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Enterprise Risk Mngt

by: Adrien Kuhn II

Enterprise Risk Mngt FINC 3134

Adrien Kuhn II
GPA 3.62

Kevin Eastman

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Kevin Eastman
Class Notes
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This 7 page Class Notes was uploaded by Adrien Kuhn II on Monday October 12, 2015. The Class Notes belongs to FINC 3134 at Georgia Southern University taught by Kevin Eastman in Fall. Since its upload, it has received 45 views. For similar materials see /class/222017/finc-3134-georgia-southern-university in Finance at Georgia Southern University.


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Date Created: 10/12/15
FINC 3134 quot 39 Risk 39 39 Review for Exam 3 CHAPTER 12 LEGAL LIABILITY FOR INJURIES SOME BACKGROUND ON THE LAW There are two main sources of legal liability 1 common law law that has evolved over time as a result of previous court decisions and 2 statutory law passed by legislative bodies amp signed into law by the executive branch Law can also be categorized as either I criminal law covers acts against the state and 2 civil law covers acts against individuals includes both contract law amp tort law OVERVIEW OF TORT LIABILITY RULES amp PROCEDURES Liability rules allocate accident risk to various members of society and thus affect incentives to engage in risky activities and to take precautions There are three types of liability rules 1 A no liability rule makes some institutions andor professions such as charitable organizations immune from liability for certain types of actions 2 A negligence rule holds people liable if they fail to exercise the required standard of care to prevent injury to another party 3 A strict absolute liability rule holds parties such as manufacturers of defective products or those who engage in ultrahazardous activities liable even ifthey are not negligent Tort liability law allows injured parties to recover damages for losses There are two categories of damages 1 compensatory damages which compensate victims for monetary losses eg medical expenses lost wages and nonmonetary losses eg pain amp suffering and 2 punitive damages which are designed to punish the defendant amp deter future actions in cases in which the defendant recklessly or willfully disregards the risk of harm to the plaintiff In cases where the actions of more than one party combine to cause a loss the doctrine ofjoint amp several liability means that if some parties are unable to pay the full burden of paying damages will fall on the other parties However the plaintiff can only recover damages once LIABILITY FROM NEGLIGENCE To recover damages under a negligence rule a plaintiff generally must establish the existence of a legal duty by the defendant to prevent harm to the plaintiff a breach ofthis legal duty by failing to exercise the required standard of care that the breach was the proximate cause of the plaintiff s harm and that an injury was suffered WNT In many nonbusiness liability cases the required standard of care usually is what a reasonablyprudent personquot would have done under similar circumstances In the case of professional liability the standard often is what a reasonable adequately trained professional with the same area of expertise would have done in the same circumstances In many business liability cases the court apply an economic standard under which a business is liable if it fails to take costjusti edprecautions to prevent harm A breach of duty is considered the proximate cause of an injury if it would not have occurred but for the defendant s action sine qua non or but forquot rule When there are intervening events between a defendant s action and the ultimate injury the courts often apply a foreseeability test ie if a defendant should have reasonably foreseen that hisher action could create a significant risk of injury then that action is deemed the proximate cause of the injury even if there are unusual intervening events FINC 3134 quot 39 Risk 39 39 Review for Exam 3 Under a negligence rule a defendant may be able to avoid or reduce liability by showing that the plaintiff assumed the risk assumption of risk or that the plaintiff s negligence or actions contributed to the accident contributory or comparative negligence Under contributory negligence the defendant is not liable for any of the plaintiff s losses while under comparative negligence the defendant can be found partially liable THE ECONOMIC ROLE OF THE TORT LIABILITY SYSTEM From an economic perspective the tort system has two fundamental objectives 1 to provide incentives for parties to engage in the optimal level of loss control and 2 to provide optimal compensation insurance coverage to accident victims The optimal level of loss control occurs where the additional marginal benefits of loss control expenditures equal the additional marginal costs It is rarely optimal to try to achieve a zerorisk society The optimal amount of compensation is equal to the amount of insurance coverage that a victim would have wanted to purchase prior to knowing whether heshe would be involved in an accident if heshe were fully informed about both the risk of an accident amp the costs associated with coverage via the tort system The tort system usually attempts to compensate victims fully for both their economic amp noneconomic losses However riskaverse people typically do not want to purchase either full insurance coverage for economic losses because of premium loadings moral hazard amp adverse