INSURANCE AND THE CORPORATE COST OF CAPITAL 1

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1 INSURANCE AND THE CORPORATE COST OF CAPITAL 1 Monika Wieczorek-Kosmala 2 Abstract The purpose of paper is to provide some support to sis that insurance may reduce cost of capital in a company by influencing both cost of capital components and need for rising capital. The problem is here perceived from two perspectives classical concept related to weighted average cost of capital (WACC) and a novel concept related to risk-based capital structure model with total average cost of capital (TACC). The paper explains idea of insurance as a retrospective (post-loss) risk financing tool and risk transfer mechanism upon it. As risk financing tool insurance reduces need for balance-sheet capital in a company and thus financial distress costs. Also, insurance may reduce level of operating risk and thus influences required returns of capital providers. These observations allow emphasising impact of insurance on WACC. However, according to novel concept of risk-based capital structure, insurance (as a risk financing tool) represents an off-balance sheet capital component. As a consequence, it extends volume of total capital. The presented conceptual model, based on TACC concept, indicates that large volume of insurance ( insurance sum) and its relatively low cost ( insurance premium) gives possibility to significant reduction of cost of capital on average. The concluding remarks discuss some dilemmas over utility of TACC concept. JEL Classification: G22, G32 Keywords: insurance, cost of capital, capital structure, risk management, risk capital Received: Accepted: Introduction Insurance is primarily referred to as a tool useful in a protection against negative financial consequences of risk occurrence. The benefits of insurance are perceived through indemnification for a loss whereas costs of insurance are associated with burden of insurance premiums. This perspective, however, is to narrow from a corporate finance point of view. Insurance adds value to company in numerous ways and an important value driver is direct and indirect impact on corporate cost of capital. The purpose of paper is to support sis that insurance may reduce cost of capital in a company by influencing both cost of particular capital structure components and volume of particular sources of funds. Within latter issue, new arguments are provided by means of by novel concept addressing problem of risk-based capital structure in a company. The methodology of paper is based primarily on conceptual analysis of current state of affairs. The paper is structured as follows. Section one discusses mechanism of insurance risk transfer and explains idea of insurance as a risk finance tool from risk management perspective. Section two concerns impact of insurance implementation on cost of capital 1 The research is sponsored by National Science Centre (Poland), granted with decision No. DEC- 2011/01/D/HS4/ Dr Monika Wieczorek-Kosmala, Uniwersytet Ekonomiczny w Katowicach, Wydział Finansów i Ubezpieczeń, Katedra Finansów, Katowice, ul. Bogucicka 14, m.wieczorek-kosmala@ue.katowice.pl. 61

2 components with regard to both cost and volume perspective. It provides some arguments based on evidence provided in literature. Section three presents insurance as component of risk-based capital in a company and its consequences, touching new idea of average cost of capital computation TACC (total average cost of capital). The last section provides some evidence on dilemmas over TACC implementation. The paper is closed by some concluding remarks. Insurance as a risk finance tool From a company s perspective, insurance should be defined as tool that allows financing negative outcomes of risk. The idea of insurance is an old one and from beginning insurance was based on risk transfer mechanism and concept of pooling (Outreville, 1998, p ). The risk transfer mechanism results in transfer of insurance from an individual (e.g. a company) into a group (of companies). As a consequence, a pool of risk is being created. The mechanism of insurance risk transfer ascertains insured entities (companies) that in case of risk occurrence loss will be refunded. By means of insurance, a loss of a particular entity (company) is shared by all members of group ( pool) (Vaughan and Vaughan, 2003, p. 33). In or words, insured entities make a formal agreement to share loss and thus economic burden of loss is spread through group. The insurance premium should be perceived as a price for being a participant of insurance pool. The volume of premiums collected creates a special fund which is managed by insured with a purpose to support financially those members of insurance pool who suffered from a loss. In a more formal way, insurance definition provided from individual perspective explains insurance as an instrument whereby a company substitutes a relatively low certain loss embodied in