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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. Copyright The Journal of Risk and Insurance, 2007.

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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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Find related papers by 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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  1. Myers, Stewart C., 1984. "Capital structure puzzle," Working papers 1548-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Stewart C. Myers, 1984. "Capital Structure Puzzle," NBER Working Papers 1393, National Bureau of Economic Research, Inc.
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  4. Hoerger, Thomas J & Sloan, Frank A & Hassan, Mahmud, 1990. " Loss Volatility, Bankruptcy, and the Demand for Reinsurance," Journal of Risk and Uncertainty, Springer, vol. 3(3), pages 221-45, September.
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Cited by:

  1. Julien Hardelin & Sabine Lemoyne De Forges, 2009. "Raising capital in an insurance oligopoly market," Working Papers hal-00417573, HAL.
  2. Schlütter, Sebastian, 2011. "Capital requirements or pricing constraints? An economic analysis of measures for insurance regulation," ICIR Working Paper Series 03/11, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt.
  3. 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.
  4. 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 06/11, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt.
  5. Gibson, Rajna & Habib, Michel A. & Ziegler, Alexandre, 2014. "Reinsurance or securitization: The case of natural catastrophe risk," Journal of Mathematical Economics, Elsevier, vol. 53(C), pages 79-100.
  6. 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, vol. 30(1), pages 11-23, February.
  7. Lin, Yijia & Cox, Samuel H., 2008. "Securitization of catastrophe mortality risks," Insurance: Mathematics and Economics, Elsevier, vol. 42(2), pages 628-637, April.
  8. Schlütter, Sebastian, 2011. "The role of frictional costs for insurance pricing and insurer default risk," ICIR Working Paper Series 07/11, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt.

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