The cost of holding risk is a crucial concept for any corporation to understand. Most financial policy decisions, whether they concern capital structure, dividends, capital allocation, capital budgeting, or investment and hedging policies, revolve around the corporate costs of holding risk. These decisions can be made well only with a thorough understanding of how costly it is to originate and warehouse risk.
This issue is particularly acute for financial firms, since the origination and warehousing of risk constitutes their core value added. For these firms, capital is often their most expensive and important input in production. They deploy capital by holding a large number of financial risk positions that need to be evaluated. Moreover, these positions turn over and are competitively repriced far more often than the physical assets of non-financial firms. Unanticipated shocks to the demand for financial firms’ products can be planned for and actively protected against, unlike those for non-financial firms. For these reasons, financial firms have the greatest need to understand the costs and benefits of holding risk.
Insurers and reinsurers certainly belong in this group. They have large underwriting and reinsurance portfolios, as well as investment and hedge portfolios. Often they have a large number of clients who view their insurance contracts as financially large and important claims. However, there are two basic features of insurers and reinsurers that make them especially sensitive to the costs of holding risk. The first is that their customers – especially retail policyholders – face contractual performance risks which are large relative to their wealth. Once premiums are paid, policyholders worry whether their future policy claims will be honored swiftly and fully. Commercial bank customers, for example, are less exposed, because they are protected by deposit guarantees as depositors and are not exposed to bank performance risk as borrowers.
The large contractual performance risk borne by insurance and reinsurance customers makes demand sensitive to underwriter risk. It seems sensible that firms whose capital is at greater risk are likely, all else equal, to have a tougher time selling their products. There is considerable empirical evidence suggestive of this. For example, Sommer (1996) seeks evidence of an empirical relationship between insolvency risk and property-liability premiums. He finds that, all else equal, firms with a greater ratio of surplus to assets have greater ratios of profit to premium. In addition, he finds greater volatility of surplus-to-assets is associated with lower profitability rates. In addition, Grace, Klein, and Kleindorfer (2001, 2003) examine homeowners coverage in New York and Florida and find that higher-rated insurers get higher premiums. In particular, they find that rating is more important for premiums for customers who may have claims above state guarantee fund coverage limits than for those customers who would not have claims above state specified coverage limits. Finally, Epermanis & Harrington (2001) find that insurers with high AM Best ratings grew annual premiums during 1992-1996 approximately 6% faster than those that were not highly rated. The effect is largest statistically and economically for changes in lower-rated and small firms, in the year of and year subsequent to the ratings change, and with respect to negative rating changes.
There is thus considerable evidence that customer demand is sensitive to the financial standing of the insurer. Note that the change in customer demand may appear as either a change in the price an insurer can charge or a change in the quantity that the insurer can sell. The investigation of profits in Sommer (1996) and of premiums written in Epermanis and Harrington (2001) detects both of these channels.
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Risk Management, Capital Budgeting and Capital Structure Policy for Insurers and Reinsurers