insurance premium for a large uncertain loss which is embodied in contingency insured against. From this point of view, transfer of risk is emphasised. The insurance definition provided from collective perspective, explains insurance as an economic device which reduces and eliminates risk through combining a large number of homogenous exposures into a group. By this, insurer makes a loss predictable for group ( pool) as a whole. Here, insurance pooling of risk is emphasised (Vaughan and Vaughan, 2003, p. 34). Recalling risk management idea, insurance is one of tools applied in managing risk. Traditionally, se tools are divided into risk retention and risk transfer tools. However, latter innovations brought possibility to implement in a company so called alternative risk transfer (ART) or alternative risk finance (ARF) instruments which are combination of risk transfer and risk retention 3. Risk management places insurance among so called risk finance (or risk financing) tools. This point of view is of a particular importance for discussion on impact of insurance on corporate cost of capital as it perceives insurance as anor source of funding. Such context of insurance perception and analysis is a novel one and allows developing a few distinctive features of insurance. First of all, insurance is a retrospective risk financing tool as cash (in form of indemnification for a loss) inflows to a company after risk occurrence. This cash infusion is directed with a purpose of covering negative outcome of risk visible in cash flows volatility. The retrospective risk financing is here associated with post-loss funding. A characteristic of 3 An extended analysis of corporate use of various alternative risk transfer (alternative risk finance) instruments is discussed among ors in (Hartwig and Wilkinson, 2007, p ; Wieczorek-Kosmala, 2010a, p ; Wieczorek-Kosmala, 2010b, p ). 62

3 volatility. The retrospective risk financing is here associated with post-loss funding. A post-loss characteristic funding of agreements post-loss funding including agreements insurance including is that cash insurance stream flows is that from cash primarily stream defined flows from (agreed) primarily source and defined on predefined (agreed) source rules. A and model on of predefined insurance rules. as a retrospective A model of (post-loss) insurance as funding a retrospective mechanism (post-loss) is presented funding on Figure mechanism 1. is presented on Figure 1. Figure 1: Insurance as retrospective (post-loss) finance mechanism a company s cash inflow through insurance indemnification for a loss insurance premium (premiums) paid for insurer in exchange of its readiness to cover loss a company s cash outflow as outcome of risk occurrence t Source: Own study In In period period of of t=1 t=1 to to t=5 t=5 company company pays pays insurance insurance premiums premiums which which incur incur cash cash outflows. outflows. This This cash cash outflows outflows should should be be perceived perceived as as price price for for insurer insurer readiness readiness to cover to cover loss loss in case in case of of risk risk occurrence. occurrence. In In period period of t=6 of t=6 company company affects affects loss loss as a as result a result of of negative negative outcome outcome of risk. of risk. In order In order to simplify to simplify graphic graphic model, model, it is assumed it is assumed that that damage damage caused caused by by risk is going risk is to going be covered to be (repaired) covered (repaired) within within period of risk period occurrence. of risk The occurrence. loss causes The that loss causes company that is company affected by is affected cash by outflow cash (e.g. outflow in (e.g. event in of fire event company of fire must company restore must restore damaged assets damaged or buy assets new or assets). buy new However, assets). thanks However, to thanks insurance insurance indemnification indemnification cash flows cash into flows company into company which finally which balances finally balances cash flows cash in to flows period in t=6. period The total t=6. The cash total outflow cash in outflow period in t=6 period is higher t=6 than is higher cash than inflow cash from inflow indemnification from indemnification for a loss as for company a loss as incurs company cash outflow incurs due to cash outflow premium due payments to (as premium it was in payments period (as of it t=1 was to in t=5). period of t=1 to t=5). The The above presented model underlines second distinctive feature of of insurance as as a risk financing tool. tool. The The payment payment of of indemnification for for a loss a loss is conditional is conditional upon upon negative negative out- outcome of of risk occurrence. risk occurrence. The conditions The conditions are predefined are predefined insurance insurance contract contract with regard with to regard type to of risk type and of risk maximum and level maximum