Gene C. Lai

Underwriting Cycles in Property and Liability Insurance: An Empirical Analysis of Industry and By- Line Data

Using industry and by-line data, we examine the causes of insurance cycles in a vector autoregressive model. Some of the important findings are summarized below. First, the uncertainty variable explains significant portions of forecast errors of premiums. Second, the significant factors that determine premiums are different for different lines. Third, investment incomes in general are more important for long-tail lines than short-tail lines. Evidence on the response of premiums to shocks suggests that all one-time shocks to variables tend to be relatively permanent. The overall results seem to imply that no single hypothesis is able to explain the insurance cycle.

Efficiency and Demutualization: Evidence from the U.S. Life Insurance Industry in the 1980s and 1990s

This article examines the efficiency changes of U.S. life insurers before and after demutualization in the 1980s and 1990s. We use two frontier approaches (the value-added approach and the financial intermediary approach) to measure the efficiency changes. In addition, we use Malmquist indices to investigate the efficiency and productivity change of converted life insurers over time. The results using the value-added approach indicate that demutualized life insurers improve their efficiency before demutualization. On the other hand, the evidence using the financial intermediary approach shows the efficiency of the demutualized life insurers relative to mutual control insurers deteriorates before demutualization and improves after conversion. The difference in the results between the two approaches is due to the fact that the financial intermediary approach considers financial conditions. The results of both approaches suggest that there is no efficiency improvement after demutualization relative to stock control insurers. There is, however, efficiency improvement relative to mutual control insurers when the financial intermediary approach is used.

Great (and not so great) expectations: An endogenous economic explication of insurance cycles and liability crises

ABSTRACT The causes of insurance cycles and liability crises have been vigorously sought, claimed, and debated by academic investigators for years. The model provided here partially synthesizes several stands of this literature and provides an additional cause. In addition to causes such as the loss-shocks and interest-rate changes included as explanations in the literature, this model posits changing expectations about the parameters of corporate net income as causes of cycles and crises. Since both sides of the market form expectations about losses and interest rates, changes in both demand and supply in the market are incorporated in the explanation. Changing expectations during the crisis reduced supply and made it more inelastic. The same changing expectations increased demand and made it more inelastic and so amplified the effect due to a change in supply. The model predicts an increase in the equilibrium premium, when the mean and variance of losses increase. The model also predicts an increase in the equilibri um premium when the mean interest rate decreases and variance increases. The empirical results of cross-sectional regression and time-series analyses are consistent with the predictions. The analysis then provides some insight on how to dampen future cycles and reduce the effect of future liability crises. INTRODUCTION Insurance cycles [2] have been recognized for decades and have been the object of study by academic investigators for that long (see Cummins, 1987). The reason for this intense study is both basic (theoretical) and practical. At a basic level, questions arise about whether such cycles conflict with rational corporate decision making in an efficient financial market. From a practical perspective, such cycles can, at their extreme-most valleys, create crises in affordability and availability of insurance, affecting the very productivity of the country involved. The liability insurance crisis in the United States from late 1984 through 1986 is an example of such an extreme in the insurance cycle, being characterized by significant economic disruptions in commercial liability insurance markets. The disruptions created concerns about both the availability and affordability of certain covers. For example, professional and commercial liability insurance consumers were adversely affected by the crisis, as were others such as chemical and pharmaceutical companies, day-care centers, doctors, and municipalities. The cycle ultimately resulting in the crisis was characterized by a sudden increase in liability premiums in late 1984 after about six years of relatively stable prices. An additional response to changes in this cycle included the lowering of policy limits and a reduction in scope of coverage in commercial liability lines that were characterized by long-tails. In addition, insurers were unwilling to provide any coverage at all for some risks, e.g., those involving pollution liability exposures. [3] Academics, attorneys general, consumers, insurers, and regulators have not agreed on the causes of insurance cycles, and the causes of the commercial liability insurance crisis of the late 1980s are still debated. The cycles and crisis theories that do appear in the literature share at least two common characteristics. First, the theories focus on the supply of liability insurance and ignore the demand. Although it is implicit in some theories, the demand for liability insurance during the cycles and crisis is generally not addressed. Second, the theories emphasize a single factor as the cause of the crisis or cycle, although exactly what the single factor is has varied from explanation to explanation. This shared single-factor approach to insurance cycle and crisis explications creates problems. First, the single-factor theories do not explain enough aspects of the crisis, even though each offers some insight. For example, the U. S. Justice Department (Justice, 1986) has cited the expansion of business liability under tort law as the factor explaining higher premiums and reduced coverage limits. …

Organizational Structure, Board Composition, and Risk Taking in the U.S. Property Casualty Insurance Industry

This study examines the impact of organizational structure and board composition on risk taking in the U.S. property casualty insurance industry, addressing different risk‐taking behaviors from different perspectives. The risk‐taking measures include total risk, underwriting risk, investment risk, and leverage risk. The evidence shows that mutual insurers have lower total risk, underwriting risk, and investment risk than stock insurers. In terms of board composition variables, we find that some board composition variables not only have impact on risk‐taking behaviors but also affect different risk measures differently. Thus, using different risk measures is better than using one risk measure to assess risk‐taking behavior. Finally, we conclude that an insurer can control its total risk through management of underwriting, investment, and leverage risks that determine an insurers risk profile.

