Capital Constraints and Risk Shifting: An Instrumental Approach

Alejandro Drexler and Thomas King

No WP-2021-13, Working Paper Series from Federal Reserve Bank of Chicago

Abstract: When firms approach distress, whether they engage in asset substitution (risk shifting) or rebuild equity (risk management) may depend on their access to capital markets. The property-casualty insurance industry has two features that make it ideal for testing this hypothesis: (1) the main losses for insurers are exogenous events like hurricanes that provide a strong instrument for financial distress; and (2) many insurers are organized as mutual companies, which cannot issue stock. Consistent with the importance of capital constraints, stock companies issue new equity following a negative shock, while mutual companies increase the riskiness of their investment portfolios.

Keywords: Risk shifting; insurance; reinsurance; capital structure (search for similar items in EconPapers)
JEL-codes: G22 G32 (search for similar items in EconPapers)
Pages: 40
Date: 2021-09-02
New Economics Papers: this item is included in nep-cfn, nep-ias, nep-isf and nep-rmg
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DOI: 10.21033/wp-2021-13

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