selection or any coverage for noneconomic losses This suggests that the tort system forces many people to pay for more insurance than they probably desire One possible explanation is that lessthanfull compensation would not produce sufficient incentives for loss control amp our tort system may place greater weight on optimal safety than on optimal compensation LIMITED WEALTH amp LIMITED LIABILITY The judgmentproof problem means that some people are able to avoid paying damages either because they do not have sufficient wealth or their wealth is protected by limited liability bankruptcy rules So these people may invest too little in safety and injured victims may not receive the optimal amount of compensation Compulsory liability insurance ie forcing judgmentproof people to buy liability insurance in some cases can improve victim compensation and loss control incentives PROPOSALS FOR TORT REFORM Two major types of tort reform proposals have been made to address problems in the tort liability system 1 reforms that modify incentives to bring suits eg limits on contingency fees and adoption of a loser pays rule under which the loser pays at least part ofthe winning side s legal costs and 2 reforms that reduce damages paid to victims eg caps on pain amp suffering awards and punitive damages altering the collateral source rule to allowjuries to take into account compensation from sources other than the tort system and limiting the application ofjoint amp several liability FINC 3134 quot 39 Risk 39 39 Reviewfor Exam 3 CHAPTER 18 WORKERS COMPENSATION amp EMPLOYEE INJURIES OVERVIEW OF WORKERS COMPENSATION LAWS All states have WC laws with two main features 1 employers are required to pay specified benefits for monetary loss to injured employees without regard to employer fault or negligence and 2 employees are not allowed to sue employers for injuries under tort law ie WC is the employee s exclusive remedy WORKERS COMPENSATION BENEFITS There are three major types of WC benefits 1 medical expenses 2 payments for lost income associated with total or partial disability and 3 death benefits payments to survivors of workers killed on the job Medical expenses are paid without any limitation deductibles or coinsurance To control moral hazard various states either 1 allow employers to select physicians who initially treat or later approve treatment of the employee 2 adopted fee schedules for workplace injuries andor 3 implemented various types of managed care plans that give employers amp WC insurers a greater ability to control costs Disability benefits for total disability are usually twothirds of the worker s preinjury wage subject to a maximum equal to 100 percent of the state s average weekly wage and in many states also subject to a minimum Benefits for temporary total disability are paid until the worker can return to work while benefits for a permanent total disability are usually paid until a specified retirement age eg age 65 However the injured worker amp WC insurer may agree to payment of a lump sum settlement that is equal to the present value of future benefits rather than having benefits paid over time Disability benefits for permanent partial disability ie permanent injuries that partially reduce the worker s earnings capacity represent a large proportion of the total cost of disability benefits The amount of benefits for some injuries generally is specified in a schedule eg 50000 for loss of a thumb while the amount of benefits for nonscheduled injuries is based on the worker s estimated loss of earnings capacity eg if earnings capacity is reduced by 50 the worker would receive a benefit equal to twothirds of 50 of his pre disability weekly wage Survivor benefits are paid in the case of the death of a worker and typically include 1 a flat amount 1000 to 5000 toward burial costs and 2 a weekly payment to a surviving spouse amp dependent children that is similar to payments for total disability twothirds of the preinjury wage perhaps a lower percentage if there are no children or there is only one child but no surviving spouse The duration of the benefits is limited by a number of factors such as the remarriage of the spouse or the child s eighteenth birthday WHY HAVE WORKERS COMPENSATION WC laws combine mandatory benefits provided by employers with employer immunity from tort liability exclusive remedy Alternative approaches to WC include 1 no mandatory employerprovided benefits and no tort liability for employers the noremedy case 2 no mandatory employerprovided benefits with employer tort liability for injuries and 3 mandatory employerprovided benefits with tort liability for employers To understand the rationale for WC compared to the alternative methods you need to recognize that the cost of employee injuries is ultimately borne by employees rather than employers ie employers will tend to reduce wages over time by the amount necessary to recover these costs or if wages cannot be reduced fewer workers will be employed 80 employees should want a system that 1 provides proper safety incentives 2 provides the amount of compensation that employees are willing to pay for and 3 keeps administrative costs amp the costs of dispute resolution low Compared to the alternatives WC systems provide reasonable safety incentives amp compensation for monetary loss and also produce lower dispute resolution costs than would be the case with tort liability Many workers are likely to find the broad structure of WC laws attractive compared to alternative systems given that workers bear