Reinsurance, debt capacity and financial flexibility
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Reinsurance, debt capacity and financial flexibility Xiaoyi Li1 · Yung‑Ming Shiu2 Received: 23 April 2020 / Accepted: 27 August 2020 © The Geneva Association 2020
Abstract Prior studies conclude that hedging has a positive effect on firms’ debt capacity; however, in the present study, we argue that this relationship is moderated by their financial flexibility. Using statutory data from 2001 to 2016 from the National Asso‑ ciation of Insurance Commissioners database on U.S. property and casualty insurers and a simultaneous equations model, we examine how financial flexibility moder‑ ates the effect of reinsurance—a risk management tool commonly used by insurance firms—on debt capacity. We find that the relationship between reinsurance usage and debt capacity is positive for financially inflexible insurers, but negative for their financially flexible counterparts, thereby suggesting that the effects of reinsurance are actually dependent upon the financial flexibility of insurers. Several robustness checks are conducted and our main results remain qualitatively unchanged. Keywords Reinsurance · Debt capacity · Financial flexibility
Introduction Debt capacity, which refers to a firm’s ability to service debt without financial dis‑ tress, has been linked to risk management for several decades, with prior studies find‑ ing a consistently positive association between risk management and debt ratios.1 Haushalter (2000) more specifically pointed out that the use of hedging was positively 1
For example, hedging has been shown to alleviate expected bankruptcy costs (Smith and Stulz 1985; Pérez-González and Yun 2013), thereby facilitating higher leverage (Leland 1998). Hedging, in the form of insurance or reinsurance, can also help insurers take on more risk and expand their debt capacity (Zou * Yung‑Ming Shiu [email protected] Xiaoyi Li [email protected] 1
Department of Risk Management and Insurance, National Chengchi University, 64, Sec. 2, Zhi‑Nan Road, Wen‑Shan District, Taipei 11605, Taiwan
2
Department of Risk Management and Insurance, Risk and Insurance Research Center, College of Commerce, National Chengchi University, 64, Sec. 2, Zhi‑Nan Road, Wen‑Shan District, Taipei 11605, Taiwan
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X. Li, Y.-M. Shiu
associated with the debt ratio, such that firms that were less financially flexible tended to hedge more. Financial flexibility appears to be an important factor affecting hedg‑ ing, with prior studies providing evidence of such financial flexibility playing a cru‑ cial role in financial policy. Marchica and Mura (2010) argued that firms will tend to use their debt capacity conservatively in order to maintain their financial flexibility, whilst DeAngelo et al. (2018) similarly demonstrated that deleveraging was an effec‑ tive means of restoring financial flexibility. Taken together, these findings indicate that hedging can directly affect debt capac‑ ity, whilst financial flexibility is related to debt capacity and financial decisions; how‑ ever, none of the above studies has explored
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