International Review of Economics and Finance xxx (xxxx) xxx

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International Review of Economics and Finance

journal homepage: www.elsevier.com/locate/iref

Portfolio rebalancing behavior with operating losses and

investment regulation
M. Martin Boyer a, *, Elicia P. Cowins b, Willie D. Reddic c
a
Power Corporation of Canada Research Chair and CIRANO Fellow, Department of Finance, HEC Montr
eal (Universit
e de Montr
eal), 3000, chemin de
la C^
ote-Ste-Catherine, Montr
eal, QC, H3T 2A7, Canada
b
Washington and Lee University, 204 W. Washington Street, Lexington, VA, 24450, USA
c
DePaul University, 1 East Jackson Blvd, suite 6000, Chicago, IL, 60604, USA

A R T I C L E I N F O A B S T R A C T

JEL Classifications: Firms should make every attempt to reduce their tax burden by, for instance, preferring higher-
G22 yield taxable investments when faced with operating losses and lower-yield tax-exempt in-
G28 vestments otherwise. We examine in this paper whether there are impediments to rebalancing
K23
which result from a firm's regulatory environment. Using an original measure of investment
Keywords: regulatory stringency that U.S. property and casualty insurers encounter, we find that insurers
Statutory accounting principles
operating in more stringent regulatory environments receive a lower percentage of their invest-
Property and casualty insurance
ment income from taxable sources. We conclude that regulatory constraints limit insurers from
Tax-exempt and taxable securities
Regulatory investment limitations rebalancing efficiently their investment portfolio in response to operational performance.

1. Introduction

One of the most important operational objectives of property and casualty (P&C) insurers is the generation of sufficient cash flows to
ensure timely payment of future claims. To that end, P&C insurers actively manage the complementarities between their underwriting
returns and their investment portfolio returns under the constraint that the insurer's uncertain liquidity needs restrict the types of in-
vestment vehicles they can use (Lambert & Hofflander, 1967). These limits are a function of the insurance company's business model and
at odds with its shareholders' demands for investment returns, both in terms of the potential to generate earnings from which dividends
could be declared and the likelihood of positive changes in market value from which capital gains could be realized.
The optimal mix of income generating investment instruments depends on numerous external factors, such as interest rate policies
and GDP growth, as well as numerous firm-specific characteristics such as the prevalence and the presence of operational gains and
losses. Emphasizing the latter point, Hendershott and Koch (1980) find that in the absence of taxable income, after-tax returns on
investment portfolios are maximized by fully investing in taxable securities (see also Buser & Hess, 1986; Cummins & Grace, 1994;
Pasiouras & Gaganis, 2013). Once taxable income is present, it is advantageous to shift to tax-exempts. This result suggests that P&C
insurers should choose their investment mix of tax-exempt and taxable instruments as a function of their underwriting performance.
The search for an optimal portfolio is not the preserve of the insurance industry. Achieving the appropriate mix of taxable and tax-
exempt investments is, however, particularly salient for insurers because their ability to settle claims in a timely manner is directly tied
to their ability to generate sufficient returns from their investment portfolios. Given the relative lack of correlation between a single
insurer's underwriting results and returns on market-traded securities, an insurer's investment portfolio can serve as a key source of

* Corresponding author.
E-mail addresses: martin.boyer@hec.ca (M.M. Boyer), cowinse@wlu.edu (E.P. Cowins), wreddic@depaul.edu (W.D. Reddic).

https://doi.org/10.1016/j.iref.2018.10.001
Received 21 November 2016; Received in revised form 5 October 2018; Accepted 7 October 2018
Available online xxxx
1059-0560/© 2018 Elsevier Inc. All rights reserved.

Please cite this article as: Boyer, M. M. et al., Portfolio rebalancing behavior with operating losses and investment regulation,
International Review of Economics and Finance, https://doi.org/10.1016/j.iref.2018.10.001
M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

financial stability and diversification in a competitive environment. The theoretical result in Hendershott and Koch (1980) suggests that
maintaining the optimal investment portfolio requires active management whereby insurers that are incurring net underwriting losses
(resp. gains) rebalance their investment portfolios in favor of taxable (resp. tax-exempt) sources of investment income that provide
higher (resp. lower) pre-tax yields on average. If limitations placed on the type of investments held at any given point in time prohibit
insurers from fully responding to changes in operational profitability, then a sub-optimal investment portfolio would be held.
The general investment philosophy of insurers can be qualified as conservative,1 with bonds instinctively preferred to common
shares. Despite this natural appetite for safe investments, state regulation often imposes limits on “riskier” securities, which may
constrain the investment preferences of insurers. The wide range of externally imposed investment constraints that P&C insurers face
provides a unique environment for studying the behavior of sophisticated and financially literate agents (Eling & Pankoke, 2016).
Because investment constraints are set at the state level, researchers have access to the cross-section of U.S. states, which impose
different investment limitations at different points in time. To our knowledge, our study is the first to examine the decision of P&C
insurers (and other regulated entities for that matter) to invest in taxable and non-taxable securities in an environment where they face
major regulatory limits on the type of instruments they are permitted to hold.
Using the Compendium of State Laws on Insurance Topics—Limitations on Insurers’ Investments published by the National Association of
Insurance Commissioners, we develop an original index that accounts for the degree of regulatory investment stringency that insurers
face in a given year. The index takes into consideration both the level of and the change in regulatory stringency for different types of
assets for each state in which an insurer operates. The investment regulatory stringency measure we employ is thus insurer and year
specific.2
By investigating whether and how variation in regulatory environments affect insurers’ portfolio management decisions, we aim to
address the following two research questions:

(1) Do insurers, when faced with underwriting losses, rebalance their investment portfolios away from tax-exempt securities3 and
toward taxable securities?
(2) Are insurers, operating in an investment-constrained regulatory environment, limited in the extent to which they rebalance their
investment portfolios between taxable and tax-exempt securities based on their underwriting performance?

Whether we observe the portfolio-rebalancing behavior in a manner consistent with the theory developed by Hendershott and Koch
(1980) is an empirical question. Cummins and Grace (1994) find that when insurers are subject to the alternative minimum tax, the
optimal outcome could include a failure to rebalance portfolios toward tax-exempt instruments because the alternative minimum tax
eliminates the after-tax yield spread between tax-exempt and taxable investments. Similarly, PonArul and Viswanath (1995) finds that
the optimal outcome could result in no shift toward tax-exempt investments even when (1) the after-tax yield on tax-exempt securities is
greater than that on taxable, (2) the relative yields from taxable and tax-exempt securities are sufficiently different, and (3) default
probabilities are positive.
Moreover, it is not entirely obvious that solvency regulation will restrict rebalancing in the way we predict. While not a perfectly
analogous study, Born (2001) examines the relation between insurers’ overall profitability and the legal and regulatory environments in
which they operate in the wake of the insolvency crisis that struck the industry in the mid-1980s. Our particular interest is the fact that
new regulatory measures were expected to restrict investment choices and thus place downward pressure on investment income.
Instead, Born (2001) finds that regulation was only weakly related to performance. More recently, a series of studies have examined the
effects of the risk-based capital requirements imposed by Solvency II on the investment portfolios of life insurance companies in the
European Union. Again, the expectation is that the capital requirements will serve as a binding constraint for risk and force insurers to
restructure their portfolios away from equities to an extent that may harm rather than help. After constructing a balance sheet and
investment portfolio for a representative European life insurance company, H€ oring (2013) estimates the level of capital required under
two alternative models: The Solvency II standard, and the S&P rating. His results suggest the new regulatory framework would not
materially affect the investment strategies of insurers because the greater capital charge against one asset class (equities) is offset by
larger credits for portfolio diversification. Conversely, Rudschuck, Basse, Kapeller, and Windels (2010) and Braun, Schmeiser, and
Schreiber (2017) analyze the regulatory environment under Solvency II and conclude that insurers respond to capital requirements
imposed on a particular asset class by reducing their holdings of that asset class.
In our case, we find that in the year following an underwriting loss, P&C insurers report an increase in the proportion of investment
income originating from taxable securities. We interpret this result as evidence that insurers rebalance their investment portfolios in
response to the operational results in a manner consistent with theory and previous empirical studies. In other words, P&C insurers make
tax-efficient portfolio choices when faced with underwriting losses. More importantly, we find evidence that insurers operating in more
stringent regulatory environments decrease their proportion of investment income originating from taxable sources regardless of their

1
A case in point comes from the insurance industry's use of Statutory Accounting Principles (SAP) in addition to Generally Accepted Accounting Principles (GAAP).
The SAP approach is generally more conservative than GAAP because it specifically focuses on insurance companies' long-term liabilities and ability to pay claims. Using
SAP generally results in lower insurer capital.
2
Licensure in several states means that a single insurer is subject to different, and changing, levels of regulatory stringency with respect to its use of different in-
vestment classes (taxable versus tax-exempt, stocks versus bonds, mortgages versus real estate, etc.).
3
Tax-exempt investments include municipal and state issued bonds so that coupon payments and capital gains associated with the selling of such bonds are non-
taxable (and capital losses are not deductible).

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M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

operating results. Specifically, based on an OLS regression on a pooled sample of P&C insurers, we find a negative and significant
association between the year-over-year change in the percentage of investment income coming from taxable sources and our measure of
investment regulatory stringency. We conclude from these results that regulation alters the relationship between tax incentives (losses)
and efficient investment (portfolio rebalancing).
The remainder of the paper will proceed as follows. In the next section, we will present the conceptual background of our research
design. Section 3 will focus exclusively on the description of the testable hypotheses, followed by a description of the data and the
methodology used to test the hypotheses. Section 5 will present the results of our empirical analysis. Finally, we will conclude and
discuss future research opportunities.

