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

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