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Working Paper, No. 2021-13, September 2021 Crossref
Capital Constraints and Risk Shifting: An Instrumental Approach

When firms approach distress, whether they engage in asset substitution (risk shifting) or rebuild equity (risk management) may depend on their access to capital markets. The property-casualty insurance industry has two features that make it ideal for testing this hypothesis: (1) the main losses for insurers are exogenous events like hurricanes that provide a strong instrument for financial distress; and (2) many insurers are organized as mutual companies, which cannot issue stock. Consistent with the importance of capital constraints, stock companies issue new equity following a negative shock, while mutual companies increase the riskiness of their investment portfolios.


Working papers are not edited, and all opinions and errors are the responsibility of the author(s). The views expressed do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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