2. Measuring investment constraints using an investment regulatory stringency index

Regulation is an important aspect of an insurer's business environment; it affects both its underwriting and its investment activities.
In particular, P&C insurers' investment activities are typically limited in terms of the proportion of the total investment assets they hold
in various investment classes. Using the National Association of Insurance Commissioners' (NAIC) Compendium of State Laws on Insurance
Topics—Limitations on Insurers' Investment, we construct an insurer-year specific regulatory stringency index based on the insurers'
exposure to the regulation and the relative stringency of the investment statutes in different states and in different years.
We begin by characterizing the regulatory environment of each state as flexible or stringent with respect to a particular asset class by
examining the statute in effect for a given year.4 For example, if the statute contains key phrases such as “Not addressed” or “No
Provisions” for a given investment vehicle in a given state and year, then the statute is considered “Flexible”. Conversely, if the statute
contains an explicit limitation such as “Combination of corporate obligations and leased property shall not exceed 40% of admitted
assets” or “For common or preferred stock, 15% admitted assets, but for common stock, 10% admitted assets,” the statute is classified as
“Stringent” for that asset, state and year combination. Investment limitations explicitly associated with amounts invested in bonds are
based on bond ratings generated by the NAIC's Securities Valuations Office.5 Some states, for instance, allow any level of investment in
medium- and low-grade corporate and U.S. bonds (i.e., Flexible), while others place a restriction on these types of investments
(Stringent). This exercise is carried out for each state and asset class for the years 1999–2012. Once we characterize each asset, state and
year combination, we calculate the percentage of total investment subject to stringent limits for each insurer and year. For insurer i in
year t, its investment regulatory stringency index (IRSIi,t) is calculated as:

1
PSi PC  
Si s¼1 c¼1 Investmenti;c;t *Regulatory Stringencys;c;t
IRSIi;t ¼ PC
c¼1 Investmenti;c;t

where Investmenti;c;t is a continuous variable representing the amount of money invested by insurer i in investment category c in year t,
and Regulatory Stringencys;c;t is a dichotomous variable equal to one if state s has a restrictive regulatory environment with respect to
investment category c in year t and zero otherwise. By design, IRSIi,t is comprised between 0 (the insurer's entire investment portfolio is
free of constraints) and 1 (the insurer's entire investment portfolio is constrained). The amount investment in tax-exempt securities is not
included in the calculation of regulatory stringency to reduce the potential feedback effect between the share of taxable investment
income and regulatory stringency.
The construction of IRSIi,t accounts for regulatory limits on specific asset types and captures the regulatory environment to which
each insurer is specifically exposed (i.e., if insurer i is not licensed in some state, then that state's regulation is excluded from insurer i's
IRSIi,t measure). IRSIi,t therefore accommodates the number of states in which an insurer operates, as well as changes to each state's
investment regulatory regime as reported in the NAIC's Compendium of State Laws on Insurance Topics.

3. Hypotheses

Before examining how a P&C insurer's investment regulatory environment affects its asset allocation, we first investigate the relation
between an insurer's operating performance and the change in its proportion of investment income originating from taxable securities.
Assuming (1) firms are fully taxed, (2) tax-exempt and taxable investments have the same maturity and default probabilities, and (3)
expected returns on taxable investments exceed expected returns on tax-exempt investment pre-tax, the Hendershott and Koch (1980)
model predicts that investors will favor taxable investments in the presence of net losses. In other words, with net operating losses
functioning as a tax-shield, after-tax profits are maximized with investment in taxable assets. This leads us to our first hypothesis, stated
in the alternative form:
Hypothesis 1. Insurers adjust their portfolio allocations in favor of taxable investments when experiencing underwriting losses.

4
One of the authors discussed the statutes with insurance state departments (specifically the legal department) to fully understand the wording of the laws and how it
pertains to the investment limitations of P&C insurers. The Appendix provides the criteria we used to assign a level of regulatory investment limitation for all asset
classes.
5
“The NAIC's Securities Valuation Office (SVO) is responsible for the day-to-day credit quality assessment and valuation of securities owned by state regulated
insurance companies. The SVO conducts credit analysis on these securities for the purpose of assigning an NAIC ‘class rating’ designation.” The designations are not
produced to aid investment decisions for investors (NAIC, 2014).

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M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

Let us now turn to our investigation of regulatory effects. One of the goals of state regulatory bodies is to reduce the likelihood and
the economic effect of insolvencies. One method employed to achieve that goal is to limit the amount and type of investments insurers
can hold at any given time. This can be done by establishing a ceiling for (1) the level of premiums invested in risky assets and/or (2) the
proportion of the total investment portfolio invested in riskier assets. Given the tendency for tax-exempt securities to fall in the category
of lower-risk & lower-return investments, we intuitively expect a positive relation between regulatory stringency and investment in tax-
favored assets. Specifically, we expect P&C insurers to shift their investment portfolios toward (away from) tax-exempts as the state
regulator enhances (reduces) restrictions against insurers’ investment in risky assets, independent of underwriting results. It then fol-
lows that when profit-maximizing incentives to rebalance portfolios toward taxable investment arise (i.e., when P&C insurers experi-
ence underwriting losses), insurers operating in environments with greater regulatory stringency will have more difficulty rebalancing
efficiently. This leads to our second and third hypotheses:
Hypothesis 2. P&C insurers' operating in more (less) stringent regulatory environments have a higher proportion of tax-exempt
(taxable) assets in their investment portfolios.
Hypothesis 3. When experiencing underwriting losses (gains), constrained P&C insurers rebalance their portfolio allocations less
toward taxable (non-taxable) investment assets.
The effect of regulation on portfolio investment is not consistently observed empirically (see Born, 2001). Ultimately, whether P&C
insurers’ portfolio decisions are constrained as a result of regulation is an empirical question. We discuss the data next.

