L. Lee Colquitt

Determinants of Corporate Hedging Behavior: Evidence from the Life Insurance Industry

Using data collected from the annual statements of 571 life insurers, separate models are estimated for the probability and degree of use of futures and options by life insurers for the purpose of hedging economic risk. The results support the informational economies hypothesis, the bankruptcy costs and underinvestment hypotheses, and the managerial discretion hypothesis. The results also suggest that an insurers matching of asset and liability durations (on-balance-sheet hedging) serves as a substitute for hedging with futures and options (off-balance-sheet hedging) and that the use of reinsurance serves as a signal for those firms that are predisposed to hedging firm risk.

Determinants of Cash Holdings by Property-Liability Insurers

ABSTRACT This study investigates the differences in cash holdings across property-liability insurers. We conclude that relative cash holdings are less for insurers with better access to cash through capital markets and/or other group members. We also conclude that larger insurers, higher quality insurers, insurers that write longer tail lines of business, and firms with higher degrees of leverage hold less cash. Also, we find that insurers with a higher variance of cash flows tend to hold more cash. Another interesting finding is that, contrary to what managerial discretion arguments might suggest, stock insurers tend to hold more cash than do mutuals. INTRODUCTION This article examines the variation in cash holdings across property-liability insurers during the three-year period from 1993 to 1995. For the property-liability insurer, virtually all business transactions occur in cash. Premiums are received in cash, and claims are paid in cash. As a result, the insurers decision regarding the amount of cash to hold is critical to its operations and therefore to its overall financial stability. In making that decision, an insurer may choose to hold a large amount of cash; such a strategy affords much flexibility to the insurer, but the flexibility gains are offset by the opportunity costs resulting from the lower returns generated by cash compared to less liquid assets (Amihud and Mendelson, 1986). On the other hand, an insurer may choose to hold a small amount of cash; such a strategy maximizes returns by investing the cash in higher yielding assets but exposes the insurer to transaction costs--and potentially unfavorable economic conditions--when assets must be liquidat ed to meet obligations. Because there are competing costs and benefits of holding cash, the insurer must compare the marginal costs of holding cash to the marginal benefits of holding cash when determining its optimal level of cash (Opler, Pinkowitz, Stulz and Williamson, 1999). Cash holdings vary considerably across insurers. [1] Such differences can be expected for a number of reasons, including the degree of agency conflict among the insurers management, owners, and policyholders; the ability of the insurer to generate cash from alternative sources; the nature of the insurers operations; and the composition of the insurers portfolio of non-cash assets. In order to determine which insurer characteristics affect the extent of cash holdings, we employ regression analysis on a large sample of property-liability insurers over a three-year period. Our examination of cash holdings by property-liability insurers serves several purposes. First, it contributes to the large body of literature investigating corporate cash holdings (Chudson, 1945; Baumol, 1952; Meltzer, 1963; Frazer, 1964; Vogel and Maddala, 1967; Gertler and Gilchrist, 1994; Kim, Mauer and Sherman, 1998; Opler, Pinkowitz, Stulz and Williamson, 1999). Because prior literature has excluded the analysis of financial firms, investigation of insurer cash holdings provides the opportunity to evaluate the extent to which past findings hold for a totally different class of firms. Perhaps more importantly, the unique aspects of the insurance industry, such as the different organizational forms available to insurers and the phenomenon of insurer groups, provide the opportunity to generate additional insights into cash holdings. Additionally, the examination complements previous research investigating other components or aspects of insurer investment portfolios (Colquitt and Hoyt, 1997; Cummins, Philli ps and Smith, 1997; Lee, Mayers and Smith, 1997; Cox, Gayer and Wells, 1998). Finally, the examination demonstrates that insurers choose cash balances systematically based on their organizational and operational characteristics. This information should benefit stakeholders, regulators, and academics in their attempts to understand and predict insurer behavior. …

An Analysis of Contingent Commission Use by Property–Liability Insurers

The payment of contingent commissions in the property–liability insurance industry has long been commonplace, but recent events have made the practice highly controversial. Even prior to these events, wide variation existed among insurers in their use of contingent commissions. In this article, we examine the determinants of whether or not an insurer chooses to pay contingent commissions at all, as well as the determinants of the extent of their use for those insurers that pay them. We find a number of variables that have a significant relation to the use and extent of use of contingent commissions.

The Impact of Asbestos and Environmental Reserves Increases on Shareholder Wealth

Abstract Between 1992 and 2001 significant reserves increase announcements were made by several major property/liability insurers. These reserves increases were for the purpose of recognizing expected asbestos and environmental (A&E) liability. Although most analysts agree that U.S. insurers are underreserved for asbestos and environmental liability, how the market reacts to an insurer’s announcement of an increase in these reserves has not been analyzed. An insurer that is significantly underreserved is likely to be viewed by the market as lacking financial stability for the long term. However, when a company increases its reserves, there is a charge to income and a reduction in capital. If surplus is diminished sufficiently as a result of the increased reserving, regulatory attention and eroding shareholder and market confidence could result as well. By calculating the sample insurers’ cumulative abnormal returns surrounding the largest asbestos and environmental reserves increase announcements made between 1992 and 2001, the study estimates and documents the market’s reaction to these reserves increase announcements. We further explore the potential impact of additional asbestos and environmental liability exposure reporting requirements. Starting with 1995 statutory annual accounting statements, Footnote 24 required additional reporting by insurers of their asbestos and environmental liability exposure (1995 statements were publicly available by the end of the first quarter of 1996). When looking at reserves increase announcements prior to this additional reporting requirement, we find that most insurers announcing large increases in asbestos and environmental reserves prior to 1996 experience a significant reduction in stock price in the days surrounding their announcement. However, consistent with the notion that the additional accounting disclosure requirements after 1995 (Footnote 24) provide valuable information on insurers’ exposure, we find that the announcement of A&E reserves increases after 1995 had no statistically significant effect on the market value of announcing insurers.

Adverse Selection in the Credit Life Insurance Market

Adverse selection plays a prominent role in the insurance literature due to its negative implications for insurer financial performance and stability. However, there is a paucity of empirical evidence consistent with the existence of adverse selection in the U.S. insurance market. Potential reasons for the lack of evidence include: (1) that insurers effectively use underwriting and pricing to counteract adverse selection; or (2) that consumers either do not have, or fail to take advantage of, private information. We test for the existence of adverse selection in the credit life insurance market where opportunities to exploit asymmetric information are pronounced due to the lack of underwriting and highly regulated prices. Our analysis provides evidence consistent with adverse selection in the credit life market and suggests that the lack of empirical evidence regarding adverse selection may be due to effective underwriting rather than consumers failing to use informational advantages to their benefit.