Reinsurance, Debt Capacity and Financial Flexibility

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 Association of Insurance Commissioners database on U.S. property and casualty insurers and a simultaneous equations model, we examine how financial flexibility moderates 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.