4. Data and methodology

The initial sample consists of both affiliated and unaffiliated single P&C insurers operating in the United States between 1999 and
2012. The NAIC annual statement database includes all financial information needed to calculate the dependent variable, Portfolio
Rebalancing (or ΔbI i;t ), which is the change in an insurer's earned taxable investment income6 from year t  1 to year t scaled by each
year's total investment income.
The final sample consists of 2700 unique P&C insurers between 2000 and 2012 (the year 1999 had to be deleted because of our use of
lagged variables), for a total of 17,241 observations.

4.1. Main independent variables

The two independent variables of interest are the current and the previous years' underwriting income (Underwritingt and Under-
writingt-1), which are defined as an insurer's operating income scaled by total net admitted assets, and our index of investment regulatory
stringency (IRSIi,t). The IRSIi,t variable (see Section 2) is constructed using three NAIC publications:

1 The Compendium of State Laws—Limitations on Insurers' Investment to measure a state's regulatory investment environment;
2 The Exhibit of Net Investment Income Pages, from which we obtained insurers' earned investment income from taxable and tax-
exempt sources;
3 Schedule T: Exhibit of Premiums Written, from which we deduced where P&C insurers were licensed.

4.2. Control variables

Many econometric models employed to test the paper's main hypotheses include controls for confounding factors that either operate
as additional portfolio rebalancing constraints, or support competing narratives of P&C insurers' incentives to rebalance their invest-
ment portfolios.
Because one critical role of insurance regulators is to mitigate insurer insolvency, we account for the regulatory scrutiny associated
with an insurer's level of solvency. More specifically, we consider the Risk-Based Capital (RBC) requirement as our regulatory scrutiny
measure. RBC has two components: 1- A formula that establishes a minimum level of capital required to guard against insolvency, and 2-
A law that automatically grants authority to state regulators to take specific actions based on the severity of the insurer's impairment.7
Kwon, Kim, and Lee (2005) find that insurance regulators tend to prioritize policyholders' interests over that of shareholders (i.e., the
regulators' primary concerns are to minimize insurance market disruption, and to facilitate and expedite the payment of claims). The
regulatory control of a troubled insurer's operations could therefore affect the posited relation between underwriting results and
portfolio rebalancing behavior. The solvency proxy we employ, Regulatory Compliance, is a dichotomous variable equal to 1 if the RBC

6
A potentially better measure of portfolio rebalancing would be the change in taxable assets per se. The data source we use does not provide sufficient information to
classify investments in this manner.
7
The insurance economic literature recognizes that three important financial solvency measures have been developed: Financial Analysis and Solvency Tracking
(FAST) score (Cummins & Phillips, 2009; Cummins et al., 1999), the Insurance Regulatory Information Systems (IRIS) ratios (Petroni, 1992; Beaver, McNichols, &
Nelson, 2003; Gaver & Paterson, 1999, 2004, 2007), and the Risk-Based Capital (RBC) ratios. Despite the fact that Grace et al. (1998) and Cummins et al. (1995, 1999)
find little evidence that RBC ratios help predict insurers insolvencies, regulators still make use of RBC calculations to determine whether any form of remedial action is
needed. For a more thorough overview, see www.naic.org/cipr_topics/topic_risk_based_capital.htm. See Feldblum (1996) for a critique.

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M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

ratio suggests no regulatory intervention is necessary and 0 otherwise, even if there are five distinct outcomes.
We also control for the insurers' liquidity needs and the riskiness of their investment strategy.8 The insurers' need for cash or near
cash securities is likely related to their need to pay claims. Aggregate casualty losses in excess of those originally forecasted will require a
greater shift toward taxable investment income as the sale of invested assets is more likely to generate taxable capital gains. We therefore
measure the insurers' need for liquid assets using the variable called Loss Paid, which we define as the ratio of an insurer's total claims
paid to its net admitted assets (Cummins & Danzon, 1997; Danzon, Epstein, & Johnson, 2004; Harrington & Danzon, 1994). With respect
to the riskiness of the insurers' portfolio, we expect insurers whose investment income is more likely generated by capital gains to hold
more non-taxable securities since they have more freedom in deciding when to realize those taxable capital gains. To minimize their tax
liability, insurers will choose to realize their capital gains in years when their operating income is negative. The potential importance of
taxable capital gains is measured using the variable called Investment Risk, which is calculated as the sum of the value of common stock
and of real estate investments, divided by the insurer's net admitted investment assets (e.g., see Harrington & Nelson, 1986; Pottier &
Sommer, 1999).
Our fourth control variable accounts for the fact that insurers should rebalance their portfolios toward tax-exempt investments when
facing higher tax rates. We control for the influence of taxes (Tax Rate) by including the sum of federal and foreign income taxes incurred
(excluding tax on capital gains) divided by net income.
We finally control for insurer Size, as calculated by the log of total admitted assets (Wang, Lin, Werner, & Chang, 2018), and recent
revenue Growth, as calculated using the one-year percent increase in net premiums written. Both variables are included to control for
variations in liquidity incentives to rebalance. Although the incentive to smooth income in the insurance industry has been discussed in
many papers (see Anderson, 1971; Weiss, 1985; Grace, 1990; and Grace & Leverty, 2012 inter alia), we exclude this as a control in our
model because net income includes both income from operations (underwriting) and investment income, the main component of our
dependent variable. Including income smoothing in our model would present important challenges in our attempt to draw inferences
with respect to our variables of interest.

