James R. Garven

THE UNDERINVESTMENT PROBLEM, BOND COVENANTS AND INSURANCE

This article complements the earlier work by Mayers and Smith (1987) and Schnabel and Roumi (1989) which showed that a property insurance contract could be used to bond subsequent corporate investment decisions. Although these models suggest one possible approach to solving the underinvestment problem, neither model explicitly specifies the economic mechanism(s) required to guarantee that current shareholders receive the maximum possible benefits from solving this problem. We propose a financing-constrained model that not only eliminates underinvestment but also ensures that current shareholders capture the entire agency cost (net of loading) as an increase in value.

On the Application of Finance Theory to the Insurance Firm

Traditional risk theory has tended to view the insurance firm too much from within. Although the insurance firm exists in an economic environment within which it must compete with other insurance firms as well as institutions which provide close substitutes to insurance services, this fact of life appears to have largely escaped the attention of risk theorists. While the implications of default risk for insurance company decision making and regulatory policy are widely discussed in the insurance solvency literature, this literature does not provide an internally consistent theoretical framework within which an acceptable ruin probability can be determined. As noted in the above quotation from Karl Borch’s well-known and highly regarded book, the literature treats the determination of the appropriate ruin probability as exogenous to the firm. One can only hope that Borch’s government inspector is endowed with King Solomon’s wisdom.

A Reexamination of the Relationship Between Preferences and Moment Orderings by Rational Risk-Averse Investors

This article examines the relationship between risk, return, skewness, and utility-based preferences. Examples are constructed showing that, for any commonly used utility function, it is possible to have two continuous unimodal random variables X and Y with positive and equal means, X having a larger variance and lower positive skewness than Y, and yet X has larger expected utility than Y, contrary to persistent folklore concerning U‴ > 0 implying skewness preference for risk averters. In additon, it is shown that ceteris paribus analysis of preferences and moments, as occasionally used in the literature, is impossible since equality of higher-order central moments implies the total equality of the distributions involved.

A new stochastically flexible event methodology with application to Proposition 103

In this article, we developed a dynamic market model to obtain the expected returns of individual securities. This model takes into account certain known characteristics of financial time series, including time-varying beta, autocorrelated squared returns, and the fat-tailed property of daily return data. An autoregressive process with order 1, AR (1), is initialized for beta, and a GARCH (1,1) process is utilized to model the time-varying conditional variance. Our study suggests that the application of the classical event study methodology, without checking the behavior of security returns for stochastic beta and GARCH effects, may very well cause researchers to draw inappropriate conclusions. ©1999 Elsevier Science B.V. All rights reserved.

Property-Liability Insurance Pricing Models: An Empirical Evaluation

Over the past two decades, several pricing models that integrate underwriting and investment performance have been proposed or used to determine property4ability insurance rates. In general, these models have been tested separately and only over a relatively limited time horizon. In this article, the major property-liability insurance pricing models are evaluated over the 60-year period from 1926 through 1985 and the results of the various models are compared in terms of the ability to predict actual underwriting profit margins. Differences between model predictions and realized underwriting profit margin series are examined over the entire period as well as various subperiods in order to demonstrate how individual models perform under different conditions. The goal of this research is to assist actuaries and researchers in the application of pricing models and interpretation of results.

On Corporate Insurance

Although insurance contracts are regularly purchased by corporations and play an important role in the management of corporate risk, only recently has this role received much attention in the finance literature. This paper provides a formal analytic survey of recent theoretical developments in the corporate demand for insurance. Insurance contracts are characterized as simply another type of financial contract in the nexus of contracts that comprise the corporation. The model developed here focuses specifically on the efficiency gains that can be derived from using corporate insurance contracts to reduce bankruptcy costs, agency costs, and tax costs.

Incentive Contracting and the Role of Participation Rights in Stock Insurers

Corporate limited liability creates incentives for owners to shift risks onto creditors by substituting high-risk assets for low-risk assets because it rewards owners with the benefits of risky activities while penalizing them with only a portion of the costs. However, since rational creditors understand these incentives, the ensuing agency cost is borne ex ante by owners, unless they can credibly precommit themselves not to shift risk onto creditors. This article considers one specific contractual arrangement that helps resolve the risk shifting problem in stock insurers: the inclusion of participation rights in insurance policies. We assume that the insurer chooses between two mutually exclusive investment portfolios, where the riskier portfolio is a mean preserving spread of the less risky portfolio. The primary purpose of this analysis is to demonstrate that participating insurance policies resolve the risk shifting problem for stock insurers. We also present empirical evidence on policyholder participation that is consistent with our theory.

