George W. Blazenko

The Economics of Reinsurance

Features of insurance markets that affect the use of reinsurance are examined. An active reinsurance market exists when the direct market is imperfectly competitive. The manager of an insurer with monopoly power takes reinsurance. Market power in the reinsurance market restricts its use. The manager of a monopsonistic insurer takes reinsurance when his or her risk aversion is greater than that of clients; this behavior is consistent with the interests of owners. The use of reinsurance is then decreasing with the ratio of policy-holder to manager risk aversion coefficients. Costs incurred by either insurers or reinsurers in the reinsurance market reduce the use of reinsurance, while costs incurred by insurers in the original transaction leave coverage provided by insurers themselves unchanged.

Corporate Holding of Finished Goods Inventories

This paper investigates the effects of stock out avoidance and market competition on corporate holding of finished goods inventories. We consider two adverse consequences of stock outs: immediate foregone profit and long-run loss of revenue from the shift of customers to more reliable sources of supply. Firms are more inclined to avoid stock outs with greater inventory if the potential for profit is greater. Therefore, we expect inventories to be increasing in the profit margins of firms. In addition, the likelihood of lost revenue from the loss of disenfranchised customers depends upon the alternative sources of supply that are available. If there are good alternative sources, the prospect of long-term revenue loss is greater. The adverse consequence of stock outs is therefore influenced by market competition and we expect the relation between finished goods inventories and the market-power of firms to be negative. In empirical testing, we find evidence consistent with these predictions.

Repair Limit Policies for Vehicle Replacement

AbstractTwo types of economic replacement policies for a fleet of vehicles are investigated. One is a simple group replacement policy in which vehicles are replaced at a pre-set age or milage. In the second, a repair limit is set that varies with the condition of the vehicle. A vehicle is replaced whenever it requires a repair expected to cost more than this allowable repair limit. The structure of the repair limit problem is shown to be a Markovdecision process, and steady-state repair limits can be determined by Howards policy improvement routine. Because for each state the repair limit is a continuous decision variable, however, Howards routine is modified to allow a search procedure to determine the optimal limits. Using data for Postal Canada vehicles, these two types of policies are compared and the results indicate the superiority of repair limit policies over simple group replacement.Vehicle replacement using repair limit policies are found to be sensitive tothe discount rate chosen; the lower t...

Value Maximizing Hurdle Rates for R&D Investment

We show that the value maximizing hurdle rate for research and development (R&D) investments among private firms operating in a market setting is less than for conventional investments despite the fact that R&D has development risk. Because development risk arises only during R&D, entrepreneurs control this risk by deferring or pursuing R&D depending upon profitability. This risk management moderates downside loss and encourages upside gain which increases the value attraction of R&D and decreases the value maximizing hurdle rate below that of conventional investment.

New Venture Start-Ups and Technological Innovation

Purpose - The purpose of this paper is to compare investment in innovation (e.g. R&D) between new venture start-ups before commercialization and operating businesses after commercialization. Design/methodology/approach - Real options methods were used to model a new venture start-up as a perpetual call option on an operating business that grows with R&D. The operating business uses R&D to improve actual earnings while the start-up uses R&D to improve prospective earnings. When the start-up entrepreneur commercializes his/her new product, device, or service with conventional investment (e.g. plant, property, and equipment to begin production), prospective earnings convert into actual earnings. Findings - The ability of the start-up entrepreneur to avoid commercialization costs upon failed R&D makes R&D more valuable to the start-up entrepreneur than to the manager of the already operating business (for whom commercialization costs are sunk) and despite R&D costs that the start-up incurs without the revenues that only commercialization generates. The value of R&D to the start-up can be so great that the entrepreneur invests in R&D before the manager of an otherwise similar operating business in similar business conditions. Originality/value - Without favoring either

Optimal indemnity contracts

Abstract Conditions under which policies with deductible provisions, coinsurance provisions, or premium rebates are optimal are given. Results of previous papers on indemnity costs are considered as special cases. For both personal and commercial lines of insurance, further applications consider income taxes, interest income and acquisition costs.

Non-Dividend Paying Stocks and the Negative Value Premium

The value premium is the empirical observation that low market/book “value” stocks have higher returns than high market/book “growth” stocks. In this paper, we show that the profitability determined relation between risk and return is distinct for non-dividend paying businesses. High profitability dividend paying stocks have low returns whereas high profitability non-dividend paying stocks have high returns. Since profitability and market values relate positively, dividend paying stocks have a value premium whereas non-dividend paying stocks have a “negative value premium.” We argue that high profitability covers the capital expenditure costs of limited growth prospects for dividend paying firms, which decreases risk and return. Because constraints restrict external financing, firms with less exacting growth limits retain earnings rather than pay dividends to finance business investment. High profitability permits high growth which requires high capital expenditure costs which induces high risk. Consistent with this prediction, we find high returns for high profitability, high market/book, non-dividend paying “growth” stocks, which is a negative value premium.

Financial Distress and the Value Premium

The value premium is the empirical observation that low market/book “value” stocks have higher returns than high market/book “growth” stocks. In this paper, we report evidence that there is a value premium for firms in financial distress despite the anomalous observation that firms in financial distress have low returns and low values. We argue that profitability moderates distress-risk but increases growth-leverage and, thus, we test for a U-shaped relation between returns and profitability from these offsetting forces. We also find a hill-shaped relation between market/book and profitability. A U-shaped relation between returns and profitability and a hill-shaped relation between market/book and profitability generates a value premium for firms in financial distress. When market/book is low (high or low profitability), returns are high.

Corporate Sales, Equity Trading, and Risk

This paper proposes and investigates an explanation for a positive association between the signed value of common share returns and trading activity. The mixture of distributions model for stock returns and trading is applied with the added assumption that product sales for a firm is the directing process which generates the flow of information to equity markets. Because trading depends upon information arrival, sales and trading are positively related. Also, because contribution margin is positive, cash flows increase with sales. Dependence of both cash flows and trading on sales implies that returns and trading are also positively related. This explanation is tested in this paper. Copyright Blackwell Publishers Ltd 1999.

Does R & D create or resolve uncertainty?

Purpose - – This paper aims to investigate two related questions on business research and development (R & - D) simultaneously. First, does R & - D create or resolve uncertainty? Second, does uncertainty encourage or discourage business R & - D? Design/methodology/approach - – This paper uses the three-stage least squares regression method and a system of simultaneous equations to examine the two research questions simultaneously. Instrumental variables overcome the econometric endogeneity problem. Findings - – The results are consistent with the hypothesis that R & - D creates rather than resolves uncertainty. Why then do risk-averse business managers undertake R & - D? This paper argues that in creating uncertainty, R & - D also creates “shadow options” for supplementary business investment not envisaged by business managers in the original objective for R & - D. Rather, managers unexpectedly uncover shadow options in R & - D’s inherent knowledge discovery process, which encourages business R & - D in the first instance. Consistent with this real options interpretation, this paper reports evidence that volatility encourages R & - D. Originality/value - – This paper differs from the current literature in the sense that it investigates the two related R & - D questions simultaneously rather than individually. The authors argue that the two related questions are inextricably interrelated, and investigating the two questions simultaneously would provide results that can possibly solve conflicting empirical results in the current literature. The results are also particularly useful for business managers who make decisions on whether to undertake R & - D projects or not.