The Cost of Capital of Insurance Companies: Comments Author(s): J. David Cummins and David J.

Nye Source: The Journal of Risk and Insurance, Vol. 39, No. 3 (Sep., 1972), pp. 487-491 Published by: American Risk and Insurance Association Stable URL: . Accessed: 04/12/2013 02:25
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istics of intermediaries. J." The Journal of Risk and Insurance. particularly the rate of return obtainable RCt -the interaction between assets and liabilities. cost of quasi-debt. DAVID CUMMINS AND DAVID J. NYE * In the June. loss reserves. No. ( 487 ) This content downloaded from 121. Launie's = the loss on insurance operaOLt article falls short of an adequate prelimitions during period t. 2 (June. That such errors arise (either accidentally or otherwise) and are signifi263-68. 1971). David J.more in accord with the concept of the debt. KDt is subject to error if there I J. 4 Dec 2013 02:25:06 AM All use subject to JSTOR Terms and Conditions . nary treatment of the topic and thus leaves LRt = the loss reserve at the end of much of this potential undeveloped. upon the investment portfolio and (2) Even if one accepts the interduring period t if investments mediary-industrial firm analogy. authors contend that his article is inadeUPRt = the unearned premium reserve quate in two major respects: (1) The at the end of period t. J. come should be included in computing One example of the errors in Launie's the "loss on operations. during period t if investments the cost of capital concept must be modiare unconstrained by regulacharacterthe of fied to account for some tion.' where: Such a topic is clearly a legitimate area KDt = the rate of cost of quasi-debt of investigation and one which is potenduring period t. "The Cost of Capital of Insurare errors in management's estimate of ance Companies. Launie. 1971 issue of this Journwl. However.52.251 on Wed. that figure alone has he proposes the use of the statistic defined been used here." Since the use of cost of capital construct is his suggested underwriting gains or losses seems to be procedure for computing the cost of quasi. ticle leaves too many questions unanT = the marginal tax rate on corswered to constitute a successful seminal porate income. Vol.e. by (1) to measure this rate. This paper contends that the statistic * J. XXXVIII.. tially quite rewarding. t (L + KDt =(1 -T) Professor J. For a property-liability company. Wharton School of Finance and Commerce. analogy between financial intermediaries the rate of return obtainable RUt upon the investment portfolio and industrial firms is not complete. The remainder of this paper discusses these deficiencies and Launie's discussion is not completely clear regarding whether or not investment inoffers some remedial suggestions.THE COST OF CAPITAL OF INSURANCE COMPANIES: COMMENTS J. treatment of the topic. (1) concerning the application of the cost of capital concept to insurance companies. University of Florida. i. David Cummins is a Lecturer in Insurin (1) is at best a "quasi-cost" and is not ance. Launie published an article (RUt -RCt). The period t. Nye is an Assistant Professor of Insurance. the arare constrained by regulation. First. pp. cision-making context. generally useful within an economic deUniversity of Pennsylvania.158.

