Insurance and Risk Finance 640

1
Insurance and RiskFinance 640

• Class 18
• November 29, 2004

2
Option 1 With Separate Policies , Insurer pays
all losses in excess of 20 million for each
3
Option 2 With Bundled Policy , Insurer pays
aggregate losses in excess of 40 million
4
CGL Occurrence Coverage

• How occurrence coverage works
• Policy in force when injury occurs must defend
  and indemnify, regardless of when claim made
• Occurrence definition accident, including
  continuous and repeated exposure to the same
  general harmful conditions
• BI or PD must occur during policy period
• Coverage is not limited to sudden injuries
  gradual injuries are covered unless otherwise
  excluded

5
When the Date of Injury is Uncertain

• Examples gradual environmental damage and
  injury from exposure to asbestos
• Courts have applied a variety of coverage
  triggers
• Early bodily injury cases held that injury
  occurred during the period of exposure to a toxic
  substance
• The most common doctrines
• Manifestation trigger injury occurred when
  injury manifests itself to plaintiff
• Injury-in-fact trigger court estimates when the
  injury actually occurred based on expert testimony

6
Allocation Among Triggered Years

• If more than one years policies are triggered,
  costs must be allocated among the triggered
  policies
• Some states allocate losses based on the
  insurers time on the risk
• Some states instead hold all triggered policies
  jointly and severally liable
• Policyholder chooses policy for defense and
  indemnity
• Insurers of triggered policies negotiate or
  litigate how to divide the costs

7
Single vs. Multiple Occurrences

• Another issue is whether multiple injuries
  represent a single occurrence or multiple
  occurrences
• E.g., one type of product damages many different
  properties
• The answer can be very important to insureds and
  insurers because of per occurrence and aggregate
  deductibles, retentions, and policy limits
• Cause test (majority view) all injuries arising
  out of the same basic cause are a single
  occurrence
• Event test each injury is separate occurrence

8
Claims-Made Coverage

• Basic concept Insurer defends and indemnifies
  claims made during policy period, or within a
  relatively short, specified time after policy
  period
• Use
• Reduces risk for insurers and premium for buyers
• Medical malpractice coverage since early 1970s
• Otherwise primarily used for very high risk
  hazards, such as environmental liability and
  directors and officers liability
• Became coverage option in ISO CGL policy in mid
  1980s, but option is rarely purchased with that
  policy

9
Occurrence vs. Claims-Made
10
ISO Claims-Made Form

• Claim covered if
• Injury occurred after the retroactive date
  specified in the contract, and
• Claim made during policy period or extended
  reporting period
• Retroactive date
• Coordinates coverage if a policyholder switches
  from occurrence to claims-made coverage
• Reduces premiums and adverse selection

11
Extended Reporting Periods

• Allow claims to be made for some time after the
  policy period
• The ISO form
• Automatically covers claims made for occurrences
  reported within 60 days of end of the policy
  period if the claim is made within 5 years
• Allows the insured to convert to occurrence
  coverage at the end of the policy period for
  injuries that occurred during the policy period
• New policy limit
• Pay a premium no more that 200 of original
  premium
• Non-standard claims-made forms without an option
  to convert to occurrence are common

12
Pricing and Underwriting

• Compared with personal and small business
  insurance, pricing and underwriting of coverage
  for medium to large businesses differ on three
  dimensions
• Underwriters often have substantial discretion to
  negotiate the premium rate, special coverage
  features, and services
• Rating plans are often loss-sensitive (charges
  paid by the policyholder depend on its loss
  experience during the coverage period)
• Less stringent regulation of rates and policy
  forms

13
Major Types of Business Risk (Revisited)
14
Hedging Using Derivatives

• Important part of modern risk management
• Examples of the types of risk that are hedged
• commodity prices
• interest rates
• exchange rates
• Derivative markets are huge
• Integration of insurance and financial markets is
  an important trend

