Assignment1 Risk Financing

AFF9770 RISK FINANCING AND TREASURY MANAGEMENT

ASSIGNMENT 1

TUTORIAL QUESTION

PREPARED BY:

ANKUR ARORA 20559313 ANKUR BHARGAVA 19987366 WAEL AL JABRI 19615043

WORD COUNT:

12

th MAY2007.

Question. Benefits of Insurance and its effect on capital structure and value of firm

Solution: Culp, 2002 defines an insurance contract as one of the mechanism for risk transfer.

An insurance contract enables a firm to transfer the loss that may arise from a certain risk or

hazard, from firms equity holders (i.e. insurance purchaser) to the insurance providers

equity holders. The Commission on Insurance Terminology of the American Risk and

Insurance Association has defined insurance as follows- Insurance is the pooling of fortuitous

losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses,

to provide other pecuniary benefits on their occurrence, or to render services connected with

the risk.(Rejda, 2005).

The four main characteristics of an insurance contract can be outlined as follows: (Culp,

2002)

An insurable interest must exist for the purchaser of insurance.

There should be risk since the beginning of the contract.

Some portion of the risk must be transferred to the insurance provider from the

insurance purchaser. And, the purchaser must pay a specific amount as premium to

the provider of the contract for the risk transferred.

In an insurance contract, the level of honesty must be higher compared to other

commercial contracts.

The large corporations usually self-insure themselves against the small losses such as, losses

due to localised fires; employees getting injured while work etc. The total cost of such small

losses is predictable and they keep on occurring regularly. Whereas, the corporations protect

themselves from the large losses by insurance. Large losses include physical damage caused

to assets, toxic torts, among others. (Doherty, Neil A. & Smith, Clifford W. in Stern & Chew,

1998)

Benefits of Insurance

Insurance provides Lots of benefits to the society. Some of them can be stated as follows:

(Rejda, 2005)

Indemnification for Loss

Insurance helps a company in maintaining its financial security, if a loss occurs

indemnification helps the company in restoring its previous financial position. The company

is helped in re-establishment either in part or in whole after a loss occurs. It also allows a

firm to remain in business and helps employees in retaining their jobs. Indemnification as a

benefit of insurance also helps the society, as the firms keep on paying taxes and the

communitys tax base is not eroded, and the customers still receive the desired goods and

services.

Reduction of Worry and Fear

Another benefit of insurance is the reduction of worry and fear for both situations, before and

after loss. The company has no need to worry about the losses it may incur in future if it is

insured as company knows that it will be repaid if a loss occurs and can concentrate solely on

its operations.

Source of Investment Funds

A major source of investment for corporations is the insurance industry. Insurance firms

usually lend the money they do not require for immediate expenses to the business firms to

invest in capital projects. Such investments help in increasing the capital goods in the society,

and therefore contribute to economic growth of country.

Loss Prevention

There are numerous loss-prevention programs managed by the insurance companies. They

even employ a variety of personnel for loss-prevention that includes safety engineers, fire

prevention specialists, and occupational safety specialists, among others. Such activities help

a company in reducing both direct and indirect losses that may occur.

Enhancement of Credit

A firms credit is enhanced due to insurance contract. As insurance secures or guarantees the

borrowers collateral value, it helps in providing the borrower a better credit risk. For

instance, a business firm seeking a temporary loan for Christmas or seasonal business may

be required to insure its inventories before the loan is made. (Rejda, 2005, pp. 30)

Few other benefits of insurance to large corporations and in turn, increase of the shareholders

value from the insurance purchases, have been outlined by Doherty, Neil A. & Smith,

Clifford W. in Stern & Chew, 1998, pp.241:

avoiding underinvestment and other problems faced by companies whose financial

solvency (or even just liquidity) could be threatened by uninsured losses;

Transferring risk from non-owner corporate stake-holders-managers, employees,

suppliers-at a disadvantage in risk bearing;

Providing efficiencies in loss assessment, prevention, and claims processing;

Reducing taxes; and

Satisfying regulatory requirements.

