Martin F. Grace

X-Efficiency in the US life insurance industry☆

Abstract Using six years of data, 1985–1990, we estimate hybrid translog cost functions for 561 life insurers. We examine the resulting residuals to determine the relative efficiency of insurers in the sample. We then test the residuals to see if they are related to so-called X-efficiencies because of internal and external monitoring, or to other factors related to rent-seeking. Results show a large degree of persistent inefficiency seems to exist among sample firms, the inefficiencies relate to some internal or external monitoring, and rent-seeking may be occurring.

Risk-Based Capital and Solvency Screening in Property-Liability Insurance: Hypotheses and Empirical Tests

For a fixed probability of wrongly classifying a strong insurer as being weak (Type I error), this paper examines the classification power (the probability of correctly identifying a weak insurer as being weak) for two potential solvency detection methods. The first is to classify insurers using ratios based on risk-based capital (RBC) standards and the second is to use the Financial Analysis Tracking System (FAST) solvency screening mechanism created by the National Association of Insurance Commissioners (NAIC). We test the hypothesis that the RBC system has at least as much power for identifying financially weak insurers as the FAST scoring system does. Our empirical results are largely inconsistent with this hypothesis: RBC ratios are less powerful than FAST scores in identifying financially weak property-liability insurers during our sample periods. We also provide limited evidence that RBC ratios and FAST scores are jointly more powerful in identifying weak insurers than FAST scores alone, which suggests that RBC ratios may convey new information about insolvency risk despite their relatively low power on a univariate basis.

Financing and the Demand for Corporate Insurance

In this paper we examine the insurance decision of a firm with private information regarding its cash flows and insurable losses. We show that, even in the absence of bankruptcy costs and information production by insurers, the firms attempts to hedge its information risk can induce it to demand insurance. If higher operating revenues are accompanied by a lower insurance risk, the firm will choose to self-insure. In contrast, if higher operating revenues are accompanied by a higher insurance risk, the firm will demand insurance. In fact, if its insurable losses are relatively small, the firm will fully insure its losses. Further, if there exists considerable uncertainty regarding the firms insurance risk, the level of coverage demanded by the firm is dependent on its private information, with higher levels of coverage signaling favorable information regarding the firms future operations.

Dupes or Incompetents? An Examination of Management's Impact on Firm Distress

This article examines whether managers impact firm performance. We conservatively define managerial ability as the managers capacity to deploy the firms resources. We verify the validity of our metric using a manager–firm matched panel data set that allows us to track managers (CEOs) across different firms over time. We find managerial ability is inversely related to the amount of time a firm spends in distress, the likelihood of a firms failure, and the cost of failure. These results suggest that the managers of failed firms are less skilled than their counterparts. But even within failed firms there is heterogeneity in the talents of managers.

Political Cost Incentives for Managing the Property-Liability Insurer Loss Reserve

This paper examines the effect of rate regulation on the management of the property-liability insurer loss reserve. The political cost hypothesis predicts that managers make accounting choices to reduce wealth transfers resulting from the regulatory process. Managers may under-state reserves to justify lower rates to regulators. Alternatively, managers may have an incentive to report loss inflating discretionary reserves to reduce the cost of regulatory rate suppression. We find insurers over-state reserves in the presence of stringent rate regulation. Investigating the impact along the conditional reserve error distribution, we discover that a majority of the response occurs from under-reserving firms under-reserving less because of stringent rate regulation.

The Insurance Industry and Systemic Risk: Evidence and Discussion

The financial market events in September 2008 seem unprecedented in modern times. While other systemically important events happened in the last thirty years affecting U.S. markets, the one month turmoil and government response is without equal. As a result, insurance industry economists have been dusting off dictionaries and looking up what systemic risk really means. Further, there are other policy analysts who are linking the insurance industry to systemic risk with a potential goal of changing the governmental level at which the entire industry is regulated. Systemic risk and the role insurers play in the market is of concern to both state regulators and Congress. This paper presents evidence regarding systemic effect of insurers and will discuss this in light of the rationale for federal regulation of the insurance industry

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.

Insurance Company Failures: Why Do They Cost so Much?

Historical evidence shows insurer insolvencies are, on average, three-to-five times more expensive than those of other financial institutions. Using a unique dataset of insurer insolvencies from 1986 to 1999, we examine the cost of insolvency resolution and the factors driving these costs. We find firms in relatively better shape before being seized impose lower costs on the insolvency system. Further, we find evidence consistent with non-benevolent behavior by regulators, both before and after the firm fails, which adds significantly to the resulting costs of the insolvency.

Tax-Deductible Pre-Event Catastrophe Loss Reserves: The Case of Florida

After Hurricane Andrew the U.S. Congress entertained proposals to allow insurers to employ tax-deferred loss reserves. Interest was strong at first, but as the events receded interest waned. After the most recent hurricane seasons, interest in the proposals has rejuvenated. We examine the use of catastrophic loss reserves in a stylized one period model of insurance. Taking account of the potential changes in consumer behavior due to the institution of catastrophe reserves, we discover large social welfare gains are possible under certain circumstances. The benefits, however, depend on the actuarial assumptions underlying the expected loss distribution.

Market Discipline and Guaranty Funds in Life Insurance

This paper studies the effects of company risk and guaranty funds on life insurance in force using company-by-state level data during the 1985-2010 period. Our primary objective is to use the variation in the timing of guaranty fund adoptions across states to identify the impact of public guarantees on market discipline. We first confirm the existence of evidence consistent with market discipline by documenting a negative relation between company risk (measured by changes in financial strength ratings) and changes in life insurance in force and annuity considerations. Effects are especially large for annuity considerations. We find some evidence of a decline in market discipline following the creation of government-backed guaranty funds in 16 states during the sample period, with the most significant effects being observed for firms with low financial ratings.