Revisiting Optimal Investment Strategies of Value-Maximizing Insurance Firms

Abstract

We study capital management and investment decisions of a value-maximizing
insurance firm with a broad ownership base in a discrete-time setting. We
highlight that the valuation measure used to determine the value of the cash flows to
shareholders should reflect two economically sound requirements: market-consistency
and indifference to idiosyncratic risk. We provide a rigorous construction of this economic
valuation measure and use it to derive the optimal capital-management and
investment strategies that realize the economic value of the firm. Our objective is to
shed light on the controversial question of whether insurers should invest in liquidly-traded
risky assets. Decomposing firm value into net tangible value, default option
value, and franchise value, we find that whether or not taking investment risk is
optimal essentially depends on how the tradeoff between the impact of investment
risk on the owner’s option to default and on the firm’s franchise value resolves. A
variety of numerical examples illustrates how changes in the regulatory and financial
environment can result in materially different optimal investment strategies.

Keywords: Insurance Firm, Default Option, Franchise Value, Dividend Payments, Investment Strategy, Market-Consistent Valuation

JEL Classification: G21, G28, G32, G35