Academic journal article Journal of Risk and Insurance

Capital Shocks and Merger Activity in the Property-Liability Insurance Industry

Academic journal article Journal of Risk and Insurance

Capital Shocks and Merger Activity in the Property-Liability Insurance Industry

Article excerpt

INTRODUCTION

This article investigates the role that target capital needs play in mergers and acquisitions in the property-liability insurance industry. The theoretical underpinning of the article is the work of Myers and Majluf (1984) and others who argue that firm capital structure and financing decisions are driven in part by information asymmetries between firms and capital markets. If firms possess private information about their future earnings, this can lead to an adverse selection problem: the private information will lead to lower valuations of firms with better than average earnings prospects and hence, firms with the best prospects will be most reluctant to obtain capital from external sources. This adverse selection problem raises the cost of external funds relative to that of internally generated funds for all firms, and introduces a preference among firms for internally generated capital.

The point of departure for the analysis of merger motives is the idea that the high cost of external capital caused by asymmetric information, and the associated under-investment in projects which would otherwise have positive net present value, creates potential gains from mergers between well-capitalized firms and poorly-capitalized firms (Myers and Majluf 1984). Such gains could be realized if information asymmetries are lower between the capital-poor firms and potential acquirers than they are between the firm and other providers of capital. The acquiring firm can thus gain from the merger by exploiting its information advantage over the general equity market. In particular, in this circumstance the acquired firm is likely to be undervalued; given a capital infusion this undervalued asset will yield a high return relative to its low purchase price. This study refers to these types of mergers as being driven by financial synergies, and investigates the prevalence of this merger motive in the property-liability insurance industry.

The idea that insurance mergers could occur for financial synergies is appealing due to the significant potential for information asymmetries between insurance firms and capital markets.(1) Insurer liabilities consist primarily of loss reserves and thus are highly firm-specific and subject to both errors and discretion in the estimation of their value. Many insurer assets, like those of other service providers, are intangible and therefore difficult to evaluate by firm outsiders. Information asymmetries are likely to be especially severe for the large segment of the industry made up of closely held or thinly traded stock companies, or mutuals. Moreover, the regulation of surplus ratios in the industry limits the use of risky debt, a source of capital thought to be less costly than external equity issues.(2) Insurance companies that are capital constrained can reduce dividend payments or increase earnings retention, or issue stock.(3) The first two alternatives are likely to increase capital only incrementally and only with a time lag. If the final alternative leads to asymmetric information costs,(4) insurance organizations may seek capital via alternative mechanisms such as merger or the private placement of shares.

In contrast to the literature on stock issuances, the literature associated with mergers and acquisitions and private placements finds that these transactions are not associated with stock price declines (Wrack 1989). In the case of mergers, the non-negative stock price reactions to these announcements may be due to gains from financial synergies, but also to factors such as economies of scale or scope or the replacement of inefficient management. We term the gains from these latter sources as arising from operating synergies. Because of the confounding effects associated with operating synergies, it is not possible to make general predictions about the placement of mergers in the financing pecking order.(5) Nonetheless, if there are information imperfections in capital markets one expects to observe some insurance mergers motivated primarily by financial synergies. …

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