Econ Finance

Economic and Financial Perspectives on the Demand for Reinsurance
James R. Garven and Joan Lamm-Tennant

Hankamer School of Business, Baylor University GeneralCologne Re Chapter 10 in Rational Reinsurance Buying, Nick Golden (editor), London: Risk Books (January 2003), pp. 163-186.
Finance Department Workshop February 14, 2003
Page 1
Corporate Risk Management
Todays seminar kicks off our spring 2003 workshop series, which is organized around the theme "Corporate Risk Management".
Primary insight: Risk management policy and financing policy are complementary. This complementarity is captured by the term integrated risk management.
Integrated risk management from the medias perspective:
"The business of financing companies is converging with the business of insuring them." (see "The New Financiers," The Economist, September 2, 1999).
Integrated risk management from the finance professions perspective:

Froot, K. A., D. S. Scharfstein and J. C. Stein, 1993, "Risk Management: Coordinating Corporate Investment and Financing Policies", Journal of Finance, 48 (Dec.), pp. 1629-58 (hereafter, FSS) Brealey, Richard A. and Stewart C. Myers (2002). Financing and Risk Management. New York: McGraw Hill.
Integrated risk management from the risk management professions perspective :

Garven, J. R. and R. D. MacMinn, 1993, "The Underinvestment Problem, Bond Covenants and Insurance", Journal of Risk and Insurance, 60 (Dec.), pp. 635-46. Doherty, N. A. (2000). Integrated Risk Management: Techniques and Strategies for Managing Corporate Risk. New York: McGraw-Hill (required textbook for FIN/RMI 4335 and FIN/RMI 5335).
Page 2
Under what conditions is risk management irrelevant?
In a frictionless economy, risk management is a pointless activity.

Shareholders can adjust the risk profile of their portfolios by diversifying or shifting their assets. Healthy companies that suffer unwelcome financial shocks can always approach the capital markets for funding.
Adverse shocks to a company's cash flow typically create indirect costs.

These costs might stem from the threat of costly bankruptcy and financial distress, the difficulties of raising funds to finance corporate strategies or the consequences of these shocks to stakeholders.
Risk management can help lessen these threats and thereby boost and sustain the value of the company.
Page 3
Under what conditions is risk management irrelevant?
Proposition 1: Risk management is irrelevant if and only if

there are no market frictions; e.g., transaction costs, taxes, regulations, etc., there is no moral hazard, and there is no adverse selection.
Proof. Suppose the above conditions hold.

The firm may alter its risk profile by transferring risk to or from a counterparty. Investors may also alter their risk profiles by trading the firms shares along with the shares of other firms. Suppose the firm seeks to reduce the risk of its shares by transferring risk to a counterparty. While some investors might approve of such a change, others might have an appetite for more risk that can be satisfied by buying shares in other riskier firms. Since investor risk management is a perfect substitute for corporate risk management, shares of firms that differ only with respect to risk management policy must sell for the same price
Otherwise, arbitrage profits are available by shorting the (relatively) undervalued shares and going long in the (relatively) overvalued shares.
Page 4
Under what conditions is risk management relevant?

What happens to the theory of corporate risk management if Proposition 1 assumptions are violated? We will show how violations of Proposition 1 assumptions represent sufficient conditions in order for corporate risk management to matter. Alternative Hypotheses Asymmetric taxes (due to progressive marginal tax rates as well as incomplete tax loss offsets) Direct and indirect costs related to financial distress (e.g., costs of bankruptcy and moral hazard). Asymmetric information (adverse selection) Role of managerial compensation contract design
Page 5
Implications of Proposition 1 assumption violations

1.
Firm-specific risk affects the value of the corporation

Consequently, diversification may be of some value as a corporate risk management strategy.
2.
Firm-specific risk matters irrespective of the nature of investor risk preferences

What matters is the impact of risk upon the firms tax exposure, magnitude of transaction and agency costs.
3.
Risk management and financing policies have complementary economic and financial consequences.
Coordination of financial and risk management policies enables the firm to expand its debt capacity (cf. FSS (1993) and GM (1993)).
4.
Risk management is the unifying principle for all business management disciplines (not just finance, economics, and RMI).
E.g., marketing may be viewed as a risk management strategy to manage uninsurable business risks such as loss of competitive position, product substitution and obsolescence.
Page 6
Asymmetric Taxes
Consider corporate tax effects.