Corporate Governance and Efficiency: Evidence from U.S. Property–Liability Insurance Industry

This study examines the relation between corporate governance and the efficiency of the U.S. property–liability insurance industry during the period from 2000 to 2007. We find a significant relation between efficiency and corporate governance (board size, proportion of independent directors on the audit committee, proportion of financial experts on the audit committee, director tenure, proportion of block shareholding, average number of directorships, proportion of insiders on the board, and auditor dependence). We also find property–liability insurers have complied with the Sarbanes‐Oxley Act (SOX) to a large extent. Although SOX achieved the goal of greater auditor independence and might have prevented Enron‐like scandals, it had some unexpected effects. For example, insurers became less efficient when they had more independent auditors because the insurers were unable to recoup the benefits of auditor independence.

A financial-economic evaluation of insurance guaranty fund system: An agency cost perspective

Abstract Recent occurrences of financial distress to some insurers have raised questions about whether the current guaranty system is adequate to protect policyholders. Four new systems have been proposed. Using the state preference model, it was found the Stewarts national system faring the best, if it adopts uniform regulation. Based on agency theory, the pre-assessment approach and the policyholder surcharge (or premium increase) recoupment method were found to be better than the current post-assessment approach and premium tax offset method. Furthermore, uniform policy limits and regulations are recommended.

Estimating the Cost of Equity for Property-Liability Insurance Companies

Due to the highly skewed and heavy-tailed distributions associated with the insurance claims process, we evaluate the Rubinstein-Leland (RL) model for its ability to improve the cost of equity estimates of insurance companies because of its distribution-free feature. Our analyses show that there is as large as a 94-basis-point difference in the estimated cost of insurance equity between the RL model and the capital asset pricing model (CAPM) for the sample of property-liability insurers with more severe departures from normality. In addition, consistent with our hypotheses, significant differences in the market risk estimates are found for insurers with return distributions that are asymmetrically distributed, and for small insurers. Third, we find significant performance improvements from using the RL model by showing smaller values of excess return of the expected return of the portfolio to the model return for a portfolio of insurers with returns that are more skewed and for a portfolio of small insurers. Finally, our panel data analysis shows the differences in the market risk estimates are significantly influenced by firm size, degree of leverage, and degree of asymmetry. The implication is that insurers should use the RL model rather than the CAPM to estimate its cost of capital if the insurer is small (assets size is less than

Forward Market and International Trade

2,291 million), and/or its returns are not symmetrical (the value of skewness is greater than 0.509 or less than - 0.509). Copyright The Journal of Risk and Insurance, 2008.

The Chinese Insurance Market and the WTO

Many studies on hedging currency risk and international trade [6; 14; 18; 17] have investigated the simultaneous hedging and production decisions with the nonstochastic home and foreign earnings assumption. These studies derived a separation theorem which shows that the production decision made by a multinational firm for international trade is independent of the distribution of the exchange rate, and dependent only on the forward price. The separation theorem has two different implications. First, although the production decision is shown to depend on the forward price, there is still a missing link connecting the trading activity in the forward markets with international trade. Second, exchange rate uncertainty will not have an impact on the level on trade since the forward price can be used by multinational firms as a guide for the expected future spot rate. The first implication seems to contradict results by Britto [8] and Telser [37] demonstrating that futures price has a real impact on resource allocation and production within an economy. The second implication is inconsistent with a number of other empirical studies [2; 11; 12; 22; 29] that have shown exchange rate uncertainty has an adverse effect on trade and other studies [5; 13] that have found exchange rate volatility to have a positive impact on trade. Although some studies [7; 27] do recognize stochastic foreign income in the foreign hedging, they ignore the two kinds of issues discussed above. Thus, this paper attempts to investigate the simultaneous decisions for foreign exchange hedging and production under a stochastic assumption of foreign earnings. A simple model is developed here to examine (a) the interaction of forward markets with international trade; and (b) the impact of exchange risk on trade. By endogenizing the forward price in a variety of scenarios, this paper derives several interesting results. Under the stochastic foreign income scenario, a new foreign exchange hedging rule which incorporates the covariability of foreign earnings and exchange risk is derived. Further, we find that the separation theorem breaks down under such a situation. Interestingly, we are able to show a positive linkage between trading activity in forward markets and export. Furthermore,

The Impact of Deregulation on Efficiency: An Analysis of Life Insurance Industry in Taiwan from 1981 to 2004

An overview of the insurance market in China is provided, with a special focus on issues associated with Chinas accession to the WTO. Despite the rapid growth of Chinas insurance industry, its insurance market remains relatively underdeveloped. After Chinas accession to the WTO, the average efficiency of domestic insurers increased. Opening the market to foreign insurers helped to make domestic insurance companies and the national economy more efficient and improved social welfare.