Risk management, capital budgeting and capital structure policy for insurers and reinsurers

"This paper builds on Froot and Stein (1998) in developing a framework for analyzing the risk allocation, capital budgeting, and capital structure decisions facing insurers and reinsurers. The model incorporates three key features: i. value-maximizing insurers and reinsurers face product-market as well as capital market imperfections that give rise to well-founded concerns with risk management and capital allocation; ii. some, but not all, of the risks they face can be frictionlessly hedged in the capital market; iii. the distribution of their cashflows may be asymmetric, which alters the demand for underwriting and hedging. We show that these features result in a three factor model that determines the pricing and allocation of risk and the optimal capital structure of the firm. This approach allows us to integrate these features into: i) the pricing of risky investment, underwriting, reinsurance, and hedging; and ii) the allocation of risk across all of these opportunities, and the optimal amount of surplus capital held by the firm"--National Bureau of Economic Research web site.