In most industrialized countries, corporate income tax rates are state contingent, varying as a function of the level of income; typically, dt/dp > 0 (aka the progressive tax rate problem). Tax authorities typically limit the firms ability to deduct the full value of corporate losses (aka the incomplete tax loss offset problem).
Mathematically, these features imply that firms face non-linear, or convex tax schedules in which varying marginal tax rates introduce a firm-specific source of risk; typically, a risk more effectively managed by the firm than by its shareholders.
Page 7
Tax Convexity
Definition of tax convexity (Jensens Inequality):
If a function f(x) is convex, then E(f(x)) > f(E(x)).

Taxes are convex because the tax on fully hedged income f(E(x)) is less than the tax on unhedged income (E(f(x)).
Page 8
Tax Linearity
$
T(C)
E(tax) = T(B)
T(A)
A
C
Page 9
Tax Convexity
Taxes payable
T(C) E(Tax) =.5T(A)+.5T(C) T(B) T(A)
A
Corporate Earnings
Page 10
Tax Convexity Numerical Example

Loss Outcome No Loss Loss Loss Outcome No Loss Loss Strategy 1: Retain Risk Probability Taxable Income Taxes 50% 50% $1,000,000 $500,000 $350,000 $75,000 After-Tax Income $650,000 $425,000 After-Tax Income $562,500 $562,500
Strategy 2: Transfer (Insure) Risk Probability Taxable Income Taxes 50% 50% $750,000 $750,000 $187,500 $187,500
Comparing the two risk management strategies listed above, the effect of insuring risk is to simultaneously reduce the volatility and increase the expected value of after-tax income: Strategy 1 Expected Taxable Income = 50% $1,000,000 50% $500,000 = $750,000. Strategy 1 Expected Taxes = 50% $350,000 50% $75,000 = $212,500. Strategy 1 Expected After-Tax Income = 50% $650,000 50% $425,000 = $537,500. Strategy 2 Expected Taxable Income = 50% $750, 000 50% $750, 000 = $750,000. Strategy 2 Expected Taxes = 50% $187,500 50% $187,500 = $187,500. Strategy 2 Expected After-Tax Income = 50% $562,500 50% $562,500 = $562,500.
Page 11
The Incomplete Tax Loss Offset Problem

Incomplete tax loss offsets make the problem even worse. Tax-loss offsets are incomplete in the sense that firms are limited in their ability to write off, for tax purposes, the full value of corporate losses. Thus gains are taxed at a higher rate than losses are rebated. The government holds a fractional position in a call option on the firm's assets; this options exercise price is the sum of the promised payment to bondholders plus other tax write-offs (typically items such as depreciation allowances).
Page 12
Payoff to the Government (T1)

$ TS Y1
B T1 = tMax[Y1-TS,0]
B
TS
Y1
Page 13
After-tax Payoffs to Bondholders (D1) and Shareholders (S1-T1)

$ TS Y1 S1 S-T 1 B
1
D1
T1 Y1
Page 14
B
TS
Tax Convexity in the Real World
Tax convexity in the real world is quite a bit more complicated than in our numerical example, and it can vary significantly from firm to firm. For any given firm, the degree of tax convexity depends not only upon the schedule of marginal tax rates published by the tax authorities, but also upon a number of firm-specific characteristics, including
past, present and future expected profitability, whether the firm is subject to the alternative minimum tax, and whether the firm has any investment tax credits or net operating loss carrybacks and carryforwards.
Page 15
Direct Costs of Financial Distress
If a firm goes bankrupt under the U.S. Bankruptcy law, the costs of distributing its assets fall on the creditors of the firm ex post.
Legal fees Court fees Accounting Costs Incentive costs for managers under bankruptcy court review might be different than profit maximizing contracts entered into prior to bankruptcy. These constitute the direct and indirect costs of bankruptcy.
Page 16
Indirect Costs of Financial Distress
Even if the firm doesnt fail, there are indirect costs related to financial distress.
Underinvestment. Because owners and creditors share unequally (asymmetrically) in gains and losses, circumstances may arise where firms (in the absence of proper risk management) may rationally reject positive NPV projects. Risk Shifting (asset substitution). Risk management can mitigate the risk shifting problem by reducing ex ante the potential benefits that can be gained by increasing the risk of the firm after a debt issue.
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Underinvestment Problem
The Unlevered, Uninsured Firm
State Pr(s) L(s) 50% $1000 $0 no loss 50% $1000 $800 loss $1000 $400 value now Vu(s)=-L(s) $1000 $200 $600 I(s) $0 $600 $300 Vr(s)=-I(s) $1000 $400 $700
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Underinvestment Problem (Contd.)

