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Risk Management, Capital Budgeting and Capital Structure Policy for Insurers and Reinsurers

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  • 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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10184.

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Date of creation: Dec 2003
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Publication status: published as Froot, Kenneth A. “Risk Management, Capital Budgeting and Capital Structure Policy for Insurers and Reinsurers.” Journal of Risk and Insurance 74, 2(June 2007): 273-299.
Handle: RePEc:nbr:nberwo:10184

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  1. Jeremy C. Stein, 1995. "An Adverse Selection Model of Bank Asset and Liability Management with Implications for the Transmission of Monetary Policy," NBER Working Papers 5217, National Bureau of Economic Research, Inc.
  2. Kenneth A. Froot & Jeremy C. Stein, 1996. "Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 96-28, Wharton School Center for Financial Institutions, University of Pennsylvania.
  3. Myers, Stewart C, 1984. " The Capital Structure Puzzle," Journal of Finance, American Finance Association, American Finance Association, vol. 39(3), pages 575-92, July.
  4. Kenneth A. Froot & Paul G. J. O'Connell, 1997. "On The Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance," NBER Working Papers 6011, National Bureau of Economic Research, Inc.
  5. Wakker, P.P. & Thaler, R.H. & Tversky, A., 1997. "Probabilistic insurance," Discussion Paper, Tilburg University, Center for Economic Research 1997-35, Tilburg University, Center for Economic Research.
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  7. Kenneth A. Froot & David S. Scharfstein & Jeremy C. Stein, 1992. "Risk Management: Coordinating Corporate Investment and Financing Policies," NBER Working Papers 4084, National Bureau of Economic Research, Inc.
  8. Froot, Kenneth A., 2001. "The market for catastrophe risk: a clinical examination," Journal of Financial Economics, Elsevier, Elsevier, vol. 60(2-3), pages 529-571, May.
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Cited by:
  1. Schlütter, Sebastian, 2011. "Capital requirements or pricing constraints? An economic analysis of measures for insurance regulation," ICIR Working Paper Series, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt 03/11, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt.
  2. Howard C. Kunreuther & Erwann O. Michel-Kerjan, 2007. "Evaluating The Effectiveness of Terrorism Risk Financing Solutions," NBER Working Papers 13359, National Bureau of Economic Research, Inc.
  3. Schlütter, Sebastian, 2011. "The role of frictional costs for insurance pricing and insurer default risk," ICIR Working Paper Series, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt 07/11, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt.
  4. Zimmer, Anja & Schade, Christian & Gründl, Helmut, 2009. "Is default risk acceptable when purchasing insurance? Experimental evidence for different probability representations, reasons for default, and framings," Journal of Economic Psychology, Elsevier, Elsevier, vol. 30(1), pages 11-23, February.
  5. Julien Hardelin & Sabine Lemoyne de Forges, 2012. "Raising Capital in an Insurance Oligopoly Market," The Geneva Risk and Insurance Review, Palgrave Macmillan, Palgrave Macmillan, vol. 37(1), pages 83-108, March.
  6. Lin, Yijia & Cox, Samuel H., 2008. "Securitization of catastrophe mortality risks," Insurance: Mathematics and Economics, Elsevier, vol. 42(2), pages 628-637, April.
  7. Zimmer, Anja & Gründl, Helmut & Schade, Christian, 2012. "Be as safe as possible: A behavioral approach to the optimal corporate risk strategy of insurers," ICIR Working Paper Series, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt 06/11, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt.

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