. 5 Launie. be written for discrete time periods..0 by more than 5 percent. For example. if such changes are prevalent. 534. a properly modified version of formula (1) may be a reasonable first approximation to the cost of quasi-debt." The tions. If loss reserve estimates are correct.3 Where the ratio is greater than one. No. the value of the reserve is altered. 4Ibid. In the first term in (1).. loss reserves exceed actual losses.5 This comment argues that reserve is not indicative of any change such an approximation disregards the in either the frequency or the severity of portfolio selection practices of insurers the loss distributions. p. pp.251 on Wed. Failure to remove this element results in an erroneous understatement of KD. if the reserve is of size X at time t for a group of policies whose term is equal to t minus t . Launie seems to imply that. on the other hand. Launie suggests that this cost can be approximated by considering the return earned by an affiliated mutual fund. is above its true value. it is also true that their portfolio Journal of Risk and Insurance.and.(t . 1970).e. this change in the of Launie's formula for KD. then the reserve would fall to X if the term of the pol2 icy were shortened from (t . 3 Ibid. the charges. i. However. Finally. Forbes.e.52. insurer portfolios would resemble those of mutual pointed out by the author. But these altered values do not reflect the real changes in the ebb and flow of economic activity which have taken place. i. and KD.158. If the length of that time period is altered. 527-38. but the need for such an adjustment should have been ance regulations did not exist. The reserve exists simply because insurance policies must. OLt. underwriting profit (loss) is underestimated (overestimated). if carried out. 265. interest payments are made on bonds currently held by investors.0. p.488 The Journal of Risk and Insurance cant is well documented. although it is true that insurers are constrained by state regula2 Stephen W. and 71 percent were greater or equal to 1. the incurred loss development ratio is 1.. the previously referenced study found that 68. Corresponding tem. if insurwould rectify the KD figure.2 Professor Forbes found that 29 percent of his sample of incurred loss development ratios were less than 1.4 A second problem is the use of the unearned premium reserve. by necessity. no mention is made of the equity that exists in the unearned premium reserve. as an analogue of the industrial firm's cost of capital. An additional problem arises in the use funds. This term represents an implicit cost to account for the additional investment income that the firm would earn if unconstrained by state insurance regulations. Vol. since its value is affected by the average policy term. the incongruence of the numerator and denominator of the first term in (1) may cause a significant distortion of the true cost of capital. However. However. cit.1. For an industrial firm. fixed interest charges are attributable to securities currently outstanding. Now. The author's technique for approximating the second term in formula (1) is also of questionable validity. would distort the poral changes in the OL and LR figures firm's cost of capital. This content downloaded from 121. XXXVII. 4 Dec 2013 02:25:06 AM All use subject to JSTOR Terms and Conditions . "Loss Reserving Performance Within the Regulatory Framework.4 percent of the incurred loss development ratios deviated from 1. are attributable to earned premiums for the period and not to the unearned premiums figure which appears in the denominator. If the firm's size or the by line proportions of its business have not changed substantially over the period.1) ) to t (t-1).. This comment assumes that Professor Launie is referring to a diversified common stock fund rather than to a bond-stock or a bond fund.0. and the estimate of KDt is not biased. 4 (December. op.0.

Setting aside the rather profound (and undiscussed) implications of such a rule for an insurer. Because its cost of quasi-debt is almost always positive. of the risk-return characteristics of the firms' assets and liabilities and of the covariance relationships among them."9 Since the quasi-debt to equity ratio for property-liability firms is generally greater than 1.. the nature of the liability contract by which the funds are received is different. i. since research on the effects of regulatory constraints on insurer portfolios has not been conclusive. 489 of Capital" on p. earning progressively smaller rates of return. Studies of Portfolio Behavior (New York: John Wiley & Sons.251 on Wed. As one researcher has noted. such as that usually postulated for an industrial firm. Wehrle.. Professor Launie advocates as a decision rule for insurance companies the investment in securities earning no less than the company's cost of capital. cit. p. 268 does little to prove the point. but is a complicated cost of capital computation needed to arrive at such a conclusion?1' An alternative way of viewing this argument is to note that the insurance firm does not face a schedule of potential investments. it is readily seen that. Launie has noted that a negative cost of quasi-debt is a probable occurrence in some eras. In other words."6 It is thus possible that removal of all investment regulations on insurers would not change drastically the portfolio compositions of the firms.. 263. it is no accident that life insurer assets and liabilities are both primarily long term obligations. Launie notes that "The possibilities for the application of cost of capital analysis in the insurance environment are manifold. p. This content downloaded from 121. p. of course. in most cases.e. 10For example. 