Enterprise Risk Management, Insurer Value Maximisation, and Market Frictions

Abstract

Enterprise risk management has become a major focus for insurers and reinsurers. Capitalization and pricing decisions are recognized as critical to firm value maximization. Market imperfections including frictional costs of capital such as taxes, agency costs, and financial distress costs are an important motivation for enterprise risk management. Risk management reduces the volatility of financial performance and can have a significant impact on firm value maximization by reducing the impact of frictional costs. Insurers operate in imperfect markets where demand elasticity of policyholders and preferences for financial quality of insurers are important determinants of capitalization and pricing strategies. In this paper, we analyze the optimization of enterprise or firm value in a model with market imperfections. A realistic model of an insurer is developed and calibrated.Frictional costs, imperfectly competitive demand elasticity, and preferences for financial quality are explicitly modelled and implications for enterprise risk management are quantified.