Tag: risk

17 February 20143 February 2019

Flooding the insurance market

Britain has faced some its worst ever weather, with thousands of homes flooded once again, though the total number of flooded households has fallen compared to previous floods. However, for many households, it is just more of the same – if you’ve been flooded once, you’re likely to be flooded again and hence insurance against flooding is essential. But, if you’re an insurance company, do you really want to provide cover to a house that you can almost guarantee will flood?

The government has pledged thousands to help households and businesses recover from the damage left by the floods and David Cameron’s latest step has been to urge insurance companies to deal with claims for flood damage as fast as possible. He has not, however, said anything regarding ‘premium holidays’ for flood victims.

The problem is that the premium you are charged depends on many factors and one key aspect is the likelihood of making a claim. The more likely the claim, the higher the premium. If a household has previous experience of flooding, the insurance company will know that there is a greater likelihood of flooding occurring again and thus the premium will be increased to reflect this greater risk. There have been concerns that some particularly vulnerable home-owners will be unable to find or afford home insurance.

The key thing with insurance is that in order for it to be provided privately, certain conditions must hold. The probability of the event occurring must be less than 1 – insurance companies will not insure against certainty. The probability of the event must be known on aggregate to allow insurance companies to calculate premiums. Probabilities must be independent – if one person makes a claim, it should not increase the likelihood of others making claims.

Finally, there should be no adverse selection or moral hazard, both of which derive from asymmetric information. The former occurs where the person taking out the insurance can hide information from the company (i.e. that they are a bad risk) and the latter occurs when the person taking out insurance changes their behaviour once they are insured. Only if these conditions hold or there are easy solutions will the private market provide insurance.

On the demand-side, consumers must be willing to pay for insurance, which provides them with protection against certain contingencies: in this case against the cost of flood damage. Given the choice, rational consumers will only take out an insurance policy if they believe that the value they get from the certainty of knowing they are covered exceeds the cost of paying the insurance premium. However, if the private market fails to offer insurance, because of failures on the supply-side, there will be major gaps in coverage.

Furthermore, even if insurance policies are offered to those at most risk of flooding, the premiums charged by the insurance companies must be high enough to cover the cost of flood damage. For some homeowners, these premiums may be unaffordable, again leading to gaps in coverage.

Perhaps here there is a growing role for the government and we have seen proposals for a government-backed flood insurance scheme for high-risk properties due to start in 2015. However, a loop hole may mean that wealthy homeowners pay a levy for it, but are not able to benefit from the cheaper premiums, as they are deemed to be able to afford higher premiums. This could see many homes in the Somerset Levels being left out of this scheme, despite households being underwater for months. There is also a further role for government here and that is more investment in flood defences. If that occurs though, where will the money come from? The following articles consider flooding and the problem of insurance.

Articles

Insurers urged to process flood claims quickly BBC News (17/2/14)
Flood area defences put on hold by government funding cuts The Guardian, Damian Carrington and Rajeev Syal (17/2/14)
Flooding: 200,000 houses at risk of being uninsurable The Telegraph (31/1/12)
Govt flood insurance plan ‘will not work’ Sky News (14/2/14)
Have we learned our lessons on flooding? BBC News, Roger Harrabin (14/2/14)
ABI refuses to renew statement of principles for flood insurance Insurance Age, Emmanuel Kenning (31/1/12)
Wealthy will have to pay more for flood insurance but won’t be covered because their houses are too expensive Mail Online, James Chapman (7/2/14)
Buyers need ‘flood ratings’ on all houses, Aviva Chief warns The Telegraph, James Quinn (15/2/14)
Wealthy homeowners won’t be helped by flood insurance scheme The Telegraph(11/2/14)
Costly insurance ‘will create flood-risk ghettos and £4.3tn fall in house values’ The Guardian, Patrick Wintour (12/2/14)
Leashold homes face flood insurance risk Financial Times, Alistair Gray (10/2/14)

Questions

Consider the market for insurance against flood damage. Are risks less than one? Explain your answer.
Explain whether or not the risk of flooding is independent.
Are the problems of moral hazard and adverse selection relevant in the case of home insurance against flood damage?
To what extent is the proposed government-backed flood insurance an equitable scheme? Should the government be stepping in to provide insurance itself?
Should there be greater regulation when houses are sold to provide better information about the risk of flooding?
Why if the concept of opportunity cost relevant here?
How might household values be affected by recent floods, in light of the issues with insurance?

