Colleen Mansfield Class Prep September 3, 2013

1. hedging completely eliminating exposure, both upside and downside Insurance protection against the financial effects of unfavorable events, but leaves exposed party with the potential to benefit from favorable events Diversification holding a large collection of imperfectly-correlated assets to average out exposures not common to the pool

2. if one firms shares were worth more than another, identical firm due to hedging activity, an arbitrage opportunity would exist and the price would quickly even out as those opportunities were taken advantage of.

3. transferring risk to an insurance company entails administrative and overhead costs sales personnel, underwriters, appraisers, adjusters, lawyers, etc. A firms desire to buy insurance may signal that it has above-average risk, so insurance companies must be compensated for adverse selection. Insurance reduces the firms incentive to avoid risk, a change in behavior known as a moral hazard (ex: insurance fraud). Adverse selection and moral hazard costs are mitigated by screening applicants and investigating losses. Policies are structured with a deductible (initial amount of the loss thats not covered by insurance) and policy limits (limits the amount of the loss that is covered regardless of the extent of the damage). It gives the firm an incentive to avoid loss.

4. bankruptcy and financial distress costs when a firm borrows, it increases its chances of experiencing financial distress Issuance costs when a firm experiences losses, it may need to raise cash from outside investors Tax rate fluctuations when a firm is subject to graduated income tax rates, insurance can produce a tax savings if the firm is in a higher tax bracket when it pays the premium than the tax bracket it is in when it receives the insurance payment in the event of a loss Debt capacity firms limit their leverage to avoid financial distress costs Managerial incentives insurance turns the firms earnings and share price into informative indicators of managements performance, allowing the firm to increase its reliance on these measures as a part of performance-based compensation without exposing managers to unnecessary risk Risk assessment insurance companies may be better informed about the extent of certain risks faced by the firm than the firms own managers, and could therefore benefit the firm by improving investment decisions.