Hedging, Contract Enforceability and Competition

Abstract

We study how risk management through hedging impacts firms and competition among firms in the life insurance industry - an industry with over 7 Trillion in assets and over 1,000 private and public firms. We show that firms that are likely to face costly external finance increase hedging after staggered state-level financial reform that reduces the costs of hedging by granting derivatives contracts superpriority. Post reform impacted firms have lower risk and fewer negative income shocks. Product market competition is also impacted. Firms that previously are more likely to face costly external finance, lower price, increase policy sales and increase their market share post reform. The results are consistent with hedging allowing firms that face potential costly financial distress to decrease risk and become more competitive.

Keywords: Competition, risk management, hedging, financial stability, policy sales (life insurance and annuities), policy prices, market share, market leadership, derivatives superpriority

JEL Classification: D02, D22, D43, G22, G28, G31, G32, G33