the cost of whatever system is chosen FINC 3134 quot 39 Risk 39 39 Review for Exam 3 WORKERS COMPENSATION INSURANCE amp SELFINSURANCE Employers subject to WC laws are required to either purchase WC insurance or to meet state rules to qualify as a selfinsurer Five states have government monopoly WC insurers monopolistic state funds and some states have state insurers that either compete with private insurers or serve as the residual market competitive state funds In the remaining states employers purchase WC insurance from private insurers State requirements for selfinsurance generally allow only large employers who can meet minimum financial requirements to selfinsure However smaller employers can form groups that can jointly selfinsure their members WC benefits WC insurance policies cover WC benefits and employer tort liability for certain workrelated injuries not governed by workers compensation Insured employers generally pay premiums equal to a class rate per 100 of payroll times the amount ofthe firm s payroll in 100s in different occupational classifications Most states require prior regulatory approval of class rates but also allow a variety of methods to be used to modify the class rate to reflect differences in expected claim costs across employers within an occupational class Residual markets provide coverage to employers who are unable to find an insurer that is willing to provide it voluntarily ln states without monopolistic state funds or competitive state funds which serve as the residual markets in those states private insurers are required either to provide coverage to these employers or share in their losses in proportion to their share of premiums forWC insurance written voluntarily in the state Secondinjury funds allow insurers and selfinsured employers to be reimbursed for the increase in benefit costs when a subsequent second injury occurs to an employee who was previously injured For example for an employee who had previously lost the use of an arm an injury to the other arm might produce a total disability that would require larger WC benefits than ifthe worker had not been hurt previously The cost of the combined reimbursements is spread among insurers amp selfinsurers in proportion to their total claim costs PROBLEMS amp REFORMS IN WORKERS COMPENSATION From the mid1980s through the early 1990s WC claim costs grew rapidly insurance company financial results deteriorated and state residual markets mushroomed Large residual markets in some states produced large operating deficits and crosssubsidies from the voluntary to the residual market In response many states adopted WC reform legislation to reduce the growth in claim costs and changed their systems of voluntary amp residual market price regulation to reduce residual market deficits amp crosssubsidies from the voluntary market to the residual market Reforms to reduce the growth in claim costs included the adoption of medical fee schedules managed care programs programs to encourage injured workers to return to work and restrictions on compensation for stressrelated claims as well as increased fraud detection amp penalties Reforms of price regulation included residual market rate increases reduced discounts to large employers in residual markets and increased use of experience rating These changes led to slower claim cost growth improved insurer financial results and declining residual market shares amp residual market deficits during the mid1990s However cost and residual market growth have recently returned in many states GOVERNMENT SAFETY REGULATION amp OTHER SOURCES OF LIABILITY Extensive government regulation of safety exists at both the federal and state level Examples include the Occupational Safety amp Health Act OSHA enacted in 1971 and the Americans With Disabilities Act ADA enacted in 1990 Whether safety regulation has a material effect and is costeffective have been subject to considerable debate Many businesses are exposed to tort liability claims for employment practices that cause injuries apart from bodily injury amp disease governed by WC law Major tort liability exposures include allegations of illega discrimination based on factors such as age sex race and disability and allegations of wrongful termination Many of these liability exposures can be insured with employment practices liability EPL coverage FINC 3134 quot 39 Risk 39 39 Review for Exam 3 CHAPTER 28 CORPORATE LIABILITY TO CUSTOMERS THIRD PARTIES amp SHAREHOLDERS PRODUCTS LIABILITY Products liability law has evolved from contract law to negligence to strict liability for product defects Prior to 1916 a manufacturer could not be held liable unless the victim amp the manufacturer had a direct contractual relationship a requirement know as the privity limitation In 1916 the MacPherson v Buick case established that consumers injured by defective products could recover damages under tort law if the manufacturer had been negligent The case of Escola v CocaCola Bottling Company in 1944 helped establish a strict liability standard for certain kinds of productrelated injuries ie manufacturers could be held liable even when they were not negligent if their products were unreasonably dangerous and defective Since manufacturers are strictly liable for product defects the important issue is whether a product is defective There are three types of product defects 1 Manufacturing Defects exist if a particular product deviates from what the manufacturer intended ln mostjurisdictions if a product differs from the normal production run