On the Capital Structure of Liability Driven Businesses: The Case of Insurance

21 Pages Posted: 17 Feb 2017 Last revised: 19 Dec 2017

See all articles by Cynthia Van Hulle

Cynthia Van Hulle

KU Leuven - Department of Applied Economics

Hans Degryse

KU Leuven, Department Accounting, Finance and Insurance; Centre for Economic Policy Research (CEPR)

Kristien Smedts

KU Leuven - Faculty of Business and Economics (FEB)

Date Written: december 15, 2017

Abstract

Providing risk-sharing benefits to risk-averse policy holders is a primary function of insurance companies. We model that policy holders are paying a fee over the present value of indemnifications (i.e., technical provisions) to enjoy these risk-sharing benefits. Although the traditional Modigliani-Miller logic is typically applied to study the capital structure of insurance firms, this fee implies that a capital structure largely consisting of technical provisions is optimal (i.e., value maximizing) for insurance firms, making the Modigliani-Miller logic inappropriate. However, to support the issuance of technical provisions with socially desirable properties, insurance firms choose a solvency risk target vis-à-vis policy holders and maintain a minimal surplus consistent with this risk choice to absorb losses. We show that the Modigliani-Miller logic applies to the funding of this loss-absorption capacity. This explains why insurance companies may use, next to equity and technical provisions, financial debt in supporting their activities.

Keywords: capital structure, insurance, risk-sharing, solvency

JEL Classification: G22, G28, G32, G30

Suggested Citation

Van Hulle, Cynthia and Degryse, Hans and Smedts, Kristien, On the Capital Structure of Liability Driven Businesses: The Case of Insurance (december 15, 2017). Available at SSRN: https://ssrn.com/abstract=2919289 or http://dx.doi.org/10.2139/ssrn.2919289

Cynthia Van Hulle (Contact Author)

KU Leuven - Department of Applied Economics ( email )

Naamsestraat 69
B-3000 Leuven
BELGIUM
32-16-326734 (Phone)
32-16-326732 (Fax)

Hans Degryse

KU Leuven, Department Accounting, Finance and Insurance ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Kristien Smedts

KU Leuven - Faculty of Business and Economics (FEB) ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

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