5 August 201312 October 2013

Zero-hours contracts: the ultimate flexible labour market?

Despite the prolonged stagnation in the UK, unemployment has not soared. In fact, over the past two years the ILO unemployment rate (see here for a definition) has fallen slightly – from 8.6% in October 2011 to around 8.0% today. What is more, the claimant count rate is considerably lower than the ILO rate – at around 4.4%.

Part of the reason for the relatively good unemployment figures is the rise in ‘zero-hours contracts’. These allow employers to cut the hours that people work without laying them off. The Office for National Statistics estimates that last year (2012) 250,000 people, or 0.84% of the workforce, were on such contracts.

But just what is meant by ‘zero-hours contracts’? According to the ONS:

People on zero-hours contracts are classified as being in employment regardless of the number of hours they actually worked during the survey reference week. This includes anyone who was not required to work any hours during the reference week whilst remaining on their current contract of employment. The continued existence of the contract of employment is the key determinant of their employment status in these situations.

If people are working less than they would like to, this is classified as underemployment, but such people do not appear in the unemployment statistics. Such contracts thus mask the true extent of surplus labour in the economy.

The Chartered Institute of Personnel and Development (CIPD) puts the figure much higher than the ONS. In the Summer 2013 issue of its Labour Market Outlook, it estimates that one million workers are on zero-hours contracts.

Many employers use such contracts, including many voluntary-sector and public-sector organisations, including the NHS, local councils and Buckingham Palace. They are also used by many small and medium-sized enterprises and many well-known large companies, such as Sports Direct, Amazon, JD Wetherspoon and Cineworld. It gives them the flexibility to adjust the hours they employ people. It allows them to keep people in employment when demand is low. It also makes them more willing to take on staff when demand rises, as it removes the fear of being over-staffed if demand then falls back.

But many workers dislike such contracts, which give them fewer employment rights and fewer hours than they would like to work. It also makes it difficult to budget when future income is uncertain. It also make credit and mortgages harder to obtain, as people have no guaranteed income. Another complaint is that companies may use the threat of lower hours as a tool to bully staff and get away with poorer working conditions.

In May of this year, the Business Secretary, Vince Cable, announced that he was setting up a review of zero hours contracts.

Note that zero hours are not the only form of flexible working. Other examples include: ‘self-employed’ workers, contracted separately for each job they do for a company; people paid largely or wholly on commission; on-call working; part-time working, where the hours are specified in advance, but where these are periodically re-negotiated; overtime; people producing a product or service for a company (perhaps at home), where the company varies the amount paid per unit according to market conditions.

The following videos and articles look at the issue in some detail: at the extent of the practice and at its benefits to employers and its costs (and some benefits) to workers. Both The Guardian and the BBC have an extensive range of articles on the topic.

Webcasts

Do zero hours contracts create real jobs? BBC Newsnight, Allegra Stratton (14/8/12)
Record number of ‘Zero Hours Contracts’ ITV News on YouTube, Laura Kuenssberg (2/5/13)
Britons rally against ‘Zero Hour’ contracts Al Jazeera on YouTube (4/8/13)
Anger at Amazon working conditions Channel 4 News (1/8/13)
Government to include Amazon in its zero hours probe Channel 4 News (2/8/13)
Councils using zero hours contracts BBC London, Warren Nettleford (31/7/13)

