Risk management and insurance.

• Author: Froot, Kenneth A.

My research over the past several years has focused on two topics: corporate risk management, with a special emphasis on the insurance sector, and the portfolio flows of international investors. In this article, I first discuss the work on risk management, explaining why the insurance industry provides a wonderful set of experiments for testing some ideas about the subject. I then turn to my work on international portfolio flows.

Financial risk management is probably the central activity of financial intermediaries, including banks and insurance companies. Intermediaries take risks by investing their capital in illiquid and information-intensive financial activities. It is these imperfections in financial markets that allow intermediaries to make profits. But the imperfections are not merely a source of profit - they also create costs. That is, intermediaries must finance themselves by issuing claims that are at least partially illiquid and information-intensive. This suggests that exogenous shocks to intermediaries' financial capital should have implications for the pricing and availability of the instruments in which they invest.

How do financing imperfections influence financial policies, such as risk management, capital budgeting, and capital structure? For example, suppose that a financial firm becomes concerned about the feasibility or cost of raising equity capital, or that its costs of carrying a given amount of capital rise. The marginal value of the firm's internal funds will have increased. As a result, that firm will wish to reduce risks to its capital in order to conserve on internal funds.

The first thing the firm can do is to hedge out any and all "market risks" - for example, risks that can be hedged without friction in the capital markets. These hedges have zero net present value from the market's perspective, since they are done at fair prices. However, they create additional firm value because they allow the firm to use less capital and to raise needed capital less often.(1)

Having hedged all frictionless market risk, can the firm further reduce its risk? Yes, the firm can alter its capital budgeting policy by raising internal hurdle rates. At first blush, an increase in hurdle rates would seem to do little to conserve on internal funds. After all, industrial firms are more likely to reduce new investment than they are assets in place, so higher hurdle rates would not reduce risk quickly. In this regard, however, financial firms are special. Financial firms have larger and more liquid balance sheets. Higher hurdle rates would encourage a reduction in risk exposures.

However, it would not be optimal for a financial firm to raise all its hurdle rates by the same amount. Investments that co-vary positively with fluctuations in overall firm capital should receive higher hurdle rates. However, investments that co-vary negatively with internal capital should see their hurdle rates decline. In a recent paper, Jeremy C. Stein and I model these internal hurdle rates. We show that, in the presence of financing imperfections, optimal hurdle rates should include an additional factor driven by co-variance with internal capital. For internal pricing, the price of capital at risk is measured by a risk-aversion term that reflects the shadow value of internal funds, whereas the quantity of capital at risk is measured by a given investment's covariance with the rest of the firm's portfolio.(2)

If financial imperfections are present, then negative shocks to financial-firm capital...