August 3rd, 2009

The Firm-Value Risk Model

Posted at 7:00 AM ET

John Major, ASA, MAAA, Senior Vice President, Instrat

This paper, a sequel to chapter 2.6 of Guy Carpenter’s 2007 book, Enterprise Risk Analysis, illustrates some of the complex interactions between risk, capital strategy, and the optimal usage of risk transfer; and how critical decisions can be based on impact to (re)insurer value using Guy Carpenter’s Firm-Value Risk Model (FVRM) methodology.

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The FVRM combines the technology of actuarial optimal dividends models with insights regarding financial frictions from financial economics, especially as they apply to risk transfer in (re)insurance firms. This paper illustrates, by numerical solution of a set of case studies, how certain stylized facts about (re)insurer value emerge naturally from the FVRM, specifically: (1) the concave relationship between firm value and financial slack, (2) the convex relationship between firm value and risk, (3) the substitution of external capital for reinsurance, and (4) the irrelevance of risk management when external capital is freely available, even in the presence of customer risk aversion.

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