Podcasts

The real economy: Labour market BBC Today Programme, Evan Davis (24/8/11)
Zero hour contracts ‘just the norm’ BBC Today Programme, Rochelle Monte and Peter Cheese (5/8/13)

Articles

Zero-hours contracts: One million British workers could be affected Independent, Nigel Morris (5/8/13)
Zero hours contracts “spreading like wildfire”, official stats show Union News, Pete Murray (1/8/13)
Zero-hours contracts: what are they? The Guardian, Phillip Inman (30/7/13)
Buckingham Palace uses zero-hours contracts for summer staff The Guardian, Simon Neville, Matthew Taylor and Phillip Inman (30/7/13)
Nick Clegg: business department will investigate zero-hours contracts The Guardian,
Patrick Wintour, Simon Neville, Matthew Taylor and Phillip Inman (31/7/13)
Zero-hours contracts are not unavoidable The Guardian, Phillip Inman (1/8/13)
ONS admits it underestimated number of zero-hours contracts The Guardian, Simon Neville (1/8/13)
Zero-hours contract workers – the new reserve army of labour? The Guardian, Philip Inman (4/8/13)
Zero-hours contracts cover more than 1m UK workers The Guardian, Simon Goodley and Phillip Inman (5/8/13)
Zero-hours contracts use by councils needs to be moderated The Guardian, Vidhya Alakeson (5/8/13)
If zero-hours contracts are driving this ‘recovery’, it’s a lousy kind of recover The Guardian, Deborah Orr (9/8/13)
ONS increases its estimate of workers on zero hours contracts Financial Times, John Aglionby (1/8/13)
Zero Hours Herald Scotland, Ian Bell and Scott Dickson (4/8/13)
Sports Direct protests planned over zero hours contracts Channel 4 News (3/8/13)
Cable warns of exploitation of zero-hours contracts BBC News (5/8/13)
Q&A: What are zero-hours contracts? BBC News (5/8/13)
Record number of 16-24s on zero hours contracts at work BBC Newsbeat, Jim Reed (15/5/13)
Figures show 18-24s most likely on zero-hours contract BBC Newsbeat, Jim Reed and Amelia Butterly (5/8/13)
Andy Burnham calls for ban on zero hours contracts BBC News (28/4/13)
Zero-hours contracts: What is it like living on one? BBC News, Sean Clare (5/8/13)
Small Talk: Zero-hours contracts? Key for growth Independent, David Prosser (5/8/13)
Zero Hour Contracts Manchester based law firm, Emma Cross (30/7/13)

Data

People and proportion in employment on a zero-hour contract ONS (31/7/13)
Estimating Zero-Hour Contracts from the Labour Force Survey ONS (26/7/13)
One million workers on zero hours contracts, finds CIPD study CIPD, Michelle Stevens (5/8/13)
Labour Market Outlook CIPD

Questions

Distinguish between open unemployment, disguised unemployment and underemployment?
Distinguish between functional, numerical and financial flexibility? Which type or types of flexibility do zero-hours contracts give the firm?
Identify the various benefits to employers of zero-hours contracts?
What are the costs and benefits to workers of such contracts?
Identify what forms of flexible contracts are used for staff in your university or educational establishment. Do they benefit (a) staff; (b) students?
Are zero-hours contracts fair?
In what ways do zero-hours contracts transfer risks from employers to employees?
If a company introduces a system of zero-hours contracts, is this in accordance with the marginal productivity theory of profit maximisation from employment?
From the perspective of the employer, how do the benefits of zero-hours contracts compare with other forms of flexible working?
Consider the arguments for and against (a) banning and (b) regulating zero-hours contracts.

20 July 201320 July 2013

The London Olympics legacy: a cost–benefit analysis

Did the benefits of the London Olympics outweigh the costs? The government’s UK Trade and Industry (part of the Department of Business, Innovation & Skills) has just published a report, London 2012, Delivering the economic legacy, which itemises the economic benefits of the games one year on. It claims that benefits to date are some £9.9 billion.

