Risk Management, Capital Budgeting, and Capital Structure Policy for Insurers and Reinsurers |
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| Authors: | Kenneth A Froot |
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| Institution: | Kenneth A. Froot is the AndréR. Jakurski Professor of Business Administration, Harvard University and NBER, Harvard Business School, Boston, MA 02163, USA. The author can be contacted via e-mail: . The article was presented as the Geneva Risk Lecture at the 30th Seminar of the European Group of Risk and Insurance Economists, Zurich. I thank two anonymous referees and the editor, Rob Bentley, John Major, David Moss, Ryan Ogaard, Gary Venter, and especially Paul Embrechts and other participants of the EGRIE seminar for their comments and suggestions. Naturally, all mistakes are mine. |
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| 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. |
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