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Investors may underdiversify their portfolios by overweighting securities in which they perceive an informational advantage or by underweighting securities to hedge risks outside the portfolio. We investigate underdiversification in institutional portfolio construction by examining the under/overweighting of industries in U.S. property–liability (PL) insurers' equity portfolios. We find that PL insurers underweight both their own industry and highly correlated industries in their portfolios. This underweighting is larger for PL insurers exposed to higher underwriting risk. Although PL insurers have an informational advantage in investing in their peers, their underwriting risk drives them to underweight stocks in their industry. [ABSTRACT FROM AUTHOR]

Empirical evidence suggests that insurance groups allocate capital to members with better performance or growth prospects and use internal capital markets (ICMs) to protect the franchise value of less capitalized members. We propose and test an additional motivation for the use of ICMs—to manage regulatory scrutiny risk. We show that almost 50% of insurers at risk of facing additional regulatory scrutiny due to failing four Insurance Regulatory Information System (IRIS) ratios received sufficient internal capital to avoid enhanced regulation. Moreover, the likelihood and extent of internal capital allocation are related to regulatory scrutiny risk and the amount of capital allocated is typically just enough to avoid regulatory scrutiny. Time series evidence indicates that groups manage regulatory scrutiny risk by allocating capital toward affiliates when their pre‐capital contribution IRIS ratio failures exceed three, and away from affiliates when they are no longer at risk of additional regulatory scrutiny. [ABSTRACT FROM AUTHOR]