265. op. A final major inadequacy of the article is its failure to justify properly the use of the cost of capital concept for insurance companies.e. the relatively greater weight of the negative or small positive cost of quasi-debt may counteract the positive cost of equity capital. "Life Insurance Investment: The Experience of Four Companies.0. the portfolio selection process of insurance companies takes account. Professor Launie's approximation should be used with extremecaution until more definitive results are available. Launie's decision rule may be somewhat more realistic for a life insurer. Inc. 4 Dec 2013 02:25:06 AM All use subject to JSTOR Terms and Conditions . 8 Launie.. The implicit cost for the effects of regulation is probably a valid concept. Hester and James Tobin. For example. Launie's cost of capital for such firms is likely to be considerably below the rate of return obtainable in current money markets. but his cost of capital is still likely to fall far below the interest rates available in the 9 Ibid.7 Some change would occur. the rule merely instructs the firm not to invest in a low yielding security when a comparable high yielding security is available. 191. For example. eds. In such cases. In the abstract of the article. i. but it is questionable to argue that insurer portfolios would approach those of mutual funds." in Donald D. Comparable arguments could be advanced with regard to property-liability investment portfolios. the rule would advise the firm to curtail the amount of insurance written if it cannot earn a rate of return greater than its cost of capital.. 1967). but it would not be as large a factor as Launie implies and should not be approximated as he suggests.52. This should be true even after adjustment for the implicit costs of regulation. a At any rate." For property-liability firms. the rule operates only as a remote lower bound on investment returns. it might better be described as a "non-rule."8 This assertion may be true. but the discussion of the "Significance of the Cost 6 Leroy S. hence each institution has a somewhat different demand function for securities..158. "For each financial institution. either explicitly or implicitly.Communications configurations are based on sound economic criteria.

J. this function of equity funds is implicitly recognized in the industrial firm in the form of "financial risk. research efforts 1' See C. Furthermore.e." i. Financial Management and Policy (Englewood Cliffs. Pt. If so. Trowbridge's article refers to life insurers. 12 James C. Perhaps Launie intended a diffeernt interpretation of his decision rule. L. Consequently." Transactions of the Society of Actuaries.52. p. Another possibility suggested by the author for the use of the cost of capital in an insurance context concerns the determination of an optimum capital structure for the firm. p. the risk of insolvency due to the inability to meet fixed charges. if so. his discussion should have been more explicit. 14 Surplus represents a large proportionof total equity even for a stock insurer.251 on Wed. however.1' For funds generated by life insurance policies already in effect when market rates fall below the cost of capital. 4 Dec 2013 02:25:06 AM All use subject to JSTOR Terms and Conditions .490 The Journal of Risk and Insurance enterprise is protection against adverse fluctuations in losses due to the risks assumed by the firm. the rule is again inoperable. The other insurance oriented uses for cost of capital to which the author refers are either quite minor or are discussed in such a cursory manner as to leave the reader essentially uninformed. Van Horne. but life insurers are more likely to adjust downwards the interest assumption in their premium calculations (thus changing the major component of their cost of debt capital) than to adhere to a rigid investment cut-off point.15Of course. It may be true that optimization of capital structure according to an appropriate cost of capital criterion would also yield an optimal surplus from a loss fluctuation standpoint. This paper contends that the analogy has been pushed too far. XIX. Vol. op.'3 However. the decision rule apparently ignores covariance effects among securities and thus is contrary to portfolio selection theory. the costs. the decision rule again appears to be inapplicable. the author should have attempted to justify this equivalence or at least have alluded to the different emphasis placed on the accumulation of surplus in an insurance context. Trowbridge. N. Mr. 168-69."16 Many of the problems cited above stem from the fact that Launie has rooted his paper in an analogy of the weighted cost of capital of an insurance firm to that of an industrial firm. 1968). To attempt to develop a viable theory of the behavior of an insurance firm based solely upon an analogy to an industrial firm will be an unrewarding task. 16 Launie. 167. An insurance company is a financial intermediary. 1 (1967). but a similar point could be made with regard to property-liability companies.. Although Launie does not specify how such a structure is to be determined. cit. which would instruct the firm to cease writing new business. Since each company can invest its entire cash flow without appreciably affecting market rates.158. Insurance managers are more conscious of this "contingency reserve" function and less aware of purely financial considerations than are their industrial counterparts. the rule may make some sense for a property-liability insurer." 12 This concept is a legitimate one for industrial firms. pp. this type of analysis should explicitly recognize that a primary justification for surplus 14 in the insurance 11A temporary decrease in sales effort might take place until the interest adjustmentcould be made. '3 Ibid. Inc. 218. It is thus clear that the author has not substantiated his claim that "benefits to be gained from further research in this field should far outweigh current securities markets. 268. When interest rates are low. This content downloaded from 121. presumably he is referring to a procedure by which the firm finances in such a way that "the marginal real cost of each available method of financing is the same.: Prentice-Hall. "Theory of Surplus in a Mutual Insurance Organization.. p.. and methods are available to apply it in practical situations..

