Academic journal article Journal of Risk and Insurance

Insurer Capital Structure Decisions and the Viability of Insurance Derivatives

Academic journal article Journal of Risk and Insurance

Insurer Capital Structure Decisions and the Viability of Insurance Derivatives

Article excerpt

Introduction

Claim costs for property-liability insurers are correlated because of common "shocks" that impact the frequency or severity of claims (e.g., catastrophes, changes in tort law, inflation). These events affect insurer profits and may also affect the price and availability of coverage. For example, large natural catastrophes can disrupt reinsurance markets, thus aggravating the effects on primary insurance markets (see Berger, Cummins, and Tennyson, 1992, and Insurance Services Office, 1994). Winter (1994), Cummins and Danzon (1994), Gron (1994), and Cagle and Harrington (1992) all present models that demonstrate how industry shocks can influence insurance prices and quantities. In each of these models, insurance supply is an increasing function of insurer capital, and capital market imperfections make raising new capital costly. A shock that reduces insurer capital thus causes a reduction in supply and a corresponding increase in price.

An insurer could earn higher profits if it could avoid losing capital following a shock that depletes its competitors' capital and raises industry prices. Thus, insurers have an incentive to manage correlated risks to mitigate the impact of industry shocks on their operations. Potential methods of managing correlated risk include holding additional equity capital, purchasing reinsurance, and sharing risk with policyholders.(1) This article's purpose is to examine whether insurance futures and option contracts recently introduced by the Chicago Board of Trade (CBOT) are likely to lower insurers' costs of bearing correlated risk.(2) Two separate issues are examined. First, a conceptual analysis is provided of the costs of using futures relative to alternative methods of dealing with correlated risk. Second, empirical evidence is presented on the magnitude of correlated risk and on the potential effectiveness of insurance futures in hedging correlated risk.

The conceptual analysis focuses on insurance futures and equity capital as alternative methods of managing correlated risk. This reflects, in part, the current lack of research on the tradeoffs between equity capital and futures.(3) Moreover, since correlated risk cannot be diversified within the industry, both reinsurers and primary insurers must manage correlated risk. If reinsurers have an advantage relative to primary insurers in bearing correlated risk, the advantage arises because they have lower costs of equity capital or specialized knowledge of the measurement and/or management of correlated risk.

The analysis assumes that insurers are averse to default risk because it lowers the price informed consumers are willing to pay for insurance and increases the likelihood that the insurer will lose its "franchise value" (i.e., the loss of future quasi rents from investments in reputation and building a book a business). Although holding equity capital reduces default risk, market imperfections make holding equity capital costly--for example, equityholders require compensation for tax and agency costs. These costs might be reduced by having investors provide capital only when it is needed to pay claims (e.g., following a catastrophe). Contingent capital contracts, however, can suffer from nonperformance. Investors may renege on their implicit or explicit promises to provide contingent capital because such capital may largely benefit policyholders. As explained below, because of the daily settlement (marking to market) system employed by the futures exchange, insurance derivatives represent a credible form of contingent capital that can substitute for equity capital. The analysis predicts that insurers tradeoff the marginal tax and agency costs of equity capital against the transaction costs of making derivatives a credible source of contingent capital plus any residual risk of nonperformance.

To provide evidence on the ability of insurance futures contracts to hedge correlated risk, indices are constructed based on industry incurred losses for several lines of insurance and on catastrophe losses in multiple lines. …

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