On the Capital Structure of Liability Driven Businesses: The Case of Insurance
21 Pages Posted: 17 Feb 2017 Last revised: 19 Dec 2017
Date Written: december 15, 2017
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: Suggested Citation