Risk management and insurance 2e scott harrington gregory niehaus solutions manual

Risk management and insurance 2e scott harrington gregory niehaus solutions manual 

Chapter 2

Solutions to Questions and Problems

 

1.    The cost of achieving zero risk is too high.

      

2a.	Worker Injuries:
	Cost of Risk Component		Specific Examples
	Expected losses		Expected workers’ compensation benefits (medical expenses, lost wages), expected employee replacement costs, expected lost productivity
	Residual Uncertainty		Reduction in value due to owners’ risk aversion; higher wages demanded by employees for the uncertainty associated with having uninsured losses from injuries
	Loss Control		Safety expenditures
	Loss Financing		Loading on workers’ compensation insurance premiums
	Internal Risk Reduction		Investments in information concerning the likelihood and severity of accidents.
2b. Expropriation by a foreign government:
		Cost of Risk Component	Specific Examples
		Expected Loss	Expected property losses, expected lost profits
		Residual Uncertainty	Reduction in value due to owners’ risk aversion
		Loss Control	Costs due to designing operations to reduce the probability of expropriation (e.g., having the facility produce an incomplete product, where completion requires expertise that the foreign country will find costly to obtain); costs of lobbying government officials
		Loss Financing	Loading on political risk insurance premiums
		Internal Risk Reduction	Costs due to inefficiencies associated with spreading facilities across different geographical areas

2c.	Demand Changes
	Cost of Risk Component	Specific Examples
	Expected Losses	Expected lost profits, expected severance pay, expected unemployment insurance costs, expected losses on sale of idle capacity
	Residual Uncertainty	Reduction in value due to owners’ risk aversion; higher compensation demanded by employees for the risk of losing their jobs
	Loss Control	Advertising costs to reduce preference changes
	Loss Financing
	Internal Risk Reduction	Costs of establishing production facilities in wine and soda

3a.        Businesses have incentives to make safe products if consumers are informed about the product's risk. Provided consumers are informed, the terms of sale will reflect the risk imposed on consumers, i.e., consumers will pay less for more risky products.  Consequently, reducing risk will increase product prices, all else equal.

3b.       Businesses have incentives to reduce the frequency and severity of worker injuries if employees are informed about the risk.  Reducing risk on employees will alter the terms of contract, i.e., labor costs will be lower, all else equal.  Also, worker injuries often disrupt operations.

3c.        Businesses have incentives to care for the environment to the extent that people who transact with the firm care about the environment and alter the terms at which they are willing to transact if the firm harms the environment.  For example, if consumers are willing to pay higher prices for products produced by firms that take care of the environment or if potential employees are willing to work at lower salaries at firms that take care of the environment, then firms will have an incentives not to pollute then environment.

4.         Mr. Fatcat will be motivated to operate the firm in the best interests of shareholders (as opposed to his own interests) because of the following forces:

The market for corporate control -- if Mr. Fatcat fails to maximize shareholder wealth then the firm will more likely be subject to a hostile takeover and the acquirer will likely replace Mr. Fatcat with a new manager.

The managerial labor market -- if Mr. Fatcat fails to maximize shareholder wealth, then he will likely have fewer opportunities for higher paying, more prestigious managerial positions.

Incentive contracts  -- the firm most likely will have incentive contracts that make Mr. Fatcat's compensation depend on the firm's performance and therefore motivate him to act to maximize shareholder wealth.

Legal duty to shareholders  -- under all state incorporation laws, managers have a legal duty to act in shareholders interests.  If they violate these duties, they can be sued by shareholders (see chapter 28).

            Monitoring by shareholders -- some shareholders (typically those with large stakes) have an incentive to monitor managers and to remove managers via the board of directors if managers do not act in shareholders' interests.

            Of course, these forces do not operate costlessly and perfectly.  Thus, managers will not always act in shareholders’ interest.

5.         Without a legal system that holds firms liable for the damage they impose on the environment, We-Dump-It may take too few precautions in disposing toxic substances.  In other words, the cost to society of dumping substances in a river could exceed the cost to We-Dump-It if the legal system did not impose liability.

6.         Since consumers prefer safer products, consumers are willing to pay higher prices for safer jet skis.  However, because of limited resources, the amount that consumers are willing to pay for additional safety is likely to diminish as safety increases.  For example, consumers might be willing to pay an extra $100 for a safety feature that reduces the likelihood of an accident from 0.0005 to 0.0003, but they might not be willing to pay an extra $100 for a safety feature that reduces the likelihood of an accident from 0.0003 to 0.0001.  Since consumers are willing to pay to some extent for additional safety, a manufacturer of jet skis would maximize profits by spending resources on design, production, and distribution to enhance safety to the extent that consumers are willing to pay for the additional safety.  The higher costs associated with making jet skis safer will in turn cause the price to increase.  These effects occur regardless of whether there is government regulation or product liability; however, these effects require consumers to be informed about product safety.

Value maximization can cause a manufacturer to consider the adverse effects of noise if communities adopt rules that prevent excessively noisy jet skis from being used in particular areas.  In this case, consumers who would like to use jet skis in the designated “quiet” areas will be willing to pay higher prices for quiet jet skis.  Without community action such as this, however, manufacturers may have little incentive to consider the effects of the noise on people that do not purchase jet skis (the users of beaches).

7.         While more extensive security checks of passengers and luggage can reduce the likelihood of terrorist acts, it is also costly.  Security checks can always be made more extensive (and thus air travel can be made safer), but the cost of the additional security checks must be compared to the benefits.  The costs include the costs of security personnel, security devices, passengers’ time, and the reduction in the demand for air travel (and thus greater use of automobile travel and the resulting increase in the number of injuries from automobile accidents).

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