The Levered, Uninsured Firm (B=$700)
State Pr(s) no loss 50% $1000 50% $1000 loss $1000 value now L(s) $0 $800 $400 Du(s) $700 $200 $450 Su(s) $300 $0 $150 I(s) $0 $600 $300 Dr(s) $700 $400 $550 Sr(s) $300 $0 $150
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Levered, Insured Firm (Bc=$500 & d=$500)
State Pr(s) no loss 50% $1,000 50% $1,000 loss $1,000 value now L(s) $0 $800 $400 I(s) $0 $600 $300 pc(s) = I(s)-d *= -I(s)+pc(s) $0 $1,000 $100 $500 $50 $750 Dc(s) Sc(s) $500 $500 $500 $0 $500 $250
Page 20

Effect of Transaction Costs (Bl = $600 & d = $400)
State Pr(s) L(s) no loss 50% $1,000 $0 50% $1,000 $800 Loss $1,000 $400 value now I(s) pl(s) = I(s)-d *= -I(s) + pl(s) $0 $0 $1,000 $600 $200 $600 $300 $100 $800 Dl(s) Sl(s) $600 $400 $600 $0 $600 $200
Page 21
Who pays agency and bankruptcy costs?

Shareholders bear these costs ex ante. Bondholders know that if the firm has an asymmetric payoff structure, there is a moral hazard problem, in that shareholders benefit from ripping off bondholders! In the absence of legally enforceable guarantees against such moral hazards, bondholders have no choice but to discount bond prices to account for this risk. Consequently, the cost of debt is higher to such a firm. Ex ante, firms want to convince potential bond investors that the likelihood of bankruptcy is low.
Page 22
Why Does Risk Management Matter - Summary
Why does risk management matter? Answers so far include:

Asymmetric taxes Bankruptcy risk and related costs Bankruptcy costs include direct costs of the bankruptcy process (e.g., legal fees, accounting fees and court costs), plus indirect costs such as value foregone due to suboptimal contracting. Lowering bankruptcy risk also reduces costs related to other agency problems such as underinvestment and asset substitution.
Page 23
Pre- versus Post-loss Financing

Suppose a firm suffers a loss involving the destruction of a physical asset such as a manufacturing facility. Rebuilding (reinvestment) will make sense only if the NPV of the rebuilt facility is positive and greater than any other alternative use of the capital. Reinvestment can be financed two ways:
Post-loss methods typically involve the use of traditional debt and equity instruments to finance rebuilding costs. Post-loss methods incur costs due to adverse selection and moral hazard. Pre-loss methods involve the use of insurance or some other form of hedging. the firm must commit cash up front; there also may be transaction costs incurred in implementing the hedge.
Page 24
Pre- versus Post-loss Financing
The decision to use pre- or post-loss financing comes down to comparing the marginal costs and benefits of each approach. One benefit of pre-loss versus post-loss financing is that pre-loss financing guarantees liquidity at a future date on favorable terms.
Following a loss, the unhedged firm might experience difficulty raising additional capital on favorable terms.
Page 25
Pecking Order Theory
Adverse selection in equity markets