15
Exposure Diagrams Revisited
16
Hedging Oil Price Risk with Call Options

• NeedOil has oil price risk
• To reduce its oil price risk, NeedOil signs a
  contract with OPTCO
• OPTCO pays NeedOil in six months
• 250,000 x (Poil - 15) if Poil gt 15
• 0 if Poil lt 15
• NeedOil pays OPTCO 100,000 today

17
Hedging Oil Price Risk with Call Options

• What are NeedOils profits (ignore discounting)?
• if oil price 14 gt
• profits from operations 1,250,000
• profits from OPTCO contract -100,000
• total profits 1,150,000
• if oil price 15 gt
• profits from operations 1,000,000
• profits from OPTCO contract -100,000
• total profits 900,000
• if oil price 16 gt
• profits from operations 750,000
• profits from OPTCO contract 125,000
• total profits 900,000

18
Hedging Oil Price Risk with Call Options
19
Hedging Oil Price Risk with Call Options
20
Call Option Contracts

• NeedOils contract with OPTCO is an example of a
  derivative contract, called a call option.
• A derivative contract is a contract whose payoff
  or value is derived from the value of some other
  asset or index.
• The asset on which the derivative contract is
  based is called the underlying asset
• A call option contract pays the purchaser of the
  option a positive amount if the underlying asset
  exceeds the exercise price.
• The option price is the amount paid for the
  option.
• For every call option buyer, there is a call
  option seller.

21
Payoff to Seller of the Call Option
22
Put Options

• Put option contract receives a positive payoff
  only if the value of the underlying asset falls
  below the exercise price

23
Cash Settlement versus Physical Delivery

• Some options are settled in cash (like the ones
  NeedOil used)
• Other options are settled with the physical
  delivery of the underlying asset
• Example call option on oil 1,000 barrels with
  exercise price of 15
• If oil price at expiration 18, then the option
  buyer would exercise the option to buy 1,000
  barrels for 15 a barrel
• Distinction between cash settled and physical
  delivery contracts not important at this level of
  analysis

24
Basis Risk

• Basis risk refers to the uncertainty in the
  relationship between the variable being hedged
  and the derivative contract payoff being used to
  hedge
• Examples
• firm takes delivery in New Orleans, derivative
  contract is based on New York prices
• grade of the underlying asset used differs from
  the grade on which the contract is based.

25
Determinants of the Price of Call and Put Options

• An Increase in Call Option Price Put Option
  Price
• the value of the
• underlying asset Increases Decreases
• the exercise price Decreases Increases
• the volatility in the
• return of the
• underlying asset Increases Increases
• the time to maturity Increases Increases
• interest rates Increases Decreases

26
Hedging with Forward Contracts

• Alternative method of hedging Contract with F-CO
• F-CO does not demand an upfront premium
• Instead NeedOil pays F-CO if the price of oil
  falls below 15
• Payoffs in six months
• If Poil gt 15 ? F-CO pays 250,000 x (Poil - 15)
• if Poil lt 15 ? F-CO receives 250,000 x (15 -
  Poil)
• No payments upfront

27
Hedging with Forward Contracts
28
Hedging with Forward Contracts
29
Hedging with Forward Contracts

• A forward contract or a futures contract gives
  the buyer (NeedOil) a symmetric payoff
• equal to the difference between the actual price
  of the underlying asset and some pre-determined
  price
• called the forward price or futures price.

30
Forward Prices

• Demand and supply of contracts determines the
  forward price
• Provided people can trade the underlying asset
  and the forward contracts, traders will always
  demand more contracts or supply more contracts
  unless
• Cost of carry relationship is true
• forward price spot price at time t cost of
  carry,

31
Example of the Cost of Carry Relationship

• Assume
• spot price of oil is 16 a barrel,
• the interest rate equals 9,
• cost of storing and insuring oil for one year is
  1
• 1-yr forward price 16 16 x (0.09 0.01)
• 17.60