of insurer s level contribution. of insurer s From contribution. this perspective, From this insurance perspective, risk transfer insurance mechanism risk transfer is equivalent mechanism to mechanism equivalent of to a put option mechanism for additional of a put capital option (Culp, for additional 2006, p. capital ). (Culp, In case 2006, of p. risk ). occurrence In case of company risk will occurrence exercise option company which will means exercise that capital option flows which to means company that on capital a predefined flows conditions. to company If on risk a will predefined not occur conditions. within If agreed risk period will ( not period occur of within insurance agreed contract), period option ( period expires. of The insurance insurance contract), premium may option be compared expires. to The insurance option premium premium and may represents be compared cost of to insurer s option premium readiness and to provide represents capital in cost predefined of circumstances. insurer s readiness to provide capital in Assuming predefined that circumstances. insurance is a specific option-like source of retrospective funding, it should be examined how it affects company s capital structure. Here, two distinctive views should Sucharskiego 2

4 be underlined: traditional concept concerning weighted average cost of capital and a novel risk capital concept concerning total average cost of capital. Insurance and weighted average cost of capital (WACC) The classical concept is based on fundamental assumption that insurance contributes to stability of a company s capital structure 4. As risk finance tool, insurance ensures a stream of cash which is conditional upon occurrence of an event (risk) insured against. The best explanation and justification of this statement, however, comes from analysis of consequences of risk occurrence in uninsured company. An uninsured company in case of risk occurrence has to arrange sources of funding that will be directed to assets restoration (physical or financial assets). These funds may be raised from internal sources or externally. The internal sources of loss coverage are provided in form of capital reserves. The company may collect reserves deliberately for loss coverage, which is commonly called self-insurance (Williams and Heins, 1989, p ; Rejda, 2001, p. 48). However, it is difficult for a company to predict accurately and collect timely required level of capital reserves. Also, internal funds may come from capital reserves or than self-insurance (e.g. reserves created for or purposes including profit that might be directed to dividends pay-out) which implies additionally alternative costs. If company does not have capital reserves that might be involved in internal financing consequences of risk, it has to rise funds externally from eir equity or debt finance. Such decisions, however, change capital structure of a company and as a consequence weighted average cost of capital. In absence of capital reserves, company s capital structure includes equity (E) and debt finance (D) and se elements constitute volume of company s capital (C). In such circumstances, weighted average cost of capital (WACC) is computed as follows 5 : E D WACC = CE + C D (1) C C where C E represents cost of equity finance and C D after tax cost of debt finance. As mentioned above, if company has to raise capital as it wishes to restore physical or financial assets, capital structure changes. The increase of share of equity with higher cost (C E ) as compared to after-tax cost of debt finance (C D ) increases WACC. The cost of equity finance (C E ) is more expensive as rates of return required by owners are higher (due to higher degree of risk) and additional impact of issuance costs 6. The increase of debt finance has even larger consequences. From WACC formula point of view higher level of debt finance should decline final WACC as cost of debt finance 4 In literature one may find arguments for irrelevance of insurance (and or risk management techniques, toger with derivatives in ir hedging function) for optimisation of capital structure (Culp, 2001, p ). However, recent researches and conceptual analysis of ir results provide quite contrary evidence. In particular, arguments for relevance of risk management to capital structure decisions were developed i. a. in studies of Culp (2001, p ), MacMinn and Garven (2000, p ) or Doherty and Smith (2003, p ). 5 This formula is based on classical weighted average cost of capital (WACC) which is explained among ors in (Megginson and Smart, 2006, p. 229; Shapiro and Balbirer, 2000, p. 315; Higgins, 2007, p. 296; Fabozzi and Peterson, 2003, p. 309; Baker and Powell, 2005, p. 344; Copeland, Weston and Shastri, 2005, p ). 6 For example, compare idea of cost of equity computation assumed in Dividend Discount Model (DDM), also referred to as Gordon Growth Model (Shapiro and Balbirer, 2000, p ; Megginson and Smart, 2006, p. 226; Fabozzi and Peterson, 2003, p ). 64