Announcement of a secondary stock offering drives down the prices of currently outstanding shares because investors believe managers are more likely to issue equity when existing shares are overpriced. This represents an adverse selection problem in the equity market!
Therefore firms prefer internal equity since funds can be raised without conveying adverse signals; consequently, internal equity is a cheaper source of financing than external equity. If external financing is required, firms issue debt first and equity as a last resort (because there is less room for differences in opinion about what debt is worth).
Page 26
Pecking Order Theory of Risk Mgmt.
Now suppose an unhedged firm suffers a loss of liquidity (e.g., a major manufacturing facility is destroyed). The loss in liquidity curtails the firms internally financed investment projects. This results in a real economic loss to the firm. Risk management policies should ensure that a company always has the cash available to make value-enhancing investments.
Page 27
Managerial Compensation Contract Design
Agency costs exist because managers do not necessarily have the same objectives as shareholders.
Stockholders prefer that managers maximize (the risk-adjusted discounted value of) profits. Managers are interested in maximizing expected utility.
We can devise a management compensation scheme that attempts to reconcile these conflicting objectives.
Managers also bear corporate risks and therefore need to be properly compensated for risk bearing.
Page 28
Risk and Managers
Risk averse managers have natural incentives to reduce their firm's exposure to risk.
The manager is often not well-diversified since her human and financial capital may be closely tied to the firms financial performance. Thus a risk averse manager may use hedging to reduce her exposure to corporate risk even if it does not increase firm value.
Page 29
Designing a Managerial Compensation Contract
Assume that shareholders are risk neutral, but the manager is risk averse with utility U = W.5. Assume that interest rates are zero; thus the value of the firms shares is simply the expected value of corporate net cash flow. Irrespective of the manner in which the contract is structured, the firm must offer the manager a competitive salary package.
Suppose that competitive managerial labor market conditions imply that competitive certainty equivalent salary is $300,000 per year. Thus the compensation contract must provide the manager with expected utility of at least U($300,000) = $300,000.5 = 547.72.
Page 30
Now suppose an all-equity firms value will be

$500 million or $1000 million each with a 1/2 probability If hedged the firms value will be $780 million; thus the hedge has a positive NPV of $30 million. Will the manager find it in her self-interest to implement this hedge?
Page 31
Consider three alternative managerial compensation contracts a fixed salary, direct share ownership, and executive stock options. 1. Fixed salary of $300,000 causes the manager to be indifferent about implementing the hedge because the decision to hedge does not affect her welfare. 2. Direct share ownership. Manager receives a portion (x) of value of earnings and no salary. This incentive scheme must provide expected utility of at least U($300,000)=547.72. Solve for x: 547.72 < 0.5(500,000,000x)0.5 + 0.5(1,000,000,000x)0.5 1095.45 < (500,000,0000.5 + 1,000,000,0000.5) (x)0.5 1095.45 < 53983.46 (x)0.5 0.02029 < x0.5 x > 0.000412.
Page 32

2.
Direct share ownership (continued)

Therefore, lets assume that the manager receives .0412% of the firm. With the hedge E(U) = ( x*$780 Mill).5 = (0.000412 *$780 Mill).5 = 566.89. Without the hedge E(U) =.5(0.000412*500M ).5 +.5(0.000412*1000M).5 = 547.72. Thus, E(U) is higher w/ hedge and shareholders are also better off; consequently the direct share ownership scheme is superior to the flat salary scheme, since it does a better job of aligning shareholder and managerial incentives.
Page 33
Stock option assumptions:

Manager receives no salary nor shares of stock. There are 10 million shares outstanding; consequently, the value of a share of stock is either $50 or $100. Manager receives options to purchase 60,000 shares of stock at a price of $80 per share.
The expected profit per option is

E(profit) =.5*(Max(share price-$80,$0) =.5*($0)+.5*($20)=$10.
The expected profit and utility from holding options to purchase 60,000 shares are:
E(profit) =.5(0 x 60,000) + .5($20 x 60,000) = $600,000, and E(U) =.5(0 x 60,000).5 + .5($20 x 60,000).5 = 547.72.
The optimal decision here is to not hedge, because E(U) is higher without the hedge (547.72) than with it (0).
Page 34
Summary of Numerical Example

Type of contract Fixed Salary Contract Design Fixed Salary of $300,000 Manager owns x = .00412% of the firm Expected Utility EU = 547.72 no matter what EU = 566.89 with hedging; EU = 547.72 without hedging EU = 0 with hedging; EU = 547.72 without hedging; What to do? Indifferent between hedging and not hedging Hedge
Direct Share Ownership
Options
Manager owns option to purchase 60,000 shares of stock, exercise price of $80.
Dont Hedge
Page 35
Some What ifs on Compensation

