The Benefits of Downside Risk Reduction Through Coinsurance

Abstract

We investigate the benefits of downside risk reduction through coinsurance in multi-segment firms. Using a coinsurance measure based on industry default risk connections derived from credit default swap (CDS) spread changes of single-segment firms, we isolate the effects of downside risk reduction from those due to the upside potential of diversification. We find multi-segment firms realize significantly larger debt-related coinsurance benefits (lower cost of debt and/or higher leverage) than suggested by evidence based on total risk proxies. Coinsurance is costly for shareholders and has no effect on the WACC. The impact of coinsurance on the WACC and firm value strongly varies with financial constraints. When financial constraints are at intermediate levels, coinsurance creates value for debt holders, shareholders, and the firm. Important identification issues are addressed. Our findings shed new light on how multi-segment firms benefit from downside risk reduction through coinsurance.

Keywords: Default risk, credit default swaps, cost of capital, multi-segment firms, diversification

JEL Classification: G32, G33, L25