5 (C D ) is cheaper as compared to cost of equity finance (C E ). However, company may face adverse situation. The higher level of debt finance higher is insolvency risk, which increases expected rates of return by both equity providers and debt providers (Groppelli and Nikbakht, 2006, p. 169, ; Ogier, Rugman and Spicer, 2004, p. 5-10; Baker and Powell, 2005, p ). The prime explanation of this phenomenon is given by trade-off ory and problem of financial distress costs (Groppelli and Nikbakht, 2006, p. 250; Marks, Robbins, Fernandez, Funkhouser, 2005, p ). These costs (most of m immeasurable) include among ors: cost of loss of customers, suppliers, employees, loss of quick sale of assets, costs of lowered creditworthiness. The source of se costs is inability of effective management of a financially distressed company and facing risk of going bankrupt. Additionally, financial distress increases costs of bankruptcy springing from legal and administrative costs (such as legal and accounting expert opinions, consulting, appraisals, sale of assets) 7. The financial distress costs are often provided as arguments for risk management implementation, which includes also insurance implementation if justified (MacMinn and Garven, 2000, p ; Stulz, 2008, p ). As for insurance, anor convincing argument can be contributed to discussion. Insurance influences level of operating (business) risk of a company, where operating (business) risk is associated with risk of achieving expected operating profit (Brigham, 1992, p. 448). It is under assumption that rate of return required by capital providers (R R ) is constituted by risk-free rate (R RF ) and premium for operating risk (RP O ) toger with premium for financial risk (RP F ) resulting from a company s capital structure (Baker and Powell, 2005, p. 298): R R = R RF + RP O + RP F (2) The impact of insurance on business risk is two-tier. First of all, insurance indemnification for a loss helps company to restore assets relatively quickly and thus come to normal level of operations (where normal means in terms of undisturbed activity). As a consequence, company has a chance to maintain expected level of operations and thus achieve expected level of operating profit. As a result, capital providers of insured company should not charge higher operating risk premiums which stabilises (or even decreases) WACC. Secondly, insurance reduces worries and fears both of insured company and of entities in its business environment. Thus, insured company gains competitive advantage over uninsured one. Among ors, insured company has a chance to improve economic contacts with capital providers as a group of stakeholders. Apart from previously discussed reduction of operating risk premium, a company may benefit from a better access to additional funds while needed for extending scale of operating activity. It is because certain types of insurance might be used as protective measures in crediting (e.g. credit insurance). The same pattern is followed with regard to suppliers who may be more willing to offer trade credit (and thus reduce need for debt finance) if secured with proper insurance (Wieczorek-Kosmala, 2010c, p ). Insurance and total average cost of capital (TACC) The traditional concept of cost of capital measurement embodied in WACC formula is based on balance sheet cost of capital components. However, implementation of in- 7 The extended analysis and detailed examples of costs of financial distress and bankruptcy costs, including ir impact on value creation process according to trade-off ory, are provided in (Berk and DeMarzo, 2007, p ; Ross, Westerfield and Jaffe, 2005, p ; Copeland et al., 2005, p ). 65

6 surance (and or tools of risk finance) brings to capital structure additional, off-balance sheet sources of capital. This concept is under-pinning perception of risk capital in nonfinancial companies. Risk capital is here associated with capital gared by company for purposes of risk coverage. Thus, total capital of a company might be divided into operating capital required for operating activity and risk capital required for risk financing purposes (Duliniec, 2011, p. 152). The risk capital might be gared within both balance sheet capital and off-balance sheet capital. The company which is managing risk implements to broadly understood capital structure off-balance sheet capital which is raised conditionally upon risk occurrence. It is in form of application of different risk management tools, including insurance. The concept of risk capital and its structure was introduced by Shimpi (2001) and n extended by Culp (2002). Both discuss consequences of risk financing tools implementation with regard to conditional capital infusion. Shimpi argues that balance sheet capital of a company reflects risk retention capital. The off-balance sheet capital is risen if company implements or risk financing tools while managing risk. These instruments