The Benefits of Downside Risk Reduction Through Coinsurance
73 Pages Posted: 6 Nov 2018 Last revised: 12 Jul 2023
Date Written: July 11, 2023
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: Suggested Citation