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

  • Kenneth A. Froot

This article builds on Froot and Stein 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; and (iii) the distribution of their cash flows may be asymmetric, which alters the demand for underwriting and hedging. We show these features result in a three-factor model that determines the optimal pricing and allocation of risk and 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. Copyright The Journal of Risk and Insurance, 2007.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1539-6975.2007.00213.x
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Article provided by The American Risk and Insurance Association in its journal Journal of Risk & Insurance.

Volume (Year): 74 (2007)
Issue (Month): 2 ()
Pages: 273-299

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Handle: RePEc:bla:jrinsu:v:74:y:2007:i:2:p:273-299
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  1. Kraus, Alan & Litzenberger, Robert H, 1976. "Skewness Preference and the Valuation of Risk Assets," Journal of Finance, American Finance Association, vol. 31(4), pages 1085-1100, September.
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  4. 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 96-28, Wharton School Center for Financial Institutions, University of Pennsylvania.
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  30. repec:dgr:kubcen:199735 is not listed on IDEAS
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