Intangible Assets and Firm Asset Risk Taking: An Analysis of Property and Liability Insurance Firms

By Yu, Tong; Lin, Bingxuan et al. | Risk Management and Insurance Review, Spring 2008 | Go to article overview

Intangible Assets and Firm Asset Risk Taking: An Analysis of Property and Liability Insurance Firms


Yu, Tong, Lin, Bingxuan, Oppenheimer, Henry R., Chen, Xuanjuan, Risk Management and Insurance Review


ABSTRACT

Intangible assets facilitate insurers' capacity to retain existing business and attract new clients. In this study we analyze how the incentives to protect intangible assets affect asset risk-taking behavior of property and hability insurers. The result supports the view that insurers' incentives to protect their intangible assets lead to an inverse relation between intangible assets and asset risk. Consistent with the view that highly levered firms may go for broke, asset risk of highly levered insurers is less elastic to intangible assets than that of lower-levered insurers. An additional notable finding of our article is that tangible factors like firm size and capitalization increase insurers' appetites for asset risk taking.

INTRODUCTION

Property and liability insurance companies invest in diversified portfoUos of financial assets, including government and corporate bonds, common stocks, preferred stocks, real estate, and mortgage loans. Investment in risky assets generates revenue to cover insurers' claim payments and underwriting expenses.1 However, excessive asset risk taking subjects insurers to a volatile environment that potentially weakens insurers' ability to pay back claims and even threatens their survival.2 Thus, understanding asset risk taking is of interest to insurance company executives, policyholders, investors, and insurance regulators.

The purpose of this study is to examine the role of intangible assets in asset risk taking decisions of property and liability insurance firms. Intangible assets of insurance companies, also known as franchise value, intangible value, charter value, or quasi-economic rents, include insurers' brand names, personnel, renewable business, and specialty in claim service and underwriting. Insurers make significant investment in intangible assets in anticipation of staying in and expanding their business.3 The literature suggests that insurers' exposure to insolvency risk negatively affects their intangible assets (see, e.g., Harrington and Danzón, 1994; Babbei and Merrill, 2005). Lower insolvency risk improves an insurer's opportunity to capture the economic rents arising from intangible assets. Consequently, high-quality insurers may refrain from investing in risky assets to protect intangible assets. With a parsimonious model of intangible assets, we demonstrate insurers' asset risk is inversely related to their intangible assets. We refer this to as the protecting intangible asset hypothesis.

The literature also suggests that insurers may sometimes opt to go for broke in making asset risk taking decisions. Insurers have limited liabilities to policyholders and this may give rise to moral hazard problems. Standard option pricing theory predicts that equity holders of levered firms are inclined to assume excessive risks and expropriate wealth from policyholders.4 We expect that asset risk of a highly levered firm is less responsive to intangible assets than that of a lower-levered firm. We consider this hypothesis as the going-for-broke (or gambling) hypothesis.

To empirically examine the above two hypotheses, we analyze a large sample of property and liability firms covered by the National Association of Insurance Commissioners (NAIC) InfoPro database. We measure an insurer's asset risk by its fractional investment in common stocks and low-quality bonds. Intangible assets are proxied by the residuals of a regression of Best's ratings after controlling for certain firm characteristics. Specifically, in each year we perform cross-sectional regressions of Best's ratings with various tangible factors of insurance companies, such as firm size, capitalization, and liquidity. The residuals of the regressions are used to measure insurers' intangible assets. Our empirical finding supports the intangible asset protection hypothesis where insurers' asset risk taking in the subsequent year is inversely related to their (prior year) level of intangible assets. …

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