Risk Allocation across the Enterprise: Evidence from the Insurance Industry

Financial researchers initially regarded hedging activities as a means to reduce total firm risk, which often is defined in terms of cash flow volatility. More recently, researchers have focused on the strategic allocation of risk. Direct tests of risk allocation have been problematic, however, because hedging data are rarely available and, when available, are specific only to a single operation of the firm, such as bank lending. In this study, we exploit unique data from the insurance industry that allows us to observe hedging proxies for both investment and insurance underwriting risks and test the risk allocation hypothesis developed in the finance literature. We also conduct separate examinations of life-health and property-casualty insurers, which reveal differences in the risks and hedging activities of these two types of insurers.