Risk-sharing benefits and the capital structure of insurance companies

Cynthia Van Hulle, Hans Degryse and Kristien Smedts

No 571404, Working Papers Department of Accountancy, Finance and Insurance (AFI), Leuven from KU Leuven, Faculty of Economics and Business (FEB), Department of Accountancy, Finance and Insurance (AFI), Leuven

Abstract: 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 risksharing 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 hold a surplus 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.

Date: 2017
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Published in FEB Research report AFI_17113 , pages 1-23

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Working Paper: Risk-sharing benefits and the capital structure of insurance companies (2017)
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