1?? for a safety
feature that reduces the likelihood of an accident from ?.???' to ?.???1. 1ince consumers are
illing to pay to some extent for additional safety, a manufacturer of !et skis ould maximi-e
profits by spending resources on design, production, and distribution to enhance safety to the
extent that consumers are illing to pay for the additional safety. The higher costs associated
ith making !et skis safer ill in turn cause the price to increase. These effects occur regardless
of hether there is government regulation or product liability6 hoever, these effects re&uire
consumers to be informed about product safety. @alue maximi-ation can cause a manufacturer to
consider the adverse effects of noise if communities adopt rules that prevent excessively noisy !et
skis from being used in particular areas. $n this case, consumers ho ould like to use !et skis in
the designated A&uietB areas ill be illing to pay higher prices for &uiet !et skis. ,ithout
community action such as this, hoever, manufacturers may have little incentive to consider the
effects of the noise on people that do not purchase !et skis (the users of beaches). C. (%ir travel
trade(off) ,hile more extensive security checks of passengers and luggage can reduce the
likelihood of terrorist acts, it is also costly. 1ecurity checks can alays be made more extensive
(and thus air travel can be made safer), but the cost of the additional security checks must be
compared to the benefits. The costs include the costs of security personnel, security devices,
passengers4 time, and the reduction in the demand for air travel (and thus greater use of
automobile travel and the resulting increase in the number of in!uries from automobile accidents).
Chapter 7(solvency regulation, un!ustified forbearance asle) $nsurer insolvencies can occur as a
result of sudden unexpected events. $n addition, insurers can sometimes hide their financial
difficulties for some time from outside observers. Thus, insolvency does not necessarily imply
that regulators failed to perform their !obs. ($nsurance rating, business) 7usinesses are more likely
to use solvency ratings of insurers because of the larger amount of insurance coverage they
typically purchase and because guaranty funds typically ill not provide complete coverage if
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their insurer becomes insolvent. (0isk(based capital, insurer4s insolvency risk knoen )There
ould be no need for risk based capital re&uirements if consumers ere fully informed about
insurer insolvency risk, because consumers ould be able to make informed decisions about
hether to purchase insurance from a particular insurer. 1imilarly, the need for guaranty funds
ould be reduced, because consumers ould not unittingly purchase coverage from a risky
insurer. /onsumers ould only purchase coverage if they ere satisfied ith the price and the
&uality (insolvency risk) of the coverage. Devertheless, some consumers may still prefer to
purchase insurance against insurer insolvencies if the premium for this coverage had a relatively
small loading. (solvency problem of bank, federal deposit insurance)The broader and more
comprehensive protection to bank and savings and loan depositors creates a more severe moral
ha-ard problem. $n particular, the deposit insurance reduces the incentive for consumers to
monitor the insolvency risk of banks and savings and loans, because consumers4 deposits are
insured. :oreover, if the deposit insurance is not priced to banks and savings and loans in a ay
that increases the premiums if the managers take riskier activities, then the managers ill have an
incentive to take on more risk. $f the risky activities turn out to have a high return, then the
oners make a lot of money. #n the other hand, if the risky activities turn out to have a lo or
negative return and conse&uently the bank or savings and loan cannot pay depositors, then the
oners can simply alk aay and let the deposit insurance pay the consumers4 claims. (reduce
capital guaranty fund increase) $nsurers might be reluctant to reduce their capital because the
insurer has significant franchise value, hich ould be lost if the insurer failed.
Chapter 8 (effect of interest rate and fail) ,hen interest rates increase, insurance premiums
should decrease, all else e&ual. The farther into the future that claims are paid, the loer are
insurance premiums, all else e&ual. (gender)The main arguments for outlaing the use of gender
as a rating factor are as follos. +irst, some people ill argue that it is simply un!ust to make
distinctions based purely on gender. 1econd, gender is not an underlying determinant of expected
claim costs6 insurers should identify and use the underlying determinants, not a proxy based on
group differences. +or example, not all young males are more likely to have accidents than
young females6 insurers should identify the factors that are associated ith accident fre&uency for
both males and females The arguments against outlaing the use of gender include (1) there are
differences in claim costs beteen males and females after controlling for other factors that affect
claim costs, (") classifications costs are minimal, (') by outlaing the use of gender, males and
females behavior ill be distorted , e.g., if insurance premiums decrease (increase) for males
(females), then males (females) ill be induced to buy too much (little) insurance relative to hat
is optimal. $n addition, if insurance premiums decrease for one group, then individuals ithin
that group might engage in excessively risky behavior. (ender, rating factor) $f capital shocks
cause insurance prices to increase above the present value of expected costs, then policyholders
implicitly bear part of the risk associated ith losses that deplete insurers4 capital. (!i"
premium, capital shocks affect insurance price) %ssuming an insurance cycle exists, the best
(orse) time to buy insurance ould be during the soft (hard) portion of the cycle, i.e., hen
prices are lo (high) and availability is high (lo). (under#riting cycle, best time to buy
insurance) Chapter $ % risk(averse person ould purchase policy c because the premium is
e&ual to the expected claim cost6 i.e., there is no premium loading. % risk(averse person ould
not necessarily purchase policy d. (risk averse / D) 9oor people may simply not have sufficient
income to purchase insurance. $n addition, poor people have limited ealth to protect from
lasuits. Therefore, they ill likely purchase little liability insurance coverage. (poor people,
liability insurance) /orporate actions that reduce the variability in cash flos may be redundant
from the perspective of a diversified shareholder because the risk that insurers can diversify aay
through pooling can also be diversified aay through stockholder diversification. (@ariability in
cash flo, diversified shareholders) The absence of insurance can cause a firm to forego good
investment pro!ects because the firm4s internal funds are used to pay a loss and therefore cannot
be used to finance ne investment pro!ects. ,ithout the internal funds, the firm ould have to
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raise ne capital. =oever, the costs of raising capital can make the investment pro!ect no
longer profitable. (abuses of insurance, forgo good investment pro!ect) The insurance increases
after(tax expected profits by >1,1?? (><",'?? ) ><1,"??). The increase occurs because of
progressive tax rates. 1ince insurance increases expected after(tax income in this case, the firm
ould vie the insurance as having a negative loading.
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