NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

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

Kenneth A. Froot

NBER Working Paper No. 10184
Issued in December 2003
NBER Program(s):   AP   CF

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.

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Published: Froot, Kenneth A. “Risk Management, Capital Budgeting and Capital Structure Policy for Insurers and Reinsurers.” Journal of Risk and Insurance 74, 2(June 2007): 273-299.

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