CEQ Income U(Wceq) # Shares Risk Aversion Coefficient Option 1 Exercise Price Option 2 Exercise Price Option 3 Exercise Price $300,000 547.7226 10,000,000 0.5 $80 $70 $60 Fixed Salary Share Ownership Option 1 Option 2 Option 3 Salary $300,000 $0 $0 $0 $0 Ownership fraction 0.0000% 0.0412% 0.0000% 0.0000% 0.0000% Options 0 0 60,000 40,000 30,000 No Hedge p(s) 50% 50% Hedge Price p(s) 50% 50% V(s)
V(s)
U(V(s)) U(V(s)) U(V(s)) U(V(s)) U(V(s)) $500,000,000 547.7226 453.7482 0.0000 0.0000 0.0000 $1,000,000,000 547.7226 641.6969 1095.4451 1095.4451 1095.4451 547.7226 547.7226 547.7226 547.7226 547.7226 $220,000,000 U(V(s)) U(V(s)) U(V(s)) U(V(s)) U(V(s)) $780,000,000 547.7226 566.7313 0.0000 565.6854 734.8469 $780,000,000 547.7226 566.7313 0.0000 565.6854 734.8469
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Some What Ifs on Compensation

CEQ Income U(Wceq) # Shares Risk Aversion Coefficient Option 1 Exercise Price Option 2 Exercise Price Option 3 Exercise Price $300,000 547.7226 10,000,000 0.5 $80 $70 $60 Fixed Salary Share Ownership Option 1 Option 2 Option 3 Salary $300,000 $0 $0 $0 $0 Ownership fraction 0.0000% 0.0412% 0.0000% 0.0000% 0.0000% Options 0 0 60,000 40,000 30,000 No Hedge p(s) 50% 50% Hedge Price p(s) 50% 50% V(s)
V(s)
U(V(s)) U(V(s)) U(V(s)) U(V(s)) U(V(s)) $500,000,000 547.7226 453.7482 0.0000 0.0000 0.0000 $1,000,000,000 547.7226 641.6969 1095.4451 1095.4451 1095.4451 547.7226 547.7226 547.7226 547.7226 547.7226 $280,000,000 U(V(s)) U(V(s)) U(V(s)) U(V(s)) U(V(s)) $720,000,000 547.7226 544.4979 0.0000 282.8427 600.0000 $720,000,000 547.7226 544.4979 0.0000 282.8427 600.0000
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Managerial Compensation Summary Firms that offer incentive (direct share ownership) compensation are likely to hedge risk. Firms that offer flat salary may still hedge, but the incentives to do so are weaker (since the linkage between utility and risk is indirect). Managers paid in stock options are not likely to hedge.
Page 38
Managerial Compensation Summary

From a risk sharing view, it makes sense for managers to be paid salaries and for risk to be primarily borne by shareholders. However, from an incentive view, it makes sense to align interests of shareholders and managers in the form of incentive compensation. This trade-off can be at least partially avoided if the firm hedges risks that are largely outside managerial control.
This permits firms to use incentive compensation without unnecessarily burdening managers with risks that are outside their control.
Page 39
Empirical Predictions
Keep in mind the theoretical arguments we have advanced:

Risk management can add value by reducing taxes. Risk management can add value by reducing the cost of financial distress. Risk management can add value by facilitating optimal investment. Whether the firm manages risk depends upon the nature of the managerial compensation contract.
Page 40
Empirical Findings
Risk management to reduce taxes

Dolde (1995) reports a statistically significant positive relationship between tax loss carry forwards and the use of risk management instruments. Nance, Smith & Smithson (1993) and Mian (1994) find a statistically significant positive relationship between tax credits and the use of risk management instruments. Garven and Lamm-Tennant (2000) show that the demand for reinsurance is greater for insurers that invest in tax-exempt securities.
Page 41
Empirical Findings
Risk management to reduce the cost of financial distress.

Dolde and Samant (1996) find a statistically significant positive relationship between the use of risk management and leverage. Mayers and Smith (1990) show that demand for reinsurance is negatively related to credit standing (assigned by a rating agency); i.e., less credit-worthy insurers reinsure more. Garven and Lamm-Tennant (2000) show that demand for reinsurance is positively related to the insurers financial leverage.
Page 42
Empirical Findings
Risk management to facilitate optimal investment.

