DP11838 Risk-sharing benefits and the capital structure of insurance companies

Author(s): Hans Degryse, Kristien Smedts, Cynthia Van Hulle
Publication Date: February 2017
JEL(s): G22, G32
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11838

Providing risk-sharing benefits to risk-averse policy holders is a primary function of insurance companies. We model that policy holders are paying a fee over the present value of indemnifications (i.e., technical provisions) to enjoy these risk-sharing benefits. This fee implies that a capital structure largely consisting of technical provisions is optimal for insurance firms, making the traditional Modigliani-Miller logic inappropriate for them. To support the issuance of technical provisions with socially desirable properties, insurance firms choose a solvency risk target vis-à-vis policy holders and maintain a minimal surplus consistent with this risk choice to absorb losses. We show that the Modigliani-Miller logic applies to the composition of this loss-absorption capacity. This explains why insurance companies may use, next to equity and technical provisions, financial debt in supporting their activities.