The focal point of this essay will be the way in which the strategic behavior of a firm can affect the entire market structure (demand, output and price) and how other firms in this structure react. The traditional factors that play a part in the purchasing on corporate insurance The first and foremost factor is limiting the risk of financial instability on shareholders. This factor was fundamental for the purchase of corporate insurance.
As time passed shareholders began to diversify their portfolio and in this way they reduced their risk, thus their behavior towards risk began to neutralist. The second factor is the principle agent problem that naturally arises between managers and stakeholders. Insurance allows for managers to be monitored, to make sure that certain targets are being reached, ensuring that through contractual agreements and warranties. Thus by managers reaching their targets corporate profits increase and managers are encouraged to keep attaining their target through a manager-remuneration program.
Studies have shown that most companies want to be fully insured and, employees reported that there will be an increase in net profits for the short term that follows the inoculation of insurance but in the long term profits will decrease due to the foreseen risks occurring. Companies like any other business entity are profit driven, thus a reduction in tax liability, a reduction in the expected financial costs of bankruptcy, the expected present value of future cash flows and cheaper premiums being offered because of underwriting cycles. These third, fourth, fifth and final factors make insurance very attractive to profit driven companies.
Oligopolies markets and the interdependency between firms in this market structure Companies like individual are used to making choices every day. The choices that are made by companies are of a more strategic nature, as companies form the pillars of the economic market structure. This market structure in most industries is an oligopolies market structure and will be the structure discussed in this essay. An oligopoly is characterized by the following: 1 . Few large firms compete by selling standardized or slightly differentiated products (products are perfect substitutes), 2.
Entry into the market is difficult as there are many barriers, 3. A firm has limited control over product price as, 4. Firms are interdependent (exceptions to this is when firms collude). These characteristics govern the way firms in an oligopoly behave. The most important characteristic is the interdependency between firms. Interdependency doesn’t allow for a firm decisions to be made in isolation, rather every decision made by one firm affects all the other firm’s decisions, their position in the market and in essence the entire market structure.
This concept can clearly be seen when one firm increases their output, thus lowering their product price. The other firms in the market will now be selling their product at a higher price as compared to first firm. Consumers wants the lowest possible price to maximizes heir utility thus their demand for the product will change. The effect of this is that, consumers will change to buying the lowest priced product or they will substitute the entire product group for another product group.
Firms faced with this problem of not knowing their competitors plans to change output, will try and gather as much information on these plans as possible. This information asymmetry can lead to errors resulting in a decrease in profits, as firms make assumptions as to what another firm might do, so they change their output, but the demand for their product has not increased. Thus the firm ends up losing rather gaining. This is an unlikely but possible scenario, as firms want to maximizes their profits thus they will only change their output when there is solid information, a good cause to change for or a change in costs.
Strategic behavior and the response to risk The oligopolies structure and the interdependency between firms means that the purchasing of corporate insurance and the management of corporate risks have strategic consequences for the entire market. The strategic decisions taken by a firm tend to alter the general management of the firm (the strategic sections govern the direction of the management, thus the each decision made will have its own set of management changes.
By purchasing corporate insurance there are three main ways in which strategic consequences flow from this action. Firstly due to the nature of a competitive market, risk-neutral firms will be incentives to purchase insurance to control risks, secondly a firms risk controlling decisions cannot be made in isolation due to the interdependency between firms and thirdly the purchasing of insurance as opposed to any other form of risk control, could potentially allow for competing firms to coordinate heir behavior to achieve mutual benefit.
In order to understand and predict what the response of firms competing in an oligopolies market structure to risk, a mathematical equation is added to the study of corporate insurance. This equation illustrates a situation where two risk neutral quantity setting duopolistic, labeled i=1,2 which are characterized by perfectly substitutable outputs, SQL and q, an inverse linear demand curve where price is a function of p=a-b (SQL + q) or where a,b>0. Both firms have production functions which display constant returns to a single input Uzi.
The populists are faced with the challenges of recurring duplicative technological risk whereby IQ=size with the restrictions of (random variables), a mean standardized to 1, a variance of O and co-variance (this determines the degree to which random variables tend to deviate from their expected value) of 012. These core assumptions govern the equations. Correlation co-efficient helps determine how to variables are related i. E. How two firms response to risk is related. Correlation co-efficient gets rid of units of measurements therefore making it a good measure to Use.
