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