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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 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.

Suggested Citation

  • Kenneth A. Froot, 2007. "Risk Management, Capital Budgeting, and Capital Structure Policy for Insurers and Reinsurers," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 74(2), pages 273-299, June.
    • Handle: RePEc:bla:jrinsu:v:74:y:2007:i:2:p:273-299
    DOI: 10.1111/j.1539-6975.2007.00213.x
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    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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