What Is the Co-Insurance Effect?

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

Key Takeaways

  • 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 bigger product portfolio or larger 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, and therefore making it more affordable to raise new funds.
  • However, there are downsides to mergers that could undermine the co-insurance effect, 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

The co-insurance effect posits that firms engaging in mergers and acquisitions wind up benefiting from increased diversification. This increase in diversification comes from a broader product portfolio or an expanded customer base. 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.

On the other hand, depressed yields may make an issuance less attractive for bondholders who will seek higher rates of return to offset the risk.

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 styles of management 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.

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 the reduction in 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 reduction in risk 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.