To recognize such a loss also as a cost of capital is to engage in double accounting. The cost of capital for a stock nonlife insurer is simply an opportunity cost. home mortgages).251 on Wed. 41-48. Vol. 4 Dec 2013 02:25:06 AM All use subject to JSTOR Terms and Conditions . such theoretical treatments are not adequate substitutes for practical analytical tools such as cost of capital analysis. "Optimizing the Structure of Capital Claims and Assets of a Stock Insurance Company. XXXVII." The Journal of Risk and Insurance. 18 Robert A. 491 the insurance environment is immediately obvious. savings deposits) and use the proceeds to purchase a given type of financial asset (e. J. For example. Kroncke. If there is a loss from the insurance operation.52.g. "On the Theory of Financial Intermediation." * Associate Professor of Finance.Communications should be focused upon adapting recent developments in the theory of financial intermediation to the insurance situation. XXXVIII (June. 1970). 3 (June." The Journal of Risk and Insurance. FURTHER COMMENT STEPHEN W. Vol. No. J." and the relevance of Pyle's question for 17 David H. The recent work by Haugen and Kroncke is also a step in the right direction. analysts must place more reliance on the theory of financial intermediation and less on comparisons with unrelated industries. which attempts to measure what the shareholder could earn if he were to place his funds in the next best venture of equal This content downloaded from 121. FORBES* In a recent article in this Journal. such a recognition defeats the purpose of the cost of capital calculation. Haugen and Charles 0."Journal of Finance. pp. The cost of capital is simply the cost of the funds available to finance an investment project.g. "The Cost of Capital of Insurance Companies." 17 One has only to substitute the words "insurance policies" for "savings deposits. 1971).' He states in the Abstract to his article that "The funds which are generated through the medium of the insurance operation such as the loss reserve and the unearned premium reserve in a property-liability insurance company are considered as 'quasi-debt. pp.' The loss on operations is one portion of their imputed cost. . However.. the imputed cost of 'quasi-debt' is difficult to quantify. 1971). which is to provide a cutoff rate of return to be used in deciding whether or not to invest funds in a project. Pyle. if a satisfactory practical decision rule is to be developed for insurers. Pyle has recently published a paper in which he states that his objective is to investigate the question ". 263-68." Launie then goes on to state in his Abstract that "While estimation of the cost of equity capital of an insurance enterprise differs little from its industrial counterpart. University of Illinois at Urbana-Champaign. pp. The constraints which state insurance regulations place upon the portfolio of an insurer represent another element of imputed cost. It is the purpose of this comment to suggest that nonlife insurance company reserves should be entirely disregarded in the cost of capital calculations since they represent a by-product of the insurance transaction and have no cost as far as the insurer is concerned.. under what circumstances would a firm be willing to sell a given deposit liability (e. it should be recognized in the calculations of the discounted net cash flows accruing to the insurer's shareholders. Professor J.158. 737-47. XXVI.18 Of course. Launie. . 1 J. No. 1 (March. Launie purports to present a unique concept of the cost of capital applicable to insurance companies. Furthermore.