traditionally include risk retention instruments in form of economic reserves, as well as non-traditional solutions ( above mentioned ARTs or ARFs), and risk transfer mechanism such as derivatives (in hedging function) and insurance. Shimpi called his model insurative model, however he didn t narrow his statements to insurance solely (Shimpi, 2001, p ). Culp (2002) revised and extended this concept and called it risk-based capital structure. In Culp s concept risk retention instruments should be associated with syntic debt as implementation of such instruments does not influence situation of owners. In case of adverse risk development (e.g. catastrophic risk), that will cause exhaustion of a particular risk retention funding, owners finally will bear risk outcomes. The risk transfer instruments, however, should be associated with syntic equity, as negative outcomes of risk are transferred to third party who entered risk transfer contract (Culp, 2002, p ). In addition, Shimpi (2001) developed a formula of TACC (total average cost of capital) which is based on idea of WACC computation extended with regard to off-balance sheet capital components (Shimpi, 2001, p. 14). Taking into consideration all arguments developed by both Culp and Shimpi, it should be assumed that capital structure of a company (TC) includes equity (E), debt (D) and off-balance sheet capital components: syntic equity (SE) and syntic debt (SD). Then, with analogy to WACC computation, TACC is computed as follows: E D SE SD TACC = C E + C D + C SE + C SD (3) TC TC TC TC where C E, C D, C SE and C SD represent cost of particular capital structure components respectively and in case of C D and C SD it is after-tax cost whenever applicable. Concerning Shimpi s and Culp s concept of risk capital and risk capital structure, insurance should be perceived as off-balance sheet, conditional capital structure component. Assuming that a company implements solely insurance as risk financing instrument, model of a capital structure in such company might be characterised as presented in Figure 2. 66

7 component. Assuming that a company implements solely insurance as risk financing instrument, model of a capital structure in such company might be characterised as presented in Figure 2. Figure 2: A model of capital structure of a company implementing insurance Figure 2: A model of capital structure of a company implementing insurance TOTAL RISK CAPITAL BALANCE SHEET CAPITAL EQUITY FINANCE DEBT FINANCE RISK RETENTION OFF-BALANCE SHEET CAPITAL INSURANCE RISK TRANSFER Source: Own study Source: Own study As a consequence, total average cost of capital (TACC) should be computed as follows: As a consequence, E D total average I cost of capital (TACC) should be computed as follows: TACC = C E + C D + E C I D I (4) TC TC TACC TC CE CD CI (4) TC TC TC where I is is volume of of off-balance sheet sheet funding springing from from insurance contract and and C I I is is after-tax cost cost of of insurance (or assumptions from formula held constant). These elements require a a closer closer attention attention with with regard regard to ir to ir computation. computation. The The value value of insurance of insurance off- off-balance sheet sheet funding funding (I) should (I) should be associated be associated with with insurance insurance sum. sum. The The insurance insurance sum sum is always is always provided provided in in insurance insurance contract contract and and depending depending on on type type of insurance of insurance it is it based is based on on value value of physical of physical assets assets of a of company a company or its or expectations its expectations of of potential potential loss that loss may that arise may from arise a from particular a particular risk (e.g. risk in (e.g. liability in liability insurance). insurance). However, However, Shimpi Shimpi (2001, p. (2001, 15) argues p. 15) that argues for that purposes for of purposes TACC computation of TACC computation current value current of insurance value of sum insurance should be sum applied. should This be would applied. be This of importance would be in of case importance of multi-year in case coverage. of multi-year However, coverage. in property However, and casualty in insurance property and one-year casualty cover insurance is more one-year common. cover is more common. The cost of of insurance capital (C (C I ) should I ) should be obviously be obviously associated associated with with insurance insurance premium premium pay- payment. Here, Here, following following need need of expressing of expressing cost of cost capital of capital as rate as of rate return, of return, C I should C I be should computed be computed as value as of value insurance of insurance premium premium paid (P) divided paid (P) by divided insurance by sum insurance (I). sum (I). The dilemmas over application of insurance in The dilemmas cost of capital over computation application of insurance