The unit cost of a single output Uzi is c for both rims the firms expected profits (profits is represented by n) is a function of the following equation: E (IQ, q)] -E taxi. Big. BBC q-CZ] for i-l, 2… ? (Equation 1) This equation can be broken down into its base equation which are as follows: E revenue- Total cost = (Price x Quantity) – Total cost = [a-b (SQL + q)] IQ – CZ for i-l, 2 Therefore going back to equation 1: E [in (SQL, q)] = [a-b (SQL + q)] IQ – CZ for i=l, 2 = [a-BBC-BBC] IQ – CZ = IQ-BBC IQ-BBC IQ – CZ If i=l the equation reads as follows: E [art (IQ, q)) = aqua-bibs-BBC IQ -CZ If i=2 the equation reads as follows:
E [TTL (q 1, q)] = aqua-BBC q-bibs -CZ We now explore the impact of the multiplicative technological risk whereby SQL- Uzi Ii. Note: We use for the rest of this essay to illustrate the principle of derivation. (IQ, q)] (Uzi Ii)-be (Uzi Ii) 2-be [Zeal, Z, Ii, Ii] -cal Now adding in the given mean standardized to 1 thus E (Q) iii = (X-IS) 2 iii (Ii -1)2 iii = E (Ii [As 2?=1] Therefore E (?2) = iii+ 1 and quiz (1) – biz (t]ii +1) – biz z E (Q, ?2) – CZ Restating the 1st derivation of equation 1: E [art (IQ, q)) = a (Uzi Ii)-be (Uzi Ii) 2-be [Zeal, Z, Ii, Eel -CZ And adding in the co- variance:
Covariance (01, 2)= E (Xi – U) (Xx – U)) = E (?1 -1) (?2-1) whereby 1. 1=1 = E (?1 ?2) -1-1+1 whereby ?i=l Therefore E (?1, ?2) = 01, 2 +1 (IQ, q)] = Aziza -CZ -b (C]ii +1) Uzi- b (POI, 2 +1) = (a – c) Uzi -b (IQ +1) Uzi – b (POI, 2 +1) Size E (IQ, (a – c) Uzi -b (њii +1) Uzi – b (POI, 2 +1) (Equation 2) Equation 2 illustrates that any technological risk negatively impacts upon firm in an oligopolies market in three main ways: 1. The output variation via the co-variance decreases the firms expected profits, 2.
These expected profits are decreased so much so that p is positive and 3. Technological risks and expected output of the firm’s rivals affect profits. Thus a firm which chooses to compete in a strategic manner (output decision are interdependent with the firm’s rivals) will be negatively impacted by any output fluctuations even though its stakeholders are not risk averse, will prefer certainty to technological risk. Strategic risk management and insurance decisions A firm/s will experience random fluctuations due to externalities (e. . Liability suits, theft, fires etc. ) and this will lead to variability in output (output risk). This variability allows for the disruption of the information gathering by competing rims and exposes these firms to a changing demand schedule (demand risk). These two effects of variability in output are seen as good for the firm even though revenues decline as essentially competitors do not know what the right decision to make regarding these changes is.
Now firms are faced with the choices of what strategic decisions to make, and given that firms most likely dislike risk, any strategy that’s effect is an increase in risk is not expected to be costless. (The costs associated with an increase in the output risk are more often than not less that costs associated with an increase in the variability of demand. There exists a negative relationship between price and output and this allows a firm which exposes itself to the output risk to maintain a fairly stable line of income because the change in output is offset with the change in price.
Firms have various risk management policies, and by the nature of competition, one firm is always trying to see what another firm’s management policy is. Firms in this situation tend to have two main risk management strategies: risk, certainty and a combination of both. To illustrate this concept and its outcome, the two identical duopolistic play a non-cooperative game of complete wintertime information where the parties choose between the two option of risk and certainty.
The payoffs in this game could represent a number of things but are most likely to be expected future profits or expected future utilities. Table 1 : The management game played by the two duopolistic FIRM 1 Certainty Risk To achieve a possible equilibrium where the firm/player wants to change from its past strategies to a new strategy which takes into account the strategy of its rivals (according to a Court-Nash equilibrium), only the pure strategy choices are looked at below. 1 .
Certainty Equilibrium- Firms will both choose certainty irrespective of the others decision and will thus earn a higher payoff, if C>B and A>R (Nash equilibrium: Certainty; Certainty. ) 2. Risk Equilibrium- Both firms will choose not to remove/control the risk, irrespective of the decision of the other firm, and ill arise if B>C and R>A. (Nash equilibrium: Risk; Risk) 3. War Equilibrium-: Risk War Equilibrium- This equilibrium will only arise if B>C>R>A (Nash equilibrium: Risk; Risk). This equilibrium is where firms compete to behave as risky as possible.
Certainty War equilibrium-This equilibrium will only arise if In both the war equilibriums firms will be better off if they devise a coordinating strategy as dominating equilibrium yields a Parent inferior solution (in which one firm cannot be made better off without the other firm being made worse off). This can be avoided if the firms form a binding agreement to choose the Parent superior strategy. 4. Coordination equilibrium-This will arise if the game has two identical Nash equilibrium (e. G. And thus the equilibrium will be (Certainty; Certainty) and (Risk; Risk).