Nance, Smith & Smithson; Geczy, Minton & Schrand; and Dolde all find a statistically significant positive relationship between the firm's R&D expenditures and its use of risk management. Samant (1996) finds a statistically significant positive relationship between the market-to-book value ratio and the use of risk management. Empirical evidence cited by Froot, Scharfstein and Stein (1993) suggests that for each dollar of unhedged loss, project budgets will be cut by about 30 cents. Minton and Schrand (1999) find that capital expenditure for firms with high cash flow volatility is about 19% below average and expenditures for those with low volatility is about 11% above average.
Page 43
Empirical Findings
Risk management as a function of managerial risk aversion.

Tufano (1996) finds managerial equity positions positively correlated with risk management in gold firms, and negative relationship between risk management and larger managerial options. Geczy, Minton and Schrand (1997) find that managerial equity positions are positively correlated with foreign exchange risk management by nonfinancial firms; also, a negative relationship between risk management and larger managerial options.
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Economic and Financial Perspectives on the Demand for Reinsurance

James R. Garven and Joan Lamm-Tennant

Finance Department Workshop February 14, 2003

Economic and Financial Perspectives on the Demand for Reinsurance

Corporate Risk Management

Integrated risk management from the finance professions perspective:

Integrated risk management from the risk management professions perspective :

Under what conditions is risk management irrelevant?

In a frictionless economy, risk management is a pointless activity.

Adverse shocks to a company's cash flow typically create indirect costs.

Economic and Financial Perspectives on the Demand for Reinsurance

Under what conditions is risk management irrelevant?

Proposition 1: Risk management is irrelevant if and only if

Proof. Suppose the above conditions hold.

Economic and Financial Perspectives on the Demand for Reinsurance

Under what conditions is risk management relevant?

Economic and Financial Perspectives on the Demand for Reinsurance

Implications of Proposition 1 assumption violations

Firm-specific risk affects the value of the corporation

Firm-specific risk matters irrespective of the nature of investor risk preferences

Economic and Financial Perspectives on the Demand for Reinsurance

Consider corporate tax effects.

Economic and Financial Perspectives on the Demand for Reinsurance

Definition of tax convexity (Jensens Inequality):

If a function f(x) is convex, then E(f(x)) > f(E(x)).

Economic and Financial Perspectives on the Demand for Reinsurance

T(C) E(Tax) =.5T(A)+.5T(C) T(B) T(A)

Tax Convexity Numerical Example

The Incomplete Tax Loss Offset Problem

Economic and Financial Perspectives on the Demand for Reinsurance

Payoff to the Government (T1)

After-tax Payoffs to Bondholders (D1) and Shareholders (S1-T1)

Tax Convexity in the Real World

Economic and Financial Perspectives on the Demand for Reinsurance

Direct Costs of Financial Distress

Economic and Financial Perspectives on the Demand for Reinsurance

Indirect Costs of Financial Distress

Economic and Financial Perspectives on the Demand for Reinsurance

Economic and Financial Perspectives on the Demand for Reinsurance

Underinvestment Problem (Contd.)

Economic and Financial Perspectives on the Demand for Reinsurance

Underinvestment Problem (Contd.)

Economic and Financial Perspectives on the Demand for Reinsurance

Underinvestment Problem (Contd.)

Economic and Financial Perspectives on the Demand for Reinsurance

Who pays agency and bankruptcy costs?

Economic and Financial Perspectives on the Demand for Reinsurance

Why Does Risk Management Matter - Summary

Why does risk management matter? Answers so far include:

Pre- versus Post-loss Financing

Economic and Financial Perspectives on the Demand for Reinsurance

Pre- versus Post-loss Financing

Economic and Financial Perspectives on the Demand for Reinsurance

Pecking Order Theory

Adverse selection in equity markets

Economic and Financial Perspectives on the Demand for Reinsurance

Pecking Order Theory of Risk Mgmt.

Economic and Financial Perspectives on the Demand for Reinsurance

Managerial Compensation Contract Design

Economic and Financial Perspectives on the Demand for Reinsurance

Risk and Managers

Economic and Financial Perspectives on the Demand for Reinsurance

Designing a Managerial Compensation Contract