On the Implications of the Internet for Insurance Markets and Institutions

Focus ABSTRACT By most accounts, the Internet and related advances in information technology significantly affect financial services in general and insurance markets and institutions in particular. Coupled with other important trends such as globalization and regulatory reform, these changes are forcing far-reaching changes upon the insurance industry and making it more competitive. This article focuses specifically on the implications of the Internet for insurance markets and institutions. The conventional wisdom that the Internet constitutes a sufficient condition for the disintermediation of traditional insurance distribution networks is called into question. To the extent that the Internet reduces transaction costs, it will create opportunities for new intermediaries as well as for existing ones. It will also influence product design, in some cases making it economically attractive to unbundle and repackage various forms of coverage. By removing entry barriers and reducing insurance costs, the Internet will also provide a private market solution to a major insurance regulatory concern-enhancing insurance affordability and availability. INTRODUCTION By most accounts, the Internet and related advances in information technology significantly affect the economic efficiency and characteristics of the financial services industries. In banking, information technology investments have enabled banks to rely more upon ATMs to carry out teller functions, and the lending function has become standardized and automated to the point where far fewer loan officers are needed to manage a portfolio of a given size (Wilhelm, 2001). Similarly, human capital is being leveraged (and in some cases displaced) in the securities markets by technologies such as electronic order processing systems, electronic limit order books, and electronic auctions (Wilhelm, 2001). In insurance, firms are beginning to offer a wide array of online services, including online sales, needs analysis,1 and customer service (e.g., online policyholder account information, claims management and processing, and group insurance certificates). Coupled with other important trends such as globalization and regulatory reform, these developments are forcing far-reaching changes upon the insurance industry and making it more competitive. This article focuses specifically on the implications of the Internet for insurance markets and institutions. It is organized in the following manner. The next section summarizes what we know about Internet trends and related public policy issues. The third section calls the conventional wisdom that the Internet constitutes a sufficient condition for the disintermediation of traditional insurance distribution networks into question. Although the Internet certainly has the potential to create distribution channel conflicts as well as incentives for disintermediation, to the extent that it is successful in reducing transaction costs, it will also set into motion incentives for reintermediation; i.e., the creation of new intermediaries.2 Therefore it is far more likely that the Internet will give rise to more, not fewer, intermediaries. The third section of the article formalizes this dynamic process of disintermediation and reintermediation by introducing a concept invented by Saffo (1998) called disinter-remediation. The fourth section examines some of the commonly held beliefs about the impact of the Internet on insurer costs and offers an alternative framework for addressing how the Internet might impact cost and profitability. Finally, the fifth section offers a set of concluding remarks. INTERNET TRENDS, WEBLINING, AND THE DIGITAL DIVIDE As a starting point for our analysis, it is useful to consider statistics concerning the growth and penetration of Internet connectivity. Worldwide, the number of Internet users has increased more than thirty-fold since 1995. This represents an average annual compound growth rate in the world online population of more than 75 percent per year. …

Adverse Selection in Reinsurance Markets

This paper looks for evidence of adverse selection in the relationship between primary insurers and reinsurers. We test the implications of a model in which informational asymmetry—and therefore, its negative consequences—decline over time. Our tests involve a data panel consisting of U.S. property-liability insurance firms that reported to the National Association of Insurance Commissioners during the period 1993–2012. We find that the amount of reinsurance, insurer profitability, and insurer credit quality all increase with the tenure of the insurer–reinsurer relationship.

On the Demand for Corporate Insurance: Creating Value

Ever since Mayers and Smith first claimed, 30 years ago, that the corporate form provides an effective hedge that allows stockholders to eliminate insurable risk through diversification, the quest to explain the corporate demand for insurance has continued. Their claim is demonstrated here so that the corporate demand for insurance may be distinguished from the individual’s demand for insurance. Then some of the determinants of the demand for corporate insurance that exist in the literature are reviewed and generalized. The generalizations show how the corporation may use insurance to solve underinvestment and risk-shifting problems; the analysis includes a new simpler proof of how the risk-shifting problem may be solved with corporate insurance. Management compensation is also introduced here and the analysis shows the conditions which motivate the corporate insurance decision. Finally, some discussion is provided concerning the empirical implications of the extant theory, the tests that have been made, and the tests that should be made going forward.