4.3. Methodology

To investigate the relationship between portfolio rebalancing (ΔbI i;t ), underwriting performance (Underwritingi,t) and an insurer's
investment regulatory environment (IRSIi,t), we estimate the following insurer (Γi ) and year (Λt ) fixed effect regression model (i indexes
insurers and t indexes years):

yi;t ¼ βZi;t þ θXi;t þ Γi þ Λt þ εi;t ;

where yi;t is the dependent variable (ΔbI i;t ), Zi;t is the vector of the main variables of interest (in particular IRSIi,t), and Xi;t is a vector of
control variables. Robust standard errors are used.
Negative estimates for β1 or β2 (Underwritingi,t and Underwritingi,t-1) would provide support for Hypothesis 1, in which an insurer's
investment income from taxable sources should be negatively related to its operating profitability. Negative values for β1 and/or β2
mean that insurers facing positive (resp. negative) operational returns reduce (resp. increase) the proportion of investment income they
receive from taxable sources. In other words, the worse the underwriting performance, the more likely the insurer is to invest in taxable
instruments, because underwriting losses can be used to offset positive returns from taxable investments.
With respect to the effect of IRSIi,t, a negative coefficient of β3 would provide support for Hypothesis 2, which suggests that there is a
link between the regulatory environment insurers face and their portfolio rebalancing decisions. In contrast with the analysis conducted
with respect to Hypothesis 1, no paper has examined the effect of regulatory stringency on the distribution of P&Cs investment income
between taxable and tax-exempt sources. The construction and use of the IRSIi,t variable in explaining P&C insurers' portfolio reba-
lancing behavior are the paper's main contributions.
Finally, assuming that investment regulatory constraints limit the speed at which insurers can rebalance their investment portfolios,
a β4 coefficient (Underwritingi,t-1 * IRSIi,t) that is significantly different from zero would provide support for the possibility that insurers in
less (resp. more) stringent regulatory environments have greater (lower) flexibility to rebalance in response to the tax incentives of the
previous year's underwriting income. In other words, if it is true that investment regulatory stringency limits rebalancing, then firms that
have experienced negative (resp. positive) underwriting performance and are incentivized to hold more taxable (resp. tax-exempt)
investment products would be prohibited from rebalancing completely. This means that the sign of the β4 coefficient should depend
on whether P&C insurers suffered an underwriting loss (which would entail a positive β4 if the hypothesis is correct) or experienced a
gain (β4 negative, if the hypothesis is correct).

5. Empirical results

Table 1 shows descriptive statistics for the unbalanced panel of 17,241 insurer-year observations. On average, P&C insurers reba-
lance their portfolios away from taxable securities by 0.4% (or 0.004), although the median is almost exactly zero. In any given year,
half the insurers increase their position in tax-exempt securities whereas the other half reduce their position.
Turning our attention to our independent variables of interest, the average underwriting income scaled by total admitted assets

8
The authors would like to thank anonymous referees for suggesting to use these additional control variables.

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M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 1
Descriptive statistics.

Table 1.
Descriptive Statistics
Percentiles
Variables Mean Std. Min 10th 25th 50th 75th 90th Max
Portfolio
Rebalancing -0.004 0.057 -0.257 -0.057 -0.016 0.000 0.009 0.042 0.232
Underwritingt -0.002 0.060 -0.250 -0.067 -0.027 0.001 0.027 0.062 0.183
IRSI 0.512 0.274 0.000 0.120 0.328 0.502 0.706 0.928 1.000
Regulatory
Compliance 0.949 0.220 0.000 1.000 1.000 1.000 1.000 1.000 1.000
Loss Paid 0.224 0.138 0.000 0.045 0.113 0.218 0.320 0.410 0.576
Investment Risk 0.122 0.158 0.000 0.000 0.000 0.063 0.189 0.337 0.724
Tax Rate 0.228 0.458 -2.073 -0.007 0.066 0.259 0.351 0.480 2.352
Growth 0.087 0.424 -1.994 -0.202 -0.049 0.041 0.160 0.405 2.993
Size 11.54 10.19 11.44 12.73 14.04 16.54
1 1.860 7.809 9.160 5 8 4 4 8

Highlighted values are used in the paper for discussion purposes.