in cost of capital The computation application of TACC concept may raise some disputable problems. It is connected with specifics The application of insurance of TACC sum concept and insurance may raise premium some and disputable consequences problems. It of is ir connected changes with on average specifics cost of of insurance capital within sum and risk-capital insurance model. premium First and of all, consequences capital structure of ir is enriched changes with on an average additional cost element of capital that may within have risk-capital a value comparable model. First with of or all, important capital capital structure components enriched and with at an additional same time element has much that lower may cost have of a capital. value comparable The insurers with compute or important premi- is ums capital using components insurance and premium at rates same expressed time has per much mille lower due to cost ir of small capital. height. The The insurers insurance premium rates depend on type of insurance which is influenced mainly by type of risk insured and number Financial of Internet insured Quarterly e-finanse entities entering 2012, vol. 8, nr insurance 1 pool; thus it can 71 be relatively low. As a consequence, it may decrease average cost of capital significantly. The above conclusions may be supported by development of a simple analytical model. Sucharskiego 2 The prime assumption is that assets (A) of Rzeszów a company are homogenous and are insured 67

8 against one specific type of risk. Then, C I = p under assumption that P = p I (where P equals premium paid). The insured sum (I) depends on portion (hereafter denoted as α ) of assets insured against ( I = α A ). If α ( 1) > α (0), which means that greater portion of assets is being insured, n I ( 1) > I (0) and TC (1) > TC (0). Accordingly, assuming that or components of total risk capital (TC) are held constant, costs of TC components are held constant and insurance premium rate (p) is held constant, TACC ( 1) < TACC(0). Assuming that p ( 1) < p(0), which means that company managed to reduce premium payments (e.g. by changing insurance provider or reducing current risk profile within aspects taken into consideration by insurance provider), C I < C ( 1) I. Accordingly, (0) under assumption that or components of total risk capital (TC) are held constant, costs of TC components are held constant and α is held constant, TACC ( 1) < TACC(0). This simple model indicates that under assumptions of risk capital structure model in its current (above presented) state, any increase of insurance cover and any decrease in insurance rate will produce lower cost of capital. In order to present how far above described mechanism may affect TACC, a simplified hypotical numerical example is provided below. Lets assume that company X requires capital for funding assets of which half are fixed assets and or half are current assets. The capital structure with regard to volume of equity and debt for that company is provided in Table 1. Table 1: The balance sheet of a hypotical exemplary company Assets Volume Capital Volume fixed assets equity current assets debt Assets in total Capital in total Source: Own study The following assumptions are that equity costs 12% pro year (C E = 12%) and debt costs 10% pro year (C D = 10%), which gives after-tax cost of debt of 8,1% with assumption of 19% of tax rate. In order to examine possible scale of impact of insurance implementation on average cost of capital, it is assumed that hypotical exemplary company buys coverage for its fixed assets (FA) with insurance rate equal to 1% ( p = 1% ) 8 and insurance sum (I) equal to I = α FA, where α represents portion of balance sheet value of insured fixed assets. With regard to se variables, average cost of capital is computed and analysed for following situations: situation (1): WACC (1) of a company under assumption that company does not implement insurance, situation (2): TACC (2) of a company under assumption that half of a company s fixed assets are covered under insurance contract, or things held constant ( α = 0, 5 ), situation (3): TACC (3) of a company under assumption that all its fixed assets are covered under insurance contract, or things held constant ( α = 1), 8 As mentioned previously, insurance rates are usually expressed per mille. However, for simplicity of example provided assumed rate is higher (which will not influence negatively final conclusions). 68

