The Effect of Capital and Risk Transfer Instruments in Financial Groups

The aim of this paper is to examine the impact of capital and risk transfer instruments on diversification and insolvency risk in a parent-subsidiary relationship. To better assess the effects, we compare this setting to the case of a holding company and an integrated financial group. In the analysis, we account for the conglomerate discount on firm value, which is the reduction in shareholder value due to group diversification effects. It is quantified using option-pricing theory; the diversification benefit on the solvency capital is calculated based on the tail value at risk approach. Simulation results for different types of capital and risk transfers––intragroup retrocession and guarantees––are derived from the perspective of the group (diversification benefit, simultaneous default of entities) and from the viewpoint of the individual institutions being part of the group (solvency capital, individual shortfall risk).