amp a consumer is harmed as a result ofthe defect then the manufacturer is liable 2 Design Defects exist if foreseeable risks of harm presented by the product could have been 1 reduced by the adoption of a reasonably safer design or 2 discovered amp corrected through more exhaustive product testing In mostjurisdictions some form of costbenefit analysis is used to determine whether a product is unreasonably dangerous ie could the defect have been corrected at a reasonable cost 3 Warning Defects exist if a product has not been properly labeled or the risks associated with using the product have not been properly explained In mostjurisdictions courts will hold manufacturers liable if the danger was foreseeable amp the manufacturer failed to provide a warning that could have reduced the risks of harm But some jurisdictions hold the manufacturer liable even if the danger was not foreseeable as long as a warning would have prevented the harm Depending on the alleged defect amp the jurisdiction manufacturers can defend themselves by arguing that customers 1 assumed the risk or 2 engaged in the unforeseeable misuse of the product in which case the defendant s liability may be reduced in a manner similar to a comparative negligence standard In addition to tort liability firms also are subject to liability under contract law as a result of warranties that are made when products amp services are sold to consumers An express warranty is an explicit statement that a product or service will perform according to some standard An implied warrantyis an implicit performance guarantee that the product is reasonably fit for its intended use Insurance coverage for products liability is provided by a firm s Commercial General Liability CGL policy A CGL policy provides liability coverage for bodily injury amp property damage as well as a duty to defend the firm and pay defense costs in the case of a lawsuit Coverage is available on both an occurrence and a claims made basis Claimsmade coverage usually is only purchased for hazards that involve a large risk of unexpected increases in claim costs for the insurer which includes some product liability exposures Making manufacturers strictly liable for all consumer losses can improve safety incentives when consumers are uninformed about product risk because strict liability gives manufacturers proper incentives to make safe products and to reduce the likelihood that consumers will purchase too many risky products by ensuring that they are informed about product risk However it is also argued the strict liability system 1 is unnecessary when consumers are wellinformed 2 may lead to excessive safety amp higher prices 3 may discourage innovation amp encourage use of older less safe products amp 4 is regressive in nature ie lowerincome consumers paythe same price for products but receive less insurance coverage FINC 3134 quot 39 Risk 39 39 Review for Exam 3 A number of product liability reform measures have been adopted or proposed including measures that would 1 reduce the potential liability of producers curtailing joint amp several liability capping pain amp suffering awards amp punitive damages amp altering the collateral source rule 2 reduce the incentive ofplaintiff attorneys to le marginal cases by adopting a loser pays rule amp reducing contingency fees and 3 adopt a statute ofreposequot which requires that suits be brought within a certain number of years eg 20 years after the product has been purchased ENVIRONMENTAL LIABILITY Liability for environmental damage under common law expanded greatly during the last half ofthe 20m century For many years environmental hazards were handled under nuisance law with strict liability reserved for situations where the environmental damage was caused by sudden events that occurred because someone brought something unnatural in the area amp when losses were easily linked to a particular event However scientific advances led the courts to interpret gradual leaks of potentially toxic substances into the environment as being equivalent to sudden events that directly led to illness or death An important source of statutory liability is the Superfund law enacted in 1980 Its purpose is to provide funds needed to clean up waste dumps amp accidental spills of toxic substances Most courts interpret the Superfund law as imposing retroactive strict and joint amp several liability on owners former owners amp anyone who has dumped waste at a site including transporters of that waste While the Superfund law has increased incentives for safety it has been criticized for 1 spending excessive resources to clean sites that have little chance of posing harm to residents 2 setting safety standards too high by cleaning sites for any potential future use rather than limiting use amp relocating existing residents 3 providing compensation under the tort system for hazards already covered by private insurers eg medical expense disability income amp life insurance 4 imposing huge legal costs and 5 deterring development of former industrial sites Prior to 1970 most CGL policies covered liability for environmental damage as long as it was neither expected nor intended by the insured As liability expanded insurers first attempted to restrict coverage in CGL policies to only sudden amp accidentalquot pollution subsequently they introduced an absolute pollution exclusionquot that excludes coverage for most pollution other than environmental damage due to sale amp use of the insured s product Some policies today contain a total pollution