The Benefits of Downside Risk Reduction Through Coinsurance

73 Pages Posted: 6 Nov 2018 Last revised: 12 Jul 2023

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: July 11, 2023

Abstract

We investigate the benefits of downside risk reduction through coinsurance in diversified firms. Using a novel 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 upside potential in multi-segment firms. We find that diversified firms realize significantly larger debt-related coinsurance benefits (lower cost of debt and/or higher leverage) than suggested by prior studies based on total risk proxies. Coinsurance is costly for shareholders and has no effect on the WACC. However, 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 overall firm. Important identification issues are addressed. Our findings shed new light on how diversified firms benefit from downside risk reduction through coinsurance.

Keywords: Default risk, diversification, credit default swaps, cost of capital, financial flexibility

JEL Classification: G32, G33, L25

Suggested Citation

Goedde-Menke, Michael and Norden, Lars and Rose, Christian, The Benefits of Downside Risk Reduction Through Coinsurance (July 11, 2023). 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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