Note: The table presents summary statistics for the years 2000–2012. There are 17,241 insurer-year observations.
Portfolio Rebalance is the difference between the current year's (t) ratio of earned taxable investment income to
Earned taxablet
total investment income ( ) and the previous year's (t-1) ratio of earned
Earned taxablet þ Earned non  taxablet
Earned taxablet1
taxable investment income to total investment income ( ). Under-
Earned taxablet1 þ Earned non  taxablet1
writing is defined as the operating income for an insurer scaled by total net admitted assets. IRSI is the percent of
investment classes subject to the regulatory investment limitations per state, per year. Regulatory Compliance is
a dichotomous variable equal to 1 if the appropriate RBC ratio suggest “No Action” should be taken by the
regulator, and 0 otherwise. Loss Paid is calculated as the loss paid dividend by net admitted assets. Investment
Risk is calculated as the dollar ratio of total common stock and real estate investments to net admitted investment
assets. Tax Rate is defined as federal and foreign income taxes incurred, excluding tax on capital gains, divided by
net income. Growth is the one-year percent increase in net premium. Size is the logarithm of admitted assets. Size
is the log of total admitted assets.

(Underwritingt) is 0.002, which means that approximately half of the insurers have positive underwriting results. With respect to IRSIi,t,
over half of an insurer's investment portfolio is subject to some restrictive regulatory measures (IRSIi,t has a mean of 0.528 and a median
of 0.526).
Fig. 1 presents the distribution of ΔbI i;t (the more central distribution, labeled Rebalancing) and Underwritingi,t (the wider distribution,
eponymous) for the entire sample. Although both variables are essentially centered at 0 and have similar standard deviations (0.057 and
0.060 respectively), the distribution of ΔbI i;t has much more distribution mass in the center and in the tails. In other words, the fatter tail
of ΔbI i;t suggests that if a firm decides to rebalance its investment portfolio, it does so drastically.
With respect to IRSIi,t, Fig. 2 displays the histogram distribution of all values of the variable. What clearly appears in Fig. 2 is that a
fair number of observations are clustered at the two extreme points of the IRSIi,t distribution. These data reflect the importance of small
insurers operating in one or two states and investing in one or two types of securities that are subject to similar regulatory environments.
These “small in size and scope” insurers have an IRSIi,t that is exactly equal to zero or to one.
In terms of the control variables, approximately 95% of P&C insurers are in regulatory compliance (Regulatory Compliance), which is
consistent with prior studies (Cummins et al., 1995, 1999; Grace, Harrington, & Klein, 1998). P&C insurers’ average tax rate—as

Fig. 1. Distribution of Rebalancing and Underwriting variables.

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M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

Fig. 2. Histogram of the main independent variable of interest, IRSI.

Table 2
Pairwise correlation.

(1) (2) (3) (4) (5) (6) (7) (8) (9)

(1) Portfolio Rebalancing 0.093 0.073 0.016 0.026 0.052 0.054 0.027 0.027
(2) Underwriting t ¡0.061 0.049 0.037 0.163 0.042 0.241 0.037 0.038
(3) IRSI ¡0.057 0.046 0.082 0.061 0.186 0.102 0.019 0.165
(4) Regulatory Compliance 0.017 ¡0.054 0.084 0.292 0.142 0.001 0.043 0.336
(5) Loss Paid 0.031 ¡0.174 0.052 0.280 0.019 0.065 0.020 0.421
(6) Investment Risk 0.036 ¡0.046 0.143 0.097 ¡0.081 0.083 0.001 0.231
(7) Tax Rate ¡0.036 0.088 ¡0.032 0.000 ¡0.016 0.047 0.146 0.002
(8) Growth 0.010 ¡0.033 ¡0.034 0.023 ¡0.038 ¡0.028 0.057 0.013
(9) Size 0.039 0.049 0.154 0.345 ¡0.403 0.183 0.001 ¡0.032

Note: This table provides the pairwise correlations years 2000–2012. Pearson correlations are shown below the diagonal and Spearman correlation shown above diagonal
(italic). Coefficients in bold indicate significance at the 5% level.

calculated by the taxes paid on net income—is approximately 22.6%. The payment of claims consumes an average of 22.4% of admitted
assets. Insurers hold 12.2% of admitted assets in the form of investments in common stocks and real estate holdings. Finally, the growth
of the underwriting businesses (Growth) is on average 9.0 percent per year, whereas the log of the average firm size is 11.5, which
represents an average firm size (when measured in terms of assets) of over 100 million dollars.
Pairwise correlations (Pearson and Spearman) are displayed in Table 2. Consistent with Hypothesis 1, the correlation between
Portfolio Rebalancing and Underwriting is negative and significant at the 5% level. Of all the variables used in this paper, the one which has
the highest Pearson correlation with Portfolio Rebalancing () is IRSIi,t. A negative and significant correlation between IRSIi,t and ΔbI i;t
suggests that insurers’ investment income shift toward tax-exempt sources in response to more stringent regulatory environments. This
negative correlation is consistent with the notion that insurers look for less regulated asset classes (such as cash and tax-exempt bonds)
when the level of regulatory scrutiny increases. With respect to IRSIi,t, we observe a strong correlation with asset size: Larger firms are
more likely to have a greater fraction of their investment subject to regulatory oversight.

