The third type of contract is the insurance contract, designed to help avoid the financial consequences of risk7. The risk adverse transactor pays a premium in order to shift the risk to another party. The best example is insurance company premiums, paid in return for possible compensation if the risk fails. The risk borne by the lender remains high, as they are the party taking responsibility for a probability of failure.
To the lender the benefits of this would be the potential profits gained if success is achieved, if the insurance policy is never called in. The risk borne by the borrower or transactor is initially high, but immediately shifted onto the lending agent when contract is accepted. For the risk averter this type of contract is a direct reflection of the theory that risk may be considered if the compensation is high enough. The bearer of the risk, the agent, is paid heavily for removing that responsibility from transactor. The agents may be averters of risk, but if potential capital gain is high enough the risk is taken.
The value of insurance can be determined through examining the utility function of the transactor. This will show the level of compensation needed in order to encourage the investor to take the risk. In the case of the risk averse, this function is convex and upward sloping, reflecting diminishing marginal utility as risk increases. By taking out an insurance policy the investor increases his total utility, through avoiding the risk of total loss. The insurance policy simply charges the difference between maximum utility with no insurance and the higher utility that carries lower risk with insurance.
Insurance and debt contracts hold the same ability to incorporate expected default risk in the charge made for the loan or the insurance. However, while a premium is charged for expected risk, no such charge can be made for unexpected risk. This risk is taken from the borrower through the rates he pays, but is born by the insurer or lender. The premium level must reflect this shift of risk in order to make accepting the risk potentially worthwhile. No matter how well the risk is valued the danger of unexpected losses will exist. The lender or insurer is compensated for this uncertainty through higher premiums.
The lender or insurer averts his risk through diversification. He uses the capital gained from borrowers, takes responsibility for the risk and averts from that risk through spreading it across a wide number of investments. Insurance policies attract averters, despite the fact that the risks involved are often high because the compensation is also high. The borrower is compensated through insurance, paying a premium to remove the risk. The lender is compensated through potential capital gain if failure is avoided and through spreading the risk from himself by investing its capital in a range if projects, across a range of industries and economic sectors.
Diversification plays a very important role through which deposit taking institutions limit the risk of loss in all types of contract. It can be defined as ‘the spreading of business risks by reducing dependence on one product or market’8. It is undertaken in order to improve prospects of a high rate of return and reduce prospects of loss. Diversification appeals to the risk averter as it reduces risk. An investor will chose to spread his capital across more than one of the contracts discussed.
His risk appetite may vary between each type of contract, depending on the capital involved and the expected return. Highly averse to risk, the bulk of capital may be placed in an insurance contract. With what is left risk appetites may increase and equity or debt contracts used. With more certain returns on most of his capital, the averter maybe more willing to accept risks on the smaller part of capital. In this way diversification allows overall risk to be reduced, with maximum possible returns. Achieving an adequate spread of risk is achieved not only by making a large number of loans, but also by trying to ensure loans are not concentrated to heavily in any single activity or sector.
The appetite of the risk averter and need for portfolio diversification can be explained by looking at the theory of liquidity preference. This theory explains that investors require extra return for lending in the long-term compared to short term. This is because the level of unexpected risk increases with the length of the investment. The developed theory supports the need to diversify risk and illustrates why uncertainty may be avoided.
In Keynesian analysis investors were treated as holding confident expectations on potential gain on risky assets9. The decision to hold in risky or safe assets depended simply on which gave a greater return. This gives no explanation of portfolio diversification, undertaken to spread a risk that the certainty in Keynes theory eliminated. The choice of asset depended on the investor’s expectations rather than uncertainty. Keynes assumed that investors expected future rises in rates, and therefore capital losses, encouraging them towards safer assets. This explained the downward sloping liquidity preference curve. With such certainty in the future there appeared no reason to diversify in order to spread risk, as in the long term safe assets will provide a ‘normal’ level of return.
The assumption of certainty clearly can not hold true, so Tobin reformed the liquidity theory to make it more general and link it firmly to uncertainty about future asset prices. This provides a theoretical support for the idea of portfolio diversification. In this theory diversification is the result of different investor’s future expectations, particularly at the individual level. The certainty of Keynes, based on the past, can only be short term, so the long term remains uncertain. This being the case, Tobin is consistent with the practice that those averse to risk will diversify across as wide a portfolio as possible in order to lessen the risk in risky assets.
The principle underlying our discussion is that the risk averter requires an increasing return to compensate for an increase in risk. This is represented in the upwards sloping indifference curves and convex utility function10. The indifference curve shows a set of combinations of risk and return that is acceptable to the investor11. The positive slope of this curve reflects the fact risk averse investors will only accept an increase in risk if there is sufficient increase in expected return; they have a diminishing marginal utility for money. The greater the investor’s absolute risk aversion, the steeper the indifference curve. The indifference curve of a business is likely to be shallower than that of an individual, as businesses tend to own more capital, enabling them to absorb any loss caused by taking risks. The utility function is similar, representing preferences over distribution of risk and return. The convex shape reflects the reluctance to increase risk as returns increase
It is a necessary condition of any potentially profitable investment that risk exists. People and institutions can not eliminate this risk and expect any reasonable return, but those averse to it can ensure they are compensated increasingly and fairly for the risks they do choose to take. Many different options exist for an investor entering the financial market, depending on the risk they are willing to take. For those averse to risk the attractiveness of each contract depends upon the probability of potential losses occurring, and the compensation they receive for taking that risk. All investors seek to make maximum returns, so even the risk averse will take the necessary risks to ensure money is made.
Pilbeam K, (1998) Finance and Financial Markets Palgrave, Hampshire
Bain A D, (1991) The Economics of the Financial System Basil Blackwell Ltd, Oxford
Goodhart C A E, (1991) Money Information and Uncertainty 2nd Houndsmill, Hampshire
Smith P F, (1971) Financial Institutions and Markets USA