Can the Coinsurance Effect Explain the Diversification Discount?

Abstract

This paper examines whether the coinsurance effect can explain the diversification discount. Lower firm risk combined with higher leverage will cause a wealth transfer from shareholders to bondholders, thereby resulting in a lower excess value for diversified firms relative to that for focused firms. I find that firm risk is significantly lower and leverage is significantly higher for diversified firms even after controlling for other variables that may affect firm risk and leverage. However, the magnitude of the difference is not very large. For both the full sample and the sub-sample of pseudo conglomerates, the coinsurance effect is a significant determinant of the cross-sectional variation of excess value, but not the value loss from diversification. Specifically, the coefficient associated with the multi-segment dummy does not decrease and is still negative and significant even after firm leverage and firm risk are included in the regression specifications. I also find a significant and large diversification discount for all-equity firms. These results hold even after controlling for fixed firm and calendar year effects. These results stand in direct contrast to those reported in Mansi and Reeb (2002), and indicate that the coinsurance effect cannot explain away the diversification discount.