This compares with costs, estimated to be somewhere between £8.9 billion and £9.3 billion, although this figure does not include certain other costs, such as maintenance of the stadium. Nevertheless, according to the figures, even after just a year, it would seem that the Games had ‘made a profit’ – just.

The £9.9 billion of benefits consist of £5.9 billion of additional sales, £2.5 billion of additional inward investment and £1.5 billion of Olympic-related high value opportunities won overseas. Most of these can be seen as monetary external benefits: in other words, monetary benefits arising from spin-offs from the Games. The ‘internal’ monetary benefits would be largely the revenues from the ticket sales.

In a separate report for the Department of Culture, Media & Sport, Report 5: Post-Games Evaluation, it has been estimated that the total net benefits (net gross value added (GVA)) from 2004 to 2020 will be between £28 billion and £41 billion.

But benefits are not confined just to internal and external monetary benefits: there are also other externalities that are non-monetary. The Culture, Media & Sport report identified a number of these non-monetary externalities. The Summary Report itemises them. They include:

• The health and social benefits of more people participating in sport
• Inspiring a generation of children and young people
• A catalyst for improved elite sporting performance in the UK
• Setting new standards for sustainability
• Improved attitudes to disability and new opportunities for disabled people to participate in society
• Greater social cohesion as communities across the UK engaged with the Games
• Increased enthusiasm for volunteering
• Accelerated physical transformation of East London
• Beneficial socio-economic change in East London
• Important lessons learned for the co-ordination and delivery of other large-scale public and public/private projects

But with any cost–benefit analysis there are important caveats in interpreting the figures. First there may be monetary and non-monetary external costs. For example, will all the effects on social attitudes be positive? Might greater competitiveness in sport generate less tolerance towards non sporty people? Might people expect disabled people to do more than they are able (see)? Second, the costs generally precede the benefits. This then raises the question of what is the appropriate discount rate to reduce future benefits to a present value.

Perhaps the most serious question is that of the quantification of benefits. It is important that only benefits that can be attributed to the Games are counted and not benefits that would have occurred anyway, even if connected to the Games. For example, it is claimed in the UK Trade & Industry report that much of the Olympic park and stadium for the Winter Olympics in Russia was “designed and built by British businesses”. But was this the direct result of the London Olympics, or would this have happened anyway?

Another example is that any inward investment by any company that attended the London Olympics is counted in the £2.5 billion of additional inward investment (part of the £9.9 billion). As the London Evening Standard article below states:

In London, it credited the Games with helping seal the deal for the £1.2 billion investment in the Royal Albert Docks by Chinese developer ABP, the £1 billion investment in Croydon by Australian shopping centre developer Westfield with UK firm Hammerson and the £700 million investment in Battersea Nine Elms by Dalian Wander Group.

It is highly likely that some or all of these would have gone ahead anyway.

Then there are the £5.9 billion of additional sales. These are by companies which engaged with the Olympics. But again, many of these sales could have taken place anyway, or may have displaced other sales.

Many cost–benefit analyses (or simply ‘benefit analyses’) concern projects where there are strong vested interests in demonstrating that a project should or should not go ahead or, in this case, have gone ahead. The more powerful the vested interests, the less likely it is that the analysis can be seen as objective.

Questions

Distinguish between gross and net benefits; monetary and non-monetary externalities; direct costs (or benefits) and external costs (or benefits).
How should the discount rate be chosen for a cost–benefit analysis?
Give some examples of monetary and non-monetary external costs of the Games.
What are the arguments for and against including non-monetary externalities in a cost–benefit analysis?
Why might the £9.9 billion figure for the monetary benefits of the Games up to the present time be questioned?

