Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry

By Cummins, J. David; Phillips, Richard D. et al. | Journal of Risk and Insurance, March 2001 | Go to article overview

Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry


Cummins, J. David, Phillips, Richard D., Smith, Stephen D., Journal of Risk and Insurance


ABSTRACT

In this article, the authors analyze the derivatives holdings of U.S. insurers to empirically investigate the general hypotheses developed in the financial literature to explain why widely held, value-maximizing firms engage in risk management. The authors also develop a new hypothesis suggesting that although measures of risk and illiquidity will be positively associated with an insurer's decision to engage in risk management, these same measures of risk will be negatively related to the volume of hedging for the set of firms who choose to hedge using derivatives. The authors' analysis provides considerable support for general hypotheses about hedging by value-maximizing firms. The authors also find support for the hypothesis that, conditional on having risk exposures large enough to warrant participation, firms with a larger appetite for risk will engage in less hedging than firms with lower risk tolerance.

INTRODUCTION

The use of derivatives in corporate risk management has grown rapidly in recent years, fueled in part by the success of the financial industry in creating a variety of over-the-counter and exchange-traded products. A 1998 survey of major non-financial firms revealed that at least 80 percent are using some form of financial engineering to manage interest-rate, foreign exchange, or commodity price risk (Bodnar, Hayt, and Marston, 1998). Financial firms, including banks (see, for example, Gunther and Siems, 1995; and Shanker, 1996), savings and loans (Brewer et al., 1996), and insurers (Colquitt and Hoyt, 1997; Cummins, Phillips, and Smith, 1997) also are active in derivatives markets. Although the types of risks confronting managers vary across industries, there is substantial commonality in the underlying rationale for the use of derivatives and the financial engineering techniques that are employed.

At first glance, the widespread use of derivatives seems inconsistent with modern finance theory, which provides little motivation for hedging by widely held corporations. According to theory, shares of such corporations are held by diversified investors who operate in frictionless and complete markets and thus can eliminate nonsystematic risk through their portfolio choices. In this context, risk management at the firm level is a dead-weight cost that destroys shareholder value. Although valuable as a starting point, this frictionless theory has given way in recent years to a richer set of hypotheses whereby various market imperfections create motivations for value-maximizing corporate managers to alter the risk/return profile of the firm. [1] Among the market imperfections that have been identified are corporate income taxation, costs of financial distress, various types of agency costs, and information asymmetries between managers and investors. Financial firms such as insurers and banks also are motivated to hedge by product market considerations because their customers are particularly sensitive to insolvency risk (Merton and Perold, 1993). Non-value-maximizing motives resulting from uncontrolled agency problems and managerial risk aversion also may play a role in motivating risk management (MacMinn and Han, 1990).

This article provides new evidence on the use of derivatives for corporate risk management by examining factors that influence the use of financial derivatives in the U.S. insurance industry. The authors investigate rationales that might explain both the decision to use derivatives as well as the volume of these transactions. The principal objective is to empirically investigate the general motivations for corporate risk management as well as several more specific hypotheses relating to the insurance industry. The insurance industry provides a particularly revealing setting in which to analyze risk management because insurers are required to disclose considerably more information about their derivatives transactions than are firms in other industries. …

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