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AFF9770 RISK FINANCING AND TREASURY

MANAGEMENT

ASSIGNMENT 1

TUTORIAL QUESTION

PREPARED BY:
ANKUR ARORA
ANKUR BHARGAVA
WAEL AL JABRI

WORD COUNT:
12th MAY2007.

20559313
19987366
19615043

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.

Effect of Insurance on Capital Structure

Paid-up Capital

Off-balance sheet

Paid-up Capital

Firm
Capital

Senior Debt

Potential
Risk

Contingent
Capital

Mezzanine finance
Equity

Firm
Risks

Transferable

Retained

Fig. 1

Effect of Insurance on Capital Structure

Off-balance sheet

Paid-up Capital

Firm
Capital

Senior Debt

Insurance

Contingent
Capital

Mezzanine finance
Equity

Firm
Risks

Transferred

Retained

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.