CHAPTER 8: RISK RETENTION/REDUCTION DECISIONS

click to edit

RISK RETENTION (Part 1) ⭐ Decision to accept the uncertainty associated with particular risk exposure.

FACTORS AFFECTING COST INCREASED RETENTION

RISK REDUCTION ⭐ Decision to reduce uncertainty.

✅ Reduce exposure to insurance
market volatility.

✅ Reduce moral hazard.

✅ Avoiding implicit taxes due to
insurance price regulation.

✅ Maintain use of funds.

✅ Avoid high premiums caused by
asymmetric information.

Product characteristics ❌

Correlation of losses with other cash flows ❌

Financial leverage ❌

Investment opportunities ❌

Correlation of losses with investment opportunities ❌

Correlation of losses ❌

Disaggregated VS Aggregated Approach

Unnecessary coverage argument ♻

Complexity problem ♻

Transaction Cost ♻

Moral hazard problem ♻

click to edit

HEDGING WITH DERIVATE CONTRACTS (PART 2)
⭐ Contract with payoff derived from the value of some other asset or index.

⭐ The asset on which the derivative contract is based called as "UNDERLYING ASSET"

⭐ Examples types of risk that are hedged:-
--> Commodity prices
--> Interest rates
--> Exchange rates

click to edit

A contract between 2 parties in which buyer has a right but not the obligation to buy or sell a specified asset at a specified at or before specified date from seller.

A contract between 2 parties to buy/sell an asset in future date but a price is determine today.
Equal to the difference between the actual price of the underlying asset and some pre-determined price.
It is called "Forward Price/Future Price".

click to edit

Transaction between 2 parties simultaneously exchange cash flow. The rate at which the amounts are exchange is predetermined based on either a fixed amount/amount to be based on a reference measure.
Swap contracts are a series of forward contracts.

COMPARISON OF DERIVATIVES & INSURANCE

✅ Basis risk and extent of risk reduction

✅ Liquidity

✅ Market price Vs. Specific losses

✅Contracting cost

BENEFITS