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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.

Suggested Citation

  • Kenneth A. Froot, 2003. "Risk Management, Capital Budgeting and Capital Structure Policy for Insurers and Reinsurers," NBER Working Papers 10184, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:10184
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    More about this item

    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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