Working Paper

Capital Constraints and Risk Shifting: An Instrumental Approach

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;

JEL Classification: G22; G32;

https://doi.org/10.21033/wp-2021-13

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series

Publication Date: 2021-09-02

Number: WP-2021-13