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

Article excerpt

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.

INTRODUCTION

The cost of bearing risk is a crucial concept for any corporation. Most financial policy decisions, whether they concern capital structure, dividends, capital allocation, capital budgeting, or investment and hedging policies, revolve around the benefits and costs of a corporation holding risk. The costs are particularly important for financial service firms, where the origination and warehousing of risk constitutes the core of value added. And because financial service firms turn their assets more frequently than nonfinancial firms, risk pricing and repricing are needed more frequently.

Insurers and reinsurers are an important class of financial firm. They encounter financial risk in their underwriting and reinsurance portfolios, as well as in their investment and hedge portfolios. Often they have a large number of clients who view their insurance contracts as financially large and important claims. Two basic features make insurers and reinsurers especially sensitive to the costs of holding risk.

The first feature is that customers--especially retail policyholders--face contractual performance risks. Premiums are paid, and thereafter policyholders worry whether their future policy claims will be honored swiftly and fully. Customers are thought to be more risk averse to these product performance issues than are bondholders. There are several mechanisms for this greater risk sensitivity, some behavioral and others rational.

The behaviorist story is formalized in Wakker, Thaler, and Tversky (1997). They argue that "probabilistic insurance"--the name given by Kahneman and Tversky (1979) to an insurance contract that sometimes fails to pay the contractually legitimate claims of the insured--is deeply discounted by an expected utility maximizer who pays an actuarially fair premium. They also provide survey evidence that the discount is striking in size: in comparison to a contract with no default risk, a contract with 1 percent independent default risk is priced 20-30 percent lower by survey participants.

The rational argument owes most to Merton (1993, 1995a,b). He argues that customers of financial firms value risk reduction more highly than do investors because customer costs of diversifying are higher. Insurance contracts are informationally complex documents and claims payments often require customer involvement. Buying from a single insurer reduces costs. Furthermore, insurance pays off when the marginal utility of customer wealth is high. If absolute risk aversion is declining in wealth, as many suspect it is, then a customer will be more averse to an insurer's failure to perform than to a debtor's failure to perform, even if the performance failure is of equivalent size. Higher costs of diversification and greater impact on utility therefore makes risk aversion higher for customers than investors.

This motivates our assumption that when an insurer's financial circumstances decline, customer demand falls. …

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