PDF Ebook Estimating The Cost of Equity Capital For Property-Liability Insurers
Cost of capital estimation is becoming increasingly important for property-liability insurers. First introduced during the 1970s in regulatory proceedings in New Jersey, Massachusetts, and other states, the application of financial methods in pricing, reserving, and other types of financial decision making has grown rapidly over the past two decades.1 Recent developments include the emergence of asset-liability management (ALM) techniques (Panjer 1998), the development of methodologies to allocate equity capital by line of business (e.g., Myers and Read 2001), the increased focus on market-based project evaluation techniques such as risk-adjusted return on capital (RAROC), and the projected introduction of fair value accounting for insurer liabilities (Girard 2002). These and other changes have intensified the need to find reliable methods to estimate the cost of capital for insurance firms.
In terms of financial theory, insurers are no different from other corporations in the economy with respect to the general factors that determine the cost of capital and the market value of the firm. However, it is well-recognized that the cost of capital varies across industries due to the heterogeneity of the risks facing firms in various sectors of the economy; and cost of capital research has shown that there is a significant industry factor for insurance (Fama and French 1997). Insurance is a very diverse industry, however, encompassing numerous lines of business with different risk characteristics. It is unlikely, for example, that the cost of capital for a firm specializing in life insurance will be the same as the cost of capital for a firm emphasizing workers' compensation or commercial liability insurance. Unfortunately, little progress has been made in estimating costs of capital for insurers with different business line compositions. The objective of the present paper is to remedy this deficiency in the existing literature by developing cost of capital models that reflect the line of business characteristics of firms in the property-liability insurance industry. We focus on property-liability insurers because costs of capital tend to differ across industry segments (see below) and because of the long-term interest in cost of capital for property-liability insurers due to price regulation, which is not present for other types of insurance.
The problem addressed in this paper, i.e., the estimation of the cost of equity capital for insurers with different business line compositions, has been studied in the financial literature as the problem of estimating the cost of capital for divisions of conglomerate firms. The problem in estimating the divisional cost of capital is that the conglomerate firm itself rather than the division is traded in the capital market. Thus, it is possible to use market value data to estimate the overall cost of capital for the conglomerate but not for the individual divisions comprising the firm. The classic approach for estimating the divisional cost of capital is the pure play approach (Fuller and Kerr 1981). The pure play technique involves identifying publicly traded firms that specialize in the same product as the division under consideration (i.e., that have a "pure play" in that product) and then approximating the divisional cost of capital as the average cost of capital for the pure play firms.
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PDF Ebook Estimating The Cost of Equity Capital For Property-Liability Insurers
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