Co-Insurance Effect - Explained
What is the Co-Insurance Effect?
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Table of ContentsWhat is the Co-Insurance Effect?Why is the Co-insurance Effect Important?Example of the Co-Insurance EffectAcademic Research on the Co-Insurance Effect
What is the Co-Insurance Effect?
The co-insurance effect takes place when risk is spread between two or more parties when two insurance companies share risks, it is coinsurance. The coinsurance effect is an economic theory that stipulates that when two companies are merged in a merger and acquisitions (M&A), the risks of the combined entities will be less than the risks that each entity would have accrued when independently constituted. The coinsurance effect is a theory that maintains that mergers and acquisitions reduce the cost of debt of the merged entities, given that the assets and liabilities owned by the combined entities will be shared, thereby reducing risks.
Why is the Co-insurance Effect Important?
The coinsurance effect is often used in the insurance market to describe a decrease in the level of risk accrued by insurance companies when the risks are shared or spread between two parties. Usually, when two companies engage in mergers and acquisitions, there is an increased diversification of assets and a decrease in the risks accrued by the entities. Since the merged entities now operate on an expanded level, the risk of default of loans of an increase in debt is minimized. The combination of assets of the combined entities increase their financial strength and reduce their risk.
Example of the Co-Insurance Effect
The illustration below would enhance an appropriate understanding of how the coinsurance effect works; Firm A is a vibrant company in the real estate industry with multiple assets at its disposal. It also has lots of properties which it transacts with. Firm B is another emerging real estate company in another metropolitan, quite popular but not as liquid as Firm A. Firm A initiates an acquisition to Firm B through a tender offering. Once the merger and acquisitions are completed, the two entities become a companied entity, the assets and risks are shared, thereby reducing the risk of default or insolvency in any of the firms. The merger and acquisition help to achieve diversification of assets or revenue and at the same time reduce the level of risks of the combined entities.