exclusion that eliminates coverage for all pollution liability Pollution coverage is now available through customized environmental impairment liability ElL policies which usually are sold on a claimsmade basis DIRECTORS amp OFFICERS LIABILITY Directors amp officers of corporations have a legal duty to act in the interest ofthe shareholders Specifically they have a duty ofcare ie a duty to make informed decisions and a duty ofloyalty ie a duty to act in the interests of shareholders when corporate decisions involve a potentially material conflict of interest between shareholders amp directorsofficers When a duty of care violation is alleged the courts employ the businessjudgment rule under which directors amp officers are not held liable for informed decisions even if they turn out to produce poor results In suits alleging violation of the duty of loyalty not only must directors amp officers be informed but they also must take whatever steps are necessary to ensure that decisions are in the shareholders best interests Directors amp officers also can be sued by shareholders for violations of securities laws that require firms to disclose material information in a timely manner Suits brought by shareholders on behalf of the corporation are known as derivative suits while suits brought by shareholders on their own behalf are called direct action suits Direct actions against directors amp officers can be either individual actions brought by an individual who alleges harm or class actions brought on behalf of a group of plaintiffs that are alleged to have been harmed Depending on the state and corporate charter directors amp officers are indemnified by their corporations for legal defense costs andor settlements amp awards Directors amp officers DampO liability insurance often is purchased to cover 1 some nonindemnified losses to directors amp officers ie defense costs and judgments paid by the director amp officer for which they have not been reimbursed by the corporation and 2 corporate costs of indemnification ie amounts paid by the corporation to indemnify directors amp officers for their losses FINC 3134 quot 39 Risk 39 39 Review for Exam 3 CHAPTER 29 ISSUES IN LIABILITY RISK amp ITS MANAGEMENT RISK SHIFTING THROUGH LIMITED LIABILITY The doctrine of limited liability means that the liability of corporate shareholders is limited to the value of their equity investment ie those with claims against the corporation generally cannot reach the personal assets of individual shareholders or the other business assets of corporate shareholders The protection provided by limited liability is similar to insurance protection against large tort liability claims for both individual shareholders and a parent corporation with multiple subsidiaries But like insurance it can lead to moral hazard ie induce corporations to take on too much risk and excessive risk of injury because corporations might not have to pay for all of the harm they might cause from risky activities The rationale for limited liability is that the positive effects of limiting a corporation s liability more than offset the negative moral hazard effect in most circumstances The positive effects of limited liability for individual shareholders are that 1 it facilitates the separation of the management amp riskbearing functions and 2 it makes the risk associated with investment in a firm not depend on the wealth of other investors Courts sometimes have refused to uphold limited liability and forced shareholders to pay claims in excess of corporate assets or equity an outcome known as piercing the corporate veil This typically occurs when a corporation engages in obviously risky activities without insurance or significant assets or capital and it is either 1 a closely held corporation that is controlled or managed by its shareholders or 2 a subsidiary controlled by its parent company In both cases the moral hazard problem is potentially severe and the social benefits of separating the management and riskbearing functions are not present LIABILITY FOR ACTIONS OF EMPLOYEES amp OTHER PARTIES Under the doctrine of Vicarious liability principals generally are liable for the torts of their agents which includes liability of employers for torts of employees in the course of their employment This gives the principal incentives to choose agents carefully and to train amp monitor agents Firms that use independent contractors often can be held liable for torts ofthe contractor in order to mitigate the judgment proof problem and encourage safety There are three main situations where a firm can be held liable for the actions of independent contractors 1 when there is ambiguity or disagreement over whether a party is an employee or an independent contractor 2 when the state has determined that the duty to keep the public safe cannot be delegated to another party the independent contractor and 3 when a business is liable for negligence in failing to take reasonable precautions to select a safe contractor HOLD HARMLESS amp INDEMNITY AGREEMENTS A hold harmless indemnity agreement is a contract between two parties in which one party agrees to hold the other party harmless indemnifythe other party for losses that arise out of some activity Hold harmless and indemnity agreements backed by liability insurance help reduce the cost of risk by allocating the ultimate responsibility for harm to the party best able to reduce injury costs and by reducing costly disputes between the parties


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