Working Paper: NBER ID: w10184
Authors: Kenneth A. Froot
Abstract: This paper builds on Froot and Stein (1998) in developing a framework for analyzing the risk allocation, capital budgeting, and capital structure decisions facing insurers and reinsurers. The model incorporates three key features: i) value-maximizing insurers and reinsurers face product-market as well as capital market imperfections that give rise to well-founded concerns with risk management and capital allocation; ii) some, but not all, of the risks they face can be frictionlessly hedged in the capital market; iii) the distribution of their cashflows may be asymmetric, which alters the demand for underwriting and hedging. We show that these features result in a three-factor model that determines the pricing and allocation of risk and the optimal capital structure of the firm. This approach allows us to integrate these features into: i) the pricing of risky investment, underwriting, reinsurance, and hedging; and ii) the allocation of risk across all of these opportunities, and the optimal amount of surplus capital held by the firm.
Keywords: risk management; capital budgeting; capital structure; insurers; reinsurers
JEL Codes: G20; G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher risk (D81) | Increased costs (D49) |
| Increased costs (D49) | Affects capital structure decisions (G32) |
| Decline in insurer ratings (G52) | Negative impact on demand for insurance products (G52) |
| Sensitivity of customer demand to insurer risk (G52) | Sensitivity of capital provider demand (G19) |
| Negatively asymmetric distributions in insurance portfolios (C46) | Higher costs of capital (G31) |
| Higher costs of capital (G31) | Influence capital allocation decisions (G11) |
| Capital market imperfections (G19) | Decision-making regarding capital structure and risk management (G32) |
| Higher perceived risks (D81) | Conservative capital structure choices (G32) |
| Higher perceived risks (D81) | Increased hedging (G13) |
| Higher perceived risks (D81) | Adjustments in pricing strategies (D49) |