20 June 20134 July 2013

The capital adequacy of UK banks

The Prudential Regulation Authority is the new UK authority in charge of banking regulation and is part of the Bank of England. In a report published on 20/6/13, the PRA found that UK banks had a capital shortfall of £27.1 billion (see Chart 1 below for details) if they were to meet the 7% common equity tier 1 (CET1) ratio: one of the capital adequacy ratios (CARs) specified under the Basel III rules (see Rebuilding UK banks: not easy to do and Chart 2 below).

CET1 includes bank reserves and ordinary share capital (‘equities’). To derive the CET1 ratio, CET1 is expressed as a percentage of risk-weighted assets. As Economics for Business (6th ed) page 467 states:

Risk-weighted assets are the total value of assets, where each type of asset is multiplied by a risk factor. …Cash and government bonds have a risk factor of zero and are thus not included. Inter-bank lending between the major banks has a risk factor of 0.2 and is thus included at only 20 per cent of its value; residential mortgages have a risk factor of 0.35; personal loans, credit-card debt and overdrafts have a risk factor of 1; loans to companies carry a risk factor of 0.2, 0.5, 1 or 1.5, depending on the credit rating of the company. Thus the greater the average risk factor of a bank’s assets, the greater will be the value of its risk weighted assets, and the lower will be its CAR.

The data published by the PRA, based on end-2012 figures, show that the RBS group is responsible for around 50% of the capital shortfall, the Lloyds Banking Group around 32%, Barclays around 11%, the Co-operative around 5.5% and Nationwide the remaining 1.5%. HSBC, Santander and Standard Chartered met the 7% requirement. The PRA found that banks already were taking measures to raise £13.7bn, but this still leaves them requiring an additional £13.4 for current levels of lending.

So what can the banks do? They must either raise additional capital (the numerator in the CAR) or reduce their risk-weighted assets (the denominator). Banks hope to be able to raise additional capital. For example, Lloyds is planning to sell government securities and US mortgage-backed securities and hopes to have a CET1 ratio of around 10% by the end of 2013. Generally, the banks aim to raise the required level of capital through income generation, the sale of assets and restructuring, rather than from issuing new shares.

What both the Bank of England and the government hope is that banks do not respond by reducing lending. While that might enable them to meet the 7% ratio, it would have an undesirable dampening effect on the economy – just at a time when it is hoped that the economy is starting to recover. As Robert Peston states:

I understand that both Barclays and Nationwide feel a bit miffed about being forced to hit this tough so-called leverage ratio at this juncture, because they are rare in that they have been supporting economic recovery by increasing their net lending.

They now feel they are being penalised for doing what the government wants. So I would expect there to be something of a spat between government and regulators about all this.

Articles

Factbox – Capital shortfalls for five UK banks, mutuals Standard Chartered News (20/6/13)
UK banks ordered to plug £27.1bn capital shortfall The Guardian, Jill Treanor (20/6/13)
Barclays, Co-op, Nationwide, RBS and Lloyds responsible for higher-than-expected capital shortfall of £27.1bn The Telegraph, Harry Wilson (20/6/13)
UK banks need to plug £27bn capital hole, says PRA BBC News (20/6/13)
Barclays and Nationwide forced to strengthen BBC News, Robert Peston (20/6/13)
Five Banks Must Raise $21 Billion in Fresh Capital: BOE Bloomberg, Ben Moshinsky (20/6/13)
Will Nationwide be forced to become a bank? BBC News, Robert Peston (4/7/13)

PRA news release and data
Prudential Regulation Authority (PRA) completes capital shortfall exercise with major UK banks and building societies Bank of England: Prudential Regulation Authority (20/6/13)

Questions

Explain what are meant by the various Basel III capital adequacy requirements
What are the banks which were identified as having a capital shortfall doing about it?
Would it be desirable for banks to issue additional shares? Would this make the banks more secure?
Would the raising of additional capital allow additional credit creation to take place? Explain.
What other constraints are there on bank lending?

21 March 20138 October 2014

Going nuclear

The UK government has just given the go-ahead for the building of two new nuclear reactors at Hinkley Point in Somerset. The contract to build and run the power station will go to EDF, the French energy company.