9 situation (4): TACC (4) of a company under assumptions from situation (3) and additional reduction of insurance rate (p) to 0,08%, or things held constant. The WACC or TACC for each situation is provided in Table 2. Source of capital Table 2: The average cost of capital of hypotical exemplary company in revised situations Volume Share in capital structure Pre-tax cost of capital After-tax cost of capital Cost of a capital structure component and WACC/TACC SITUATION (1) Equity (E) ,00% 12,00% 6,0000% Debt (D) ,00% 10,00% 8,10% 4,0500% In total: ,00% WACC (1) = 10,0500% SITUATION (2) Equity (E) ,00% 12,00% 4,8000% Debt (D) ,00% 10,00% 8,10% 3,2400% Insurance (I) ,00% 1,00% 0,81% 0,1620% In total: ,00% TACC (2) = 8,2020% SITUATION (3) Equity (E) ,33% 12,00% 4,0000% Debt (D) ,33% 10,00% 8,10% 2,7000% Insurance (I) ,33% 1,00% 0,81% 0,2700% In total: ,00% TACC (3) = 6,9700% SITUATION (4) Equity (E) ,33% 12,00% 4,0000% Debt (D) ,33% 10,00% 8,10% 2,7000% Insurance (I) ,33% 0,08% 0,06% 0,0216% In total: ,00% TACC (4) = 6,7216% Source: Own study In situation (1) where no insurance is implemented, average cost of capital equals 10,05%. The admission of total risk-based capital concept and implementation of insurance as assumed in situation (2) reduces average cost of capital to 8,202% (so TACC ( 2) < WACC(1 ) ). The assumption that all fixed assets are insured as in situation (3) reduces average cost of capital even more to 6,97% ( TACC ( 3) < TACC(2) ). If company would gain additionally reduction of insurance premium as assumed in situation (4), n average cost of capital would decrease to 6,7216% ( TACC ( 4) < TACC(3) ). The reduction of a premium is obtainable if a company contributes significantly to insurance pool (especially in tailor-made insurance programs). This simplified example convinces clearly that insurance implementation may visibly reduce cost of capital on average if concept of risk-based capital structure and TACC are followed. Moreover, higher insurance sum and lower insurance rate, this impact will be stronger. 69

10 Conclusions The presented concept of interactions between insurance implementation and corporate cost of capital highlighted two separate approaches. The first one, as a classical concept, explains possible impact of insurance on weighted average cost of capital (WACC), computed with regard to balance sheet capital structure. It explains why and how insurance may affect changes in capital structure and/or cost of particular cost of capital components with regard to debt and equity finance. The second concept, which is a novel idea in this field, argues that implementation of insurance (and or risk financing tools) changes perception of cost of capital components, and thus decisions about capital structure. This concept, however, introduces a novel formula of cost of capital computation TACC (total average cost of capital). The presented model followed by simple numerical example convinces that a company following this concept may significantly reduce its cost of capital by implementing insurance. However, in financial decision making this concept should not be used extensively and companies should rar follow idea of WACC. Perhaps in future studies will develop areas of practical implementation of TACC concept. Currently, utility of TACC should be perceived mainly though educational dimension. It forms first attempt to clarify connections between implementation of risk management tools (in this insurance) and capital structure decisions of a company. As a consequence, TACC concept convinces that corporate need for capital springs not only from operating activity but also from need to protect against negative risk outcomes. Thus, prime concern of a company should be directed to risk management issues (including decisions about implementation of various risk finance instruments). Afterwards, company should decide about application of particular sources of risk capital. References Baker, H. K., Powell, B. E. (2005). Understanding Financial Management. A Practical Guide. Oxford: Blackwell Publishing. Berk, J., DeMarzo, P. (2007). Corporate Finance. Boston: Pearson Education. Brigham, E. F. (1992). Fundamentals of Financial Management. Fort Worth: The Dyrden Press. Copeland, T. E., Weston, J. F., Shastri, K. (2005). Financial Theory and Corporate Policy. Boston: Addison Wesley. Culp, C. (2001). The Risk Management Process. Business Strategy and Tactics. New York: John Wiley & Sons. Culp, C. (2002). The ART of Risk Management. Alternative Risk Transfer, Capital Structure and Convergence of Insurance and Capital Markets. New York: John Wiley & Sons. Doherty, N. A., Smith, C. W. (2003). Corporate Insurance Strategy: The Cost of British Petroleum. In: J. M. Stern, D. H. Chew (ed.), The Revolution in Corporate Finance. 4 th ed. (p ). Malden: Blackwell Publishing. Duliniec, A. (2011). Finansowanie przedsiębiorstwa. Strategie i instrumenty. Warszawa: PWE. Groppelli, A. A., Nikbakht, E. (2006). Finance. New York: Barron s. Hartwig, R. P., Wilkinson, C. (2007). An Overview of Alternative Risk Transfer Market. In: J. D. Cummins, B. Vernard (ed.), Handbook of International Insurance. Between Global Dynamics and Local Contingencies (p ). New York: Springer. MacMinn, R., Garven, J. (2000). On Corporate Insurance. In: G. Dionne (ed.), Handbook of Insurance (p ). Boston/Dordrecht/London: Kluver Academic Publishers. 70

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