32
Example of the Cost of Carry Relationship

• Suppose the 1-yr forward price 18.00 and the
  cost of carry equals 17.60
• Then, you could sell (take a short position) a
  forward contract (agree to sell oil in one year)
  at the 18.00 price.
• Simultaneously,
• buy oil today
• store and insure the oil for 1 year for a total
  of cost of 17.60 a barrel
• at the end of the year, you would make 0.40
  regardless of what happens to the price of oil
  (i.e., there is no risk).
• Therefore, 18.00 is not a price that will clear
  the market

33
Derivatives Building Box
Buy (long) Forward
Buy a Call
Buy a Put
Sell (short) Forward
Sell a Put
Sell a Call
34
Constructing Desired Payoffs

• How would you obtain this payoff (ignoring the
  cost of the options)

Price of Lumber in 1 year
30
35
Constructing Desired Payoffs

• How would you obtain this payoff (ignoring the
  cost of the options)

Price of Lumber in 1 year
30
36
Constructing Desired Payoffs

• How would you obtain this payoff (ignoring the
  cost of the options)

Snowfall in Aspen next December
2ft 5ft
37
Swap Contracts

• Swap contracts are a series of forward contracts
• Description of an Oil Swap
• Let Pt price of oil at time t
• swap price 15
• notional principal 250,000 (number of units
  on which the contract is based)
• 6 Mnths 12 Mnths 18 Mnths 24 Mnth
• Payoff (P6 mnths - 15) (P1 yr - 15) (P18
  mnths - 15) P2 yrs - 15)
• to NeedOil x 250,000 x 250,000 x 250,000 x
  250,000
• Payoff to (15 - P6 mnths) (15 - P1 yr) (15
  - P18 mnths) (15 - P2 yrs) SWAPCO x 250,000 x
  250,000 x 250,000 x 250,000

38
Swap Contracts

• 2-year Interest Rate Swap Contract between
  NeedOil and SWAPCO
• rt one-year T-bill rate at time t
• each entry is multiplied by 1 million (the
  notional principal)
• swap rate 5
• 6 Mnths 12 Mnths 18 Mnths 24 Mnths
• Payoff
• to NeedOil (r6 mnths - 5) (r1 yr - 5) (r18
  mnths - 5) (r2 yrs - 5)
• Payoff
• to SWAPCO (5 - r6 mnths) (5 - r1 yr) (5 -
  r18 mnths) (5 - r2 yrs)

39
Comparison Of Derivatives Insurance

• Derivative contracts
• Usually used to hedge risk arising from
  unexpected changes in market prices
• Note market prices affect many firms
• Insurance contracts
• Usually for risk arising from losses specific to
  the insured.

40
Comparison Of Derivatives Insurance

• Influence a particular firm has on payoffs from
• Derivative contracts - little, if any
• Insurance contracts
• Considerable, through its loss control activities
• gt greater moral hazard problems with insurance
• gt more investigation and monitoring costs must
  be incurred with insurance contracts than with
  derivatives
• gt contracts with retention (deductibles,
  limits, etc)

41
Comparison Of Derivatives Insurance

• Contracts based on firm specific factors (as
  opposed to market prices or indices) have less
  basis risk.
• Derivative markets generally are more liquid than
  insurance markets.
• A liquid market exists when someone can sell or
  buy an asset quickly with little price
  concession.
• Factors affecting liquidity
• Moral hazard problems
• Need to monitor creditworthiness of counterparty

42
Comparison Of Derivatives Insurance

• When prices change, there tend to be winners and
  losers
• gt firm values often are negatively correlated
• gt risk can be eliminated with just two parties
• In contrast, the liability and property losses
  tend to be independent across firms.
• ? reduce risks by diversification with many
  participants
• ? Insurers need to hold capital, which adds to
  the cost of insurance

43
Comparison Of Derivatives Insurance

• Summary of Main Differences
• Characteristics Derivatives Insurance
• Type of risk hedged Market price risk Firm
  specific risk
• Contracting costs
• (due to moral
• hazard, illiquidity) Low High
• Basis risk High Low

