What is co-insurance effect’
Co-insurance effect is an Economic theory that suggests that mergers and acquisitions reduce the risk associated with holding debt in any of the entities combined. According to this theory, it can be expected that the increase in diversification is caused by prescription measures to reduce the cost of borrowing for the company.
Breaking down the ‘coinsurance effect’
Co-insurance effect comes from the fact that firms involved in mergers and acquisitions and wind-up costs associated with the increased diversification, for example, through broader product range and increased customer base. Even when the acquiring company takes over another company, the debts, the financial strength of the combined company, in theory protects itself from default better than any of the organizations could do alone. Thus, the co-insurance effect assumes that the merger of the companies will experience financial synergies through combining operations.
The risk that the company will default on its debt should reduce the yield required by the investors from the issuance of the Corporation bonds, as bond yields rise and fall based on the amount bondholders, the risk should assume the obligation to Finance the firm with debt. This can reduce the cost of issuing new debt for the combined company, making it cheaper to raise additional funds. On the other hand, depressed the yield can make the results less attractive for bondholders seeking higher returns.
Research co-insurance action involves the opposition in activities in mergers and acquisitions is sometimes called the “diversification discount”. This effect suggests that investors may take a dim view of diversification under certain circumstances, resulting in the stock price, despite an increase in after the merger of the revenue discounting. Some economists believe that this effect may mitigate or even cancel out the effect of coinsurance in some cases.
An example of coinsurance effect
Assume that the firm owns commercial real estate are concentrated in a certain area. Revenue flows from the commercial lease will usually be at risk in a regional economic downturn. For example, if a major employer goes out of business or moved to another location the decline in economic activity can affect local businesses, restaurants and shopping centers are hard enough to drive some out of business. Low occupancy rates means lower income, so the probability of commercial real estate defaulting on its debt will increase in this situation.
Now suppose that the same firm has purchased another commercial property in other region. The risk of both regions faced with sudden economic downturn at the same time, obviously less than the probability that one or the other can cause problems, as there is at least some chance, the income from one of the two regions can keep the merged company afloat if the other ran into hard times. Reducing the risk of suggests the company will likely be able to issue debt at a lower rate after its acquisition, because of the geographical diversification it received in the merger reduces the probability of default on debt obligations.