Academic journal article Risk Management and Insurance Review

The Impact of Institutional Ownership on the Reinsurance Decision

Academic journal article Risk Management and Insurance Review

The Impact of Institutional Ownership on the Reinsurance Decision

Article excerpt

ABSTRACT

Risk management has a central role in corporate America. Insurance companies frequently manage risk by purchasing reinsurance because it reduces the downside risk (i.e., bankruptcy risk) of an insurer. Because reinsurance is costly, Mayers and Smith (1990, Journal of Business, 63: 19-40) argue that reinsurance purchases should be negatively associated with the diversification of the owners' portfolios. Further, institutional owners play a significant role in equity markets yet we know little about their effect on firm behavior. The purpose of this study is to examine empirically the influence of institutional ownership on reinsurance for a sample of widely held property-liability insurers. We hypothesize that insurers with higher levels of institutional ownership purchase less reinsurance. Using a sample of 45 publicly traded property-liability insurers from 1995 to 1997, we demonstrate that the utilization of reinsurance decreases as the level of institutional ownership increases. This suggests that the diversification of the owners' portfolios is a determinant of the insurers' reinsurance decisions.

INTRODUCTION

Risk management has a central role in corporate America. Organizations spend a considerable amount of resources on the treatment of risk. By identifying risks, analyzing and evaluating risks, and properly selecting appropriate risk treatment methods, an organization can minimize the cost of risk and help to maximize the value of the firm. Insurance companies frequently manage risk by purchasing reinsurance because it reduces the downside risk (i.e., bankruptcy risk) of an insurer. Because reinsurance is costly, Mayers and Smith (1990) argue that reinsurance purchases should be negatively associated with the diversification of the owners' portfolios. Consistent with their prediction, they find that widely held property-liability insurers purchase less reinsurance than closely held, single-owner, and association-owned property-liability insurers.

Further, institutional ownership plays a significant role in equity markets. In 1997, institutional investors controlled 55 percent of U.S. equities (Hubbard, Houminer, and Downes, 1999) yet we know little about their effect on firm behavior. Most research (see Karpoff, 1988; Black, 1998) in this area focuses on the effect of institutional ownership on performance and governance structure. Despite the significance of risk management and institutional ownership, there are few, if any, studies that explore the relationship between the two.

The purpose of this study is to extend these two lines of research by empirically examining the influence of institutional ownership on reinsurance for a sample of widely held property-liability insurers. Institutional investors are comprised of organizations with at least $100 million of assets under management, including banks, insurance companies, mutual funds, brokerage firms, pension funds, and university endowments. Because institutional investors are generally well diversified, we hypothesize that insurers with higher levels of institutional ownership purchase less reinsurance.

We test our hypothesis by estimating an ordinary least squares model (OLS) for a sample of 45 publicly traded property-liability insurers from 1995 to 1997. Consistent with our prediction, we demonstrate that the utilization of reinsurance decreases as the level of institutional ownership increases. This suggests that the diversification of the owners' portfolios is a determinant of the insurers' reinsurance decisions. Our result is robust to controlling for the economic determinants of reinsurance identified in prior literature as well as managerial holdings of stock and stock options that may affect the managers' incentive to purchase reinsurance.

It is possible that factors contributing to the level of reinsurance purchases also contribute to the level of institutional ownership. Therefore, we also estimate a two-stage least squares (2SLS) model in which institutional ownership is endogenously determined. …

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