Finding the Sweet Spot: How Financial Constraints Shape the Benefits of Coinsurance-Driven Diversification

65 Pages Posted: 6 Nov 2018 Last revised: 26 May 2022

See all articles by Michael Goedde-Menke

Michael Goedde-Menke

University of Münster - Finance Center Münster

Lars Norden

Getulio Vargas Foundation (FGV) - Brazilian School of Public and Business Administration (EBAPE); Getulio Vargas Foundation (FGV) - FGV/EPGE Escola Brasileira de Economia e Finanças

Christian Rose

University of Münster - Accounting Center Münster

Date Written: May 26, 2022

Abstract

We investigate the effects of coinsurance-driven corporate diversification. Measuring coinsurance of multi-segment firms with CDS spread-implied default risk connections of single-segment firms, we disentangle the effects for debt- and shareholders by level of financial constraints and compare them with the upside potential of diversification. Important identification issues are addressed. We find that, on average, coinsured firms benefit from lower cost of debt and higher leverage. These debt-related benefits occur at the expense of shareholders as the cost of equity increases for firms with higher coinsurance, resulting in a (zero-sum) wealth transfer from shareholders to debt holders. Importantly, financial constraints shape the realization of debt-related coinsurance benefits and ultimately determine whether coinsurance creates value at the firm level. Coinsurance helps unconstrained firms to reduce their cost of debt, while constrained firms increase their leverage. Firms with moderate levels of financial constraints have a “sweet spot” in terms of value creation through coinsurance. Next to realizing both debt-related benefits, they also exhibit lower cost of equity and lower WACC. In addition, we find coinsurance effects to be bigger and more consistent than those due to the upside potential of diversification. Our results suggest that coinsurance creates financial flexibility that diversified firms take advantage of according to their level of financial constraints.

Keywords: Corporate diversification, default risk, financial flexibility, cost of capital, capital structure

JEL Classification: G32, G33, L25

Suggested Citation

Goedde-Menke, Michael and Norden, Lars and Rose, Christian, Finding the Sweet Spot: How Financial Constraints Shape the Benefits of Coinsurance-Driven Diversification (May 26, 2022). Available at SSRN: https://ssrn.com/abstract=3279554 or http://dx.doi.org/10.2139/ssrn.3279554

Michael Goedde-Menke (Contact Author)

University of Münster - Finance Center Münster ( email )

Universitätsstraße 14-16
Münster, 48143
Germany

Lars Norden

Getulio Vargas Foundation (FGV) - Brazilian School of Public and Business Administration (EBAPE) ( email )

Rua Jornalista Orlando Dantas 30
Rio de Janeiro, 22231-010
Brazil
+552130832431 (Phone)

HOME PAGE: http://www.larsnorden.de

Getulio Vargas Foundation (FGV) - FGV/EPGE Escola Brasileira de Economia e Finanças ( email )

Praia de Botafogo 190/1125, CEP
Rio de Janeiro RJ 22253-900
Brazil

Christian Rose

University of Münster - Accounting Center Münster ( email )

Universitätsstraße 14-16
Münster, 48143
Germany

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