In such circumstances achieving a Parent superior equilibrium could well require the use of mediators or means of communication. There are two important characteristics that can be found in the above discussion. Firstly; firms are risk averse so they would like to always choose Certainty over Risk, but due to the interdependency between firms this is not always possible thus the risk strategy that is best for a firm cannot be made in isolation from its rivals and secondly; firms may decide to agree to choose the Parent superior strategy only if their actions are communicate to each other.
The usage of insurance companies and agents of the firm (including but are not limited to these two 3rd parties) will often serve to watch over the firms and ensure they stick to their agreements. Strategic Reasons for the purchase of insurance The traditional reasons for the purchase of corporate insurance play a major part in choosing whether to purchase or not to purchase insurance in a corporate environment (examples are found in the above discussion on traditional reasons to purchase insurance).
More and more reasons are emerging from the market as to the additional strategic benefits of purchasing insurance. Some of these will be discussed below. Insurance as a mean of gaining strategic advantage Firms cannot choose certainty and hope their rivals choose risk or choose sis and hope their rivals will also choose risk, because the firms are all interdependent on each other’s decisions.
Thus by having insurance both firms can choose a Nash equilibrium certainty (Certainty; Certainty) and will earn the greatest payoff possible for them even though A>R>C (Refer to table 1) Insurance as a means of avoiding risk wars Risk wars are costly to all parties involved as they cause price fluctuation, decreases in output which lead to profit fluctuations and thus firms are unhappy. Firms might also agree to follow a certain strategy but then later decide not to. This arises from the concept of what’s best for the group is not best for an individual firm and thus they may break the agreement.
Insurance serves to: monitor firm’s behavior as changes in risk associated behavior leads to and increase/decrease in premiums which underwriters monitor and assess, prevent risky behavior by incentives managers to implement risk control measures and, by insurance contract being governed by the law of contract which emphasized warranty and utmost good faith, any deviation in disclosure of material terms may be punishable by claims not being paid out or facing legal proceedings. There are various problems which are associated with insurance as a means of avoiding risk wars these are: 1.
Insurance premiums are based on past experiences of an insurance company with a firm. A firm may choose to purchase insurance but then after purchasing, increase their risky behavior and it takes some time for insurance companies to note this change. Insurance also brings about the concept of moral hazard, which increases a firm’s incentive to cheat. 2. Firms like individuals suffer from the problem of, “you move first then I’ll move”, and while firms may agree to purchase insurance the advantages of to purchasing insurance may deter firms from making the first move. 3.
Due to corporate insurance coverage being highly complex and detailed firms may find it hard to communicate their exact insured position to other firms, and thus in times of loss they may be able to down play their actual loss which is hedged by the insurance company. There are some solutions to the above three problems that are associated with insurance as a means of avoiding risk wars and these are: 1. Firms over time and experience tend to choose the outcome that is best for all the parties involved, as failure to do so will result in long term losses room risk wars.
Thus firms will purchase insurance and ensure that this is communicated to all the other parties. 2. Statute, laws, suppliers and creditors can require that firms insure against certain perils (e. G. Workman’s compensation, Insurance against bankruptcy etc. ) 3. Firms may all choose to work with one insurance company, as they will monitor all the firm’s behavior and ensure it is all in accordance with their agreement and that firms are well aware of each others agreements.
An alternative to insurance that could also decrease the chances of risk wars is he formation of captive insurance companies, which require the withdrawing firm to give notice to the captive of its intentions thus it solves the ‘You first” problem. Insurance as a means of achieving equilibrium In the game of certainty and risk, often there is one strategy that is seen as the ultimate strategy and this is known as the Shelling focal point. If firms cannot agree on a focal point then a mediator may step in and suggest an equilibrium that is best for all the players involved.
The natural role for a mediator is an insurance broker or a risk management consultant as the mediator must have extensive knowledge of the aspects of the firms and will make a decision that is best for all of them. Conclusion The purpose of this essay was to discuss whether in today’s market which is comprised of many oligopolies in different industries, whether the corporate demand for insurance may be motivated by a company’s strategic decisions on output and price risk, and in conclusion they can be motivated by price and output.
Despite the world changing and the insurance market developing every second, the traditional reasons regarding why firms purchase corporate insurance have remained mostly the same. What has occurred is due to he passing of time and the gaining of experience firms are now seeing that insurance can function as a strategic tool in making decisions that affects not only the firm but the entire oligopolies market structure. Firms can now use this to their advantage.
The three main ways in which the strategic behavior of a firm may affect risk management and the purchase of insure are as follows: the strategic nature of competition may provide an incentive for risk neutral firms to consider purchasing insurance, no single firms decision can be made in isolation due to firms being in oligopolies market structure which is characterized by interdependency between firms and insurance as opposed to other means of risk control can also allow for firms to coordinate their behavior to achieve the best possible strategy and result for the entire market.