Effect of insurance on Value of the Firm

According to (Stern & Chew, 1998), the effect of insurance on the capital structure and on

the value of the firm can be explained with the help of the following example for a

hypothetical company, X Ltd (XL).

If XL faces financial difficulties, it may be imposed with indirect costs. Such indirect costs

include the underinvestment problem as major source. In companies with significant amounts

of debt, the problem of underinvestment arises due to interest conflicts between the

shareholders and the bondholders. As this company is already facing the following:

Financial difficulties,

Negative operating cash flows which exhausted the retained earnings and in turn,

The share price of XL has fallen sharply.

If XL does not purchases fire insurance for its plants (even when it has large amounts of debt

outstanding) and one of its most profitable plant gets destroyed due to fire. It will face a

difficult decision that is whether it should reinvest in the same plant or not. Actually, the

huge loss from the fire further increases the leverage ratio of the company. Therefore, it will

not be able even to raise equity at the stock market.

The primary aim of the management of any company is to maximise its shareholders wealth.

Accordingly, if XL issues new equity in these circumstances, it will result in transfer of

wealth from shareholders to bondholders, which is not acceptable. Thus, as XL has a larger

proportion of debt in its capital structure, it will have to reject or defer the investment in a

project which even have positive Net Present Value. As a result of the following:

XL did not insure its plants, and

Has a larger percentage of debt.

This will result in deferment of the investment in plant and, consequently lead to reduction in

the overall value of the firm.

In contrast, if XL would have bought the fire insurance for its plants then the company would

have never faced this huge decision to reinvest money on its own. It would have got repaid

from the insurance company and then could have invested in the plant. If X Ltd. had

insurance, then the plant destroyed due to fire would not have increased the leverage ratio

and the value of the firm would have been more stable than the situation when there was no

insurance. This example provides a more clear view as to, how insurance helps a company in

maintaining its the value of the firm.

Effect of Insurance on Capital Structure

Effective risk management is the cornerstone of capital structure. Insurance allows you to use

the available capital to follow your vision, unrestricted by the need to maintain high reserves

to cover potential losses. Also, insurance which is a risk transformation product can work as

a synthetic equity and serve as alternative source of borrowing, same as derivatives which

can work as a substitute for debt and equity.

For example, if the company XL have a potential risk which is covered with the paid up

capital. It could insure the risk and transfer it to off-balance sheet capital and invest the

available paid up capital profitably as illustrated in the Fig.1 and Fig.2 on the following page.

This simple example provides a clear view as to, how insurance helps a company to have

capital structure that serve its goal to maximize the shareholders wealth.


Potential

RiskContingent

Capital

Senior Debt

Mezzanine finance

Equity

Firm

Capital

Firm

Risks

Off-balance sheet Paid-up Capital

Transferable Retained

Paid-up Capital

Fig. 1

Insurance Contingent Capital

Senior Debt

Equity

Off-balance sheet Paid-up Capital

Transferred Retained

Firm

Capital

Firm

Risks


Mezzanine finance

Fig. 2

References

Culp, Christopher L. (2002), The Art of Risk Management, John Wiley & Sons Inc, Canada.

Leland, Hayne E. (1998), Agency Costs, Risk Management, and Capital Structure, Vol. 53,

Issue 4, pp. 1213-1243.

Mayers, David & Smith, Clifford W. Jr. (1987), Corporate Insurance and the

Underinvestment Problem, The Journal of Risk and Insurance, Vol. 54, No. 1, March 1987,

pp. 45-54.

Rejda, George E. (2005), Principles of Risk Management and Insurance, 9th edn, Pearson

Education Inc.

Shimpi P. (2001), The Insurative Model, The Journal of Risk Management, 2001, Vol. 27

Issue 6, p10-15, 6p.

Stern, Joel M. & Chew, Donald H. Jr. (1998), The Revolution in Corporate Finance, 3rd edn,

Blackwell Publishers Ltd, USA, Malden, Massachusetts.

Documents

Assignment1 Risk Financing