The power station is estimated to cost some £14 billion to build. It would produce around 7% of the UK’s electricity. Currently the 16 nuclear reactors in the UK produce around 19%. But all except for Sizewell B in Suffolk are due to close by 2023, although the lives of some could be extended. There is thus a considerable energy gap to fill in the coming years.

Several new nuclear power stations were being considered to help fill this gap, but with rising capital costs, especially following the Fukushima disaster in Japan, potential investors pulled out of other negotiations. Hinkley Point is the only proposal left. It’s not surprising that the government wants it to go ahead.

All that remains to agree is the price that EDF can charge for the electricity generated from the power station. This price, known as the ‘strike price’, is a government-guaranteed price over the long term. EDF is seeking a 40-year deal. Some low carbon power stations, such as nuclear and offshore wind and wave power stations, have high capital costs. The idea of the strike price is to reduce the risks of the investment and make it easier for energy companies to estimate the likely return on capital.

But the strike price, which will probably be agreed at around £95 per megawatt hour (MWh), is roughly double the current wholesale price of electricity. EDF want a price of around £100 per MWh, which is estimated to give a return on capital of around 10%. The government was hoping to agree on a price nearer to £80 per MWh. Either way, this will require a huge future subsidy on the electricity generated from the plant.

There are several questions being asked about the deal. Is the strike price worth paying? Are all the costs and benefits properly accounted for, including environmental costs and benefits and safety issues? Being an extremely long-term project, are uncertainties over costs, performance of the plant, future market prices for electricity and the costs of alternative forms of power generation sufficiently accounted for? Will the strike price contravene EU competition law? Is the timescale for construction realistic and what would be the consequences of delays? The articles consider these questions and raise a number of issues in planning very long-term capital projects.

Articles

Hinkley Point: Britain’s second nuclear age given green light as planning permission is approved for first of new generation atomic power stations Independent, Michael McCarthy (19/3/13)
Will they or won’t they? New nuclear hangs in the balance ITV News, Laura Kuenssberg (19/3/13)
Hinkley Point C: deal or no deal for UK nuclear? The Telegraph, Alistair Osborne (19/3/13)
New nuclear power plant at Hinkley Point C is approved BBC News (20/3/13)
Britain’s Plans for New Nuclear Plant Approach a Decisive Point, 4 Years Late New York Times, Stanley Reed and Stephen Castle (15/3/13)
Nuclear power plans threatened by European commission investigation The Guardian (14/3/13)
New Hinkley Point nuclear power plant approved by UK government Wired, Ian Steadman (19/3/13)
Renewable energy providers to help bear cost of new UK nuclear reactors The Guardian, Damian Carrington (27/3/13)
Europe backs Hinkley nuclear plant BBC News (8/10/14)

Information/Reports/Journal Articles
Environmental permitting of Hinkley Point C Environment Agency
NNB Generation Company Limited, Radioactive Substances Regulations, Environmental Permit Application for Hinkley Point C: Chapter 7, Demonstration of Environmental Optimisation EDF
Greenhouse Gas Emission of European Pressurized Reactor (EPR) Nuclear Power Plant Technology: A Life Cycle Approach Journal of Sustainable Energy & Environment 2, J. Kunakemakorn, P. Wongsuchoto, P. Pavasant, N. Laosiripojana (2011)

Questions

Compare the relative benefits of a construction subsidy and a subsidised high strike price from the perspectives of (a) the government (b) EDF.
What positive and negative externalities are involved in nuclear power generation?
What difficulties are there in valuing these externalities?
What is meant by catastrophic risk? Why is this difficult to take account of in any cost–benefit analysis?
What is meant by a project’s return on capital? Explain how discounted cash flow techniques are used to estimate this return.
What should be taken into account in deciding the rate of discount to use?
How should the extra jobs during construction of the plant and then in the running of the plant be valued when making the decisions about whether to go ahead?

Tag: risk

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