44
Institutional Material

• Over-the-Counter versus Exchange Traded
  Derivatives
• An over-the-counter (OTC) transaction resembles a
  privately negotiated contract between two firms.
• Exchange traded derivatives are standardized
  contracts with the terms established by the
  exchanges.
• tend to be more liquid

45
Institutional Material

• The greater liquidity also is due in part to the
  method used to ensure performance.
• With OTC contracts, firms assess the default risk
  (or credit risk) prior to engaging in a contract
• With exchange traded contracts, default risk is
  reduced by using
• performance bonds, called margin
• daily marking to market

46
Institutional Material

• Example
• required margin 20 of the positions value
• value of position 1,000.
• you must post margin
• if futures price falls so the value equals 900
• amount lost on position is subtracted from margin
  
• gt you must add
• Margin and marking to market imply that you can
  trade anonymously, which increases liquidity.

47
Main Types of Risk Hedged with Derivatives

• Data from Bank of International Settlements for
  June 2002
• 
  Notional Principal
• Foreign exchange contracts
• Forwards swaps 14.6 trillion
• Options 3.4 trillion
• Interest rate contracts
• Forwards swaps 77.3 trillion
• Options 12.6 trillion
• Commodity contracts 0.8 trillion
• Equity contracts 2.2 trillion

48
Review Types of Personal Auto Coverage

• Third party liability
• First party medical payments
• In no-fault states PIP coverage for medical
  expenses and lost income
• Uninsured and underinsured motorists
• Physical damage

49
Review Material

• Chapters 13 14

50
Basic Part of Personal Auto Policy

• Part A Liability Coverage
• Part B Medical Payments Coverage
• Part C Uninsured Motorists Coverage
• Part D Coverage for Damage to Your Auto
• Part E Duties After an Accident or Loss
• Part F General Provisions

51
Liability Coverage

• Single limit known as a combined single limit
  
• Split limits
• Example
• 100,000 per person for bodily injury
• 300,000 per accident for bodily injury
• 50,000 per accident for property damage
• No annual aggregate limit

52
Liability Coverage

• Compulsory liability
• Most states make minimum limits mandatory
• Financial responsibility laws
• Penalize negligent drivers who cannot pay minimum
  damage amount
• All states have such laws
• Liability insurance satisfies laws

53
Liability Coverage

• Who is insured and when?
• Named insured plus
• resident spouse
• other family members
• others who use the covered auto with permission
• Covered auto is vehicle listed on the policy plus
• newly acquired vehicles
• temporary substitute vehicles

54
Medical Payments Coverage

• In tort liability states
• Optional
• Limits are generally low (e.g., 1,000 - 2,500)
• Payments regardless of fault
• Payments not coordinated with other medical
  expense insurance
• could collect twice

55
Medical Payments Coverage (cont.)

• Insured persons are
• Named insured and family members
• While occupying a motor vehicle
• When struck by a motor vehicle while walking
• Other persons while driving a covered auto

56
Medical Payments Coverage (cont.)

• In no-fault states
• Personal injury protection (PIP)
• Often compulsory
• Also provides limited loss of income coverage

57
Uninsured and Underinsured Motorists Coverage

• Coverage if liable party has no or insufficient
  coverage
• Coverage for all damages that otherwise would
  have been paid
• medical expenses
• lost income
• pain and suffering
• Compulsory in many states
• Applicants wishing to decline UM/UIM may be
  required to sign a waiver form.

58
Physical Damage Coverage

• Collision
• Covers damage from collisions and rollovers
• Other-than-collision (comprehensive)
• Covers damage from
• falling objects, explosions, glass breakage,
• earthquake, windstorms, hail,
• contact with an animal
• Deductibles generally used for both

59
Physical Damage Coverage (cont.)

• Payment of loss
• Company will pay the lesser of
• Actual cash value or,
• The cost to repair or
• The cost to replace
• Less any applicable deductible.
• Loss to a non-owned trailer is limited to 500

60
HO 3 Policy - Revisited