Insurance Company Capital Structure Swaps and Shareholder Wealth

Table 8: Comparative Statics
Comparative statics showing the predicted optimal capital structure swap given managers’ private information
about expected loss and volatility estimates of loss reserve. “Market higher” means that compared
with loss or volatility estimates under private information, managers believe the market has overstated the
expected loss or volatility. “No difference” means that the managers’ private information agrees with market
estimates. “Market lower” means that managers believe the market estimates of loss and volatility are too
low.
Volatility:
Expected Loss:
Market Higher No Difference Market Lower
Market Higher Issue equity in some
cases
Always issue equity Always issue equity
No Difference Always retire equity Do nothing Always issue equity
Market Lower Always retire equity Always retire equity Either action will add
value
7 Conclusion
Prior research has demonstrated that in most cases, firms that issue equity do so at the expense of
the controlling shareholders. Some research, however, has demonstrated that insurance company
investors, in particular, may benefit from a different regulatory system that addresses many of the
information asymmetry problems associated with new equity issues. Further research has shown
that insurers gain many advantages from purchasing reinsurance, including comparative advantages
in risk-bearing and provision of real services. When the managers can exploit risk aversion of
potential policyholders to sell insurance at a premium to expected loss, they can increase the
firm’s leverage and use the proceeds to retire equity or invest in new projects. At the same time,
if managers can purchase value-adding reinsurance, they may choose to issue equity to raise the
necessary cash to do so.
In this paper, we show that insurance companies have unique opportunities to engage in capital
structure arbitrage by executing transactions that take advantage of market conditions and frictions.
We use a Merton-Margrabe option pricing model to analyze the impact of an exchange of risky
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