5.1. Underwriting performance

Column 1 of Table 3 presents the regression coefficient estimates based on the entire sample. All regressions include year and firm
fixed effects, and use robust standard errors.
The results from the pooled sample show that, with respect to operational profitability, only the lagged underwriting variable
(Underwritingt-1) is significantly associated with Rebalancing. Contemporaneous underwriting performance (Underwritingt) does not seem
to play a role in determining the taxable nature of investment income. Taken together, this result tells us that when P&C insurers
experience strong underwriting performance in a given year, they then see a decrease in the percentage of their investment income from
taxable sources in the following year. P&C insurers reduce the percentage of their total taxable investment income, presumably to
compensate for incremental tax liabilities associated with their profitable insurance operations. This negative relationship between
underwriting performance and the proportion of investment income was also found in Cummins and Grace (1994) and Jiang and Nieh
(2012) inter alia.
When the sample is partitioned based on an insurer's previous year's underwriting income (i.e., whether the insurer in year t-1
experienced an underwriting loss in Column 2 or gain in Column 3), we see that firms with underwriting losses (Column 2) continue to
respond to tax incentives as predicted by economic theory (i.e., the coefficient on Underwritingt-1 is negative): The better (i.e., the less
negative) the underwriting results, the greater is the change in the proportion of investment income originating from taxable sources.
For insurers with underwriting gains, however, the proportion of investment income received from taxable sources does not seem to

7
M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 3
Fixed effect regression: Pooled sample, loss partitioned, gains partitioned.

Table 3.
Fixed Effect Regression: Pooled Sample, Loss Partitioned, Gains Partitioned

Portfolio Rebalancing
(1) (2) (3)
Pooled Sample Losses Gains
Variable Coef. t-stat Coef. t-stat Coef. t-stat
Intercept -0.012 -1.98** -0.016 -2.66*** -0.016 -2.18**
Underwritingt -0.020 -1.11 -0.029 -1.34 -0.015 -0.92
Underwritingt-1 -0.052 -3.40*** -0.065 -3.86*** 0.021 0.79
IRSI -0.020 -5.44*** -0.019 -4.96*** -0.020 -5.37***

Regulatory Compliance -0.000 -0.13 -0.003 -1.31 0.002 0.81

Loss Paid 0.003 0.57 0.005 0.75 -0.000 -0.03
Investment Risk 0.013 2.92*** 0.013 2.53** 0.015 2.13**
Tax Rate -0.004 -3.49*** -0.002 -1.53 -0.007 -2.81***
Growth -0.002 -1.09 -0.003 -1.90* 0.001 0.65
Size 0.001 2.60*** 0.002 3.18*** 0.001 2.10**
Clustering Firm? Yes Yes Yes
Clustering Year? Yes Yes Yes
Prob > F 0.0000 0.0000 0.0000
R-Sqr 0.0181 0.0165 0.0139
Obs. 17241 8584 8657

All variables are defined in Table 1. Standard errors are clustered by insurer and year (Peterson, 2009). *, **, and *** indicate significance at the
10%, 5%, and 1% levels, respectively. All variables are Windsorized using the Belsley-Kuh-Welsch (BKW) test to identify a data point as an
influential outlier. Highlighted values are used in the paper for discussion purposes.
A negative (resp. positive) coefficient means that a greater proportion of investment income is received from tax-exempt (resp. taxable) sources in
year t than in year t-1.

respond to underwriting performance. Taking the results of Columns 2 and 3 together, we conclude that only insurers that experienced
poor underwriting results in the previous year realign their investment portfolios in the current year. Finally, contemporaneous un-
derwriting performance has no effect on the taxable nature of P&C insurers' investment income.
The posited tax incentives for portfolio management are confirmed by the negative effect tax rates have on portfolio rebalancing.
When we partition observations based on the previous year's underwriting return, the implied tax rate is significant only for P&C in-
surers that experienced a profitable underwriting year (Model 3). There does not seem to be an effect of Tax Rate on portfolio reba-
lancing unless the previous year's underwriting performance was positive.

5.2. Regulatory stringency

With respect to our second hypothesis, results in Column 1 of Table 3 show a negative IRSIi,t coefficient. This means that in the face of
more stringent regulatory environments, insurers liquidate taxable investment instruments toward tax-exempt instruments. This
negative relationship is consistent with the view that insurers, when faced with major limitations on their investment portfolios, prefer
to invest in specific securities that are less subject to regulatory oversight, such as tax-exempt securities.

8
M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

When we partition the sample based on whether insurers experienced underwriting gains or losses, we find in both partitions9 that
investment regulatory stringency induces portfolio rebalancing toward less taxable sources of investment income. Moreover, the eco-
nomic effect of investment regulatory stringency seems to be quite independent of insurers' underwriting results; the coefficient of
0.019 for IRSIi,t in the loss partition (Column 2) is statistically similar to the 0.020 for IRSIi,t in the gains partition (Column 3). This
tells us that the more stringent is the insurer's investment regulatory environment, the more likely will it transition away from taxable
and higher-yield sources of investment income such as corporate bonds, and shares of preferred and common stock.
Economically, the size of the coefficients in Column 1 tells us that P&C insurers in the 75th percentile in terms of performance
(0.027) and regulatory stringency (0.706) would reduce the percentage of taxable investment income that they receive by 1.55%
(0.027*0.052–0.020*0.706 ¼ 0.0155) compared to firms with the median underwriting performance and that face no investment
regulatory constraints (that will see no change since median underwriting is zero and there are no constraints; i.e.
0*0.052–0.020*0 ¼ 0). Moving from the 75th percentile to the 25th percentile in terms of regulatory stringency (going from and index
value of 0.706 to 0.328) would reduce the variation in the proportion of taxable investment income by 0.80%
(0.027*0.052–0.020*0.328 ¼ 0.0080). The same relative movement in the distribution of regulatory constraints (from the 75th to
the 25th percentile) has a significantly larger effect when achieved with respect to the investment regulatory stringency P&C insurers
face (0.020*(0.706–0.328) ¼ 0.0076) than with respect to insurers’ underwriting performance
(0.052*(0.027 þ 0.027) ¼ 0.0028).
Apart from firm size (Size), IRSIi,t and Investment Riski,t are the only variables that have a significant effect on portfolio rebalancing in
all three partitions. This suggests that only firm size, the stringency of investment regulations, and investment risk affect P&C insurers'
portfolio holdings irrespective of insurers’ performance. In particular, we note that Regulatory Compliance, Growth, and Loss Paid do not
matter in portfolio rebalancing.
With respect to Regulatory Compliance, we proposed that regulatory control of a troubled insurer's operations would induce regulators
to favor payments of claims over profit maximization goals. Insurers in worse financial shape would thus need to secure their investment
even if it comes at the cost of having less dividends to distribute to shareholders. Generally, taxable securities generate higher yields, so
Regulatory Compliance was expected to have a positive sign. This does not seem to be the case, however, as being in compliance or not
seems to be unrelated to the taxable nature of investment income. Growth, which can be achieved through lower premiums to increase
market share, was expected to increase the proportion of investment income from taxable sources. Finally Loss Paid was initially ex-
pected to increase the proportion of taxable investment income because the sale of assets to pay for casualty losses is more likely to
generate taxable capital gains. Similar to our findings with respect to Regulatory Compliance we find no relationship between either
Growth or Loss Paid, and the change in the taxable aspects of an insurer's investment portfolio.

5.3. Interaction between regulation and underwriting performance

We now consider the interaction between underwriting performance and the level of investment regulatory stringency in deter-
mining insurers' investment rebalancing decisions. Our hypothesis is that insurers operating in more stringent regulatory environments
would find it harder to rebalance optimally in response to poorer underwriting performance. The results in Table 4 do not support that
hypothesis as an insurer's regulatory environment does not have a different effect on portfolio rebalancing when controlling explicitly
for underwriting performance (i.e., Underwritingt-1 * IRSIi,t is not different from zero).
When we partition the data based on whether the previous year's underwriting income is positive or negative, we again find that
Underwritingt-1 * IRSIi,t is not different from zero. Including the interactive term does not change the main message of the paper, which is
that greater regulatory stringency reduces the degree to which insurers rebalance their investment portfolios toward taxable securities
(IRSIi,t < 0).

5.4. Robustness

In our main regression results in Table 3, we presented the effect of regulatory stringency on the change in taxable investment
income expressed as a proportion of all investment income. We were not considering separately the different types of investment income
such as dividend, interest, and capital gains. One possible problem of doing so is that realized capital gains (and losses) are, by definition,
earned when a security is sold, which means that an action by the insurer is necessary for such capital gains (and losses) to be realized.
When we examine the importance of capital gain investment income as a percentage of total investment income (table not provided), we
note that taxable capital gains represent on average approximately one-third of total taxable investment income, compared to tax-
exempt capital gains which represent on average only 7% of total tax-exempt investment income.
In Table 5, we address this potential investment action by examining changes in investment income associated only with capital
gains (Model 1) and excluding capital gains (Model 2).10 The dependent variable in Model 1 (resp. Model 2) is constructed as the one-
year variation in investment income attributable to taxable capital gains (resp. excluding taxable capital gains) as a proportion of total
capital gain (resp. investment income excluding capital gains). The reason we separate realized capital gains from other types of in-
vestment income is that they require a more active rebalancing of the insurer's portfolio since capital gains (and losses) can be realized

9
Partitioning on the previous and the current year's underwriting performances (i.e., two negative years or two positive years) gives approximately the same results
as in Columns 2 and 3 of Table 3.
10
The number of observations decreases because some insurers' capital gains report is missing (and not zero).

9
M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 4
Pooled sample, loss partitioned, gains partitioned.

Estimation of the effects of underwriting income, of investment regulatory stringency (IRSI) and the interactive effect of investment stringency (IRSI) on the change in
the proportion of investment income originating from taxable securities (Portfolio Rebalancing). Portfolio Rebalancing is measured as.
Column (2) and (3) present partitions based on the previous year's underwriting income: Firms with negative underwriting income in Column