Co-Insurance Effect

Co-Insurance Effect

The co-insurance effect is an economic theory that suggests mergers and acquisitions (M & M&A) decrease the risk of holding debt in any of the combined entities. Since the combined entity should be more financially secure, it can reduce the cost of issuing new debt, making it cheaper to raise additional funds. Depressed yields may make an issuance less attractive for bondholders who will seek higher rates of return to offset the risk. Suppose a firm owns commercial real estate properties concentrated in a particular metropolitan area. The co-insurance effect is an economic theory that suggests mergers and acquisitions (M & M&A) decrease the risk of holding debt in any of the combined entities. Some downsides are such as if the public disdains the deal, the companies seem like a bad match, and investors knock the share price lower in response. The co-insurance effect posits that firms engaging in mergers and acquisitions wind up benefiting from increased diversification. That risk reduction suggests the company would likely be able to issue debt at a lower rate after its acquisition since the geographic diversification it gained in the merger reduced the likelihood of a debt default.

The co-insurance effect is a theory that argues that merging two or more companies lowers the risk of holding debt in the companies individually.

What Is the Co-Insurance Effect?

The co-insurance effect is an economic theory that suggests mergers and acquisitions (M & M&A) decrease the risk of holding debt in any of the combined entities. Under this theory, one would expect the increased diversification caused by acquisitive activities to reduce borrowing costs for the combined entity.

The co-insurance effect is a theory that argues that merging two or more companies lowers the risk of holding debt in the companies individually.
The idea is that the more significant product portfolio or more extensive customer base that results from the merger will cut the overall borrowing costs for the new, combined company.
Potentially, the combined entity will be more financially secure, allowing the company to lower the costs of issuing new debt, making it more affordable to raise new funds.
There are downsides to mergers that could undermine the co-insurance effect.
Some downsides are such as if the public disdains the deal, the companies seem like a bad match, and investors knock the share price lower in response.

Understanding the Co-Insurance Effect

Even when the acquiring company takes on another company’s debts, the financial strength of the combined entity theoretically shields itself from default better than any of the companies could have done singly. Therefore, the co-insurance effect suggests firms that merge will experience financial synergies through combining operations.

Reducing the risk of default on its debt should lessen the yield investors demand from the corporation's bond issuances. Bond yields rise and fall based on the level of repayment risk bondholders undertake to fund a firm’s debt. Since the combined entity should be more financially secure, it can reduce the cost of issuing new debt, making it cheaper to raise additional funds.

Depressed yields may make an issuance less attractive for bondholders who will seek higher rates of return to offset the risk.

Example of the Co-Insurance Effect

Suppose a firm owns commercial real estate properties concentrated in a particular metropolitan area. Revenue streams from commercial leases typically would be subject to risk in a regional economic downturn. For example, if a major employer goes out of business or relocates to a different area, reducing economic activity could hit local shops, restaurants, and other companies hard enough to drive lower overall regional profits and perhaps even shuttering some businesses.

A less vibrant commercial sector will impact the firm with lower occupancy rates. In turn, this will mean lower revenues, so the chance of a commercial real estate firm defaulting on its debt would rise.

Now suppose that the same firm acquired another commercial real estate entity in a different region. The risk of both areas encountering an unexpected economic downturn at the same time is less than the probability that one or the other could face trouble.

There is a higher probability that revenue from one of the two regions could keep the combined company afloat if the other ran into hard times. That risk reduction suggests the company would likely be able to issue debt at a lower rate after its acquisition since the geographic diversification it gained in the merger reduced the likelihood of a debt default.

Special Considerations

Studies of the co-insurance effect suggest a countervailing force in merger and acquisition (M&A) activities, sometimes called a diversification discount. This effect suggests investors may take a dim view of diversification under certain circumstances. These events could include a negative public view of the union, worries about varying management styles of the larger entity, and the lack of transparency during the M&A process.

In these cases, a resulting share price discount may occur, despite increased post-merger revenues. Some economists believe this effect could mitigate or even cancel out the co-insurance effect in some instances.

Related terms:

Accounting

Accounting is the process of recording, summarizing, analyzing, and reporting financial transactions of a business to oversight agencies, regulators, and the IRS. read more

Congeneric Merger

A congeneric merger is where the acquiring company and the target company do not offer the same products but are in a related industry or market. read more

Conglomerate Discount Defined

A conglomerate discount refers to investor's inclination to value a diversified group of businesses and assets at less than the sum of its parts. read more

Default Risk

Default risk is the event in which companies or individuals will be unable to make the required payments on their debt obligations. read more

Deleverage

Deleveraging is when a company or in`dividual attempts to decrease its total financial leverage. read more

Geographical Diversification

Geographical diversification is the practice of investing across geographic regions to reduce risk and improve returns. read more

Investment Banking

Investment banking is a specific division of banking related to the creation of capital for other companies, governments, and other entities. read more

Mergers and Acquisitions (M&A)

Mergers and acquisitions (M&A) refers to the consolidation of companies or assets through various types of financial transactions. read more

Predator

A predator is a powerful, financially strong company that grabs up another weaker company in a merger or acquisition. read more

Form S-4: Registration Statement Under the Securities Act of 1933

SEC Form S-4 is a regulatory form titled the "Registration Statement Under the Securities Act of 1933" and is required by any company seeking to merge. read more