Beyond the Average: Coinsurance Effects and Financial Constraints

Abstract

We investigate the differential effects of coinsurance arising from corporate diversification. Measuring coinsurance of multi-segment firms with CDS spread-implied default risks of single-segment firms, we disentangle the effects for debt- and shareholders by level of financial constraints and contrast them with the upside potential of diversification. Coinsurance effects -lower cost of debt or higher leverage- and their value impact vary monotonically with financial constraints. Coinsurance lowers the cost of equity and the WACC only for moderately constrained firms. Important identification issues are addressed. 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