Market-Consistent Valuation and Financial Management of an Insurance Firm

Abstract

We study capital management and investment decisions of a value-maximizing insurance firm with a broad ownership base in a discrete-time setting. We highlight that the valuation measure used to determine the value of the cash flows to shareholders should reflect two economically sound requirements: market-consistency and indifference to idiosyncratic risk. We provide a rigorous construction of this economic valuation measure and use it to derive the optimal capital-management and investment strategies that realize the economic value of the firm. Our objective is to shed light on the controversial question of whether insurers should invest in liquidly-traded risky assets. Decomposing firm value into net tangible value, default option value, and franchise value, we find that whether or not taking investment risk is optimal essentially depends on how the tradeoff between the impact of investment risk on the owner’s option to default and on the firm’s franchise value resolves. A variety of numerical examples illustrates how changes in the regulatory and financial environment can result in materially different optimal investment strategies.