Corporate Risk Management and the Insurance Industry

Abstract

There are at least two reasons that corporate risk management is important for firms in the insurance industry: (1) An insurance company’s value depends directly on its risk-management policy. (2) The asset risk in an insurance company’s loan portfolio depends on its customers’ risk-management policies. In this paper, I analyze these implications of corporate risk-management for life insurance companies. In section 2, I suggest that corporate risks can be arrayed along a spectrum. At one extreme are firm-specific risks while at the other are market-wide risks. I note that forwards, futures, options, and swaps are specialized risk-management tools that allow the firm to hedge many sources of market-wide financial risk. In addition to these off-balance-sheet hedging alternatives, financially engineered instruments, such as dual-currency bonds, provide on-balance-sheet hedging alternatives. In section 3, I focus on motives for value-maximizing firms to purchase such specialized risk-management instruments. This section thus identifies the implications of hedging by customers for the insurer’s asset portfolio risk. Section 4 examines the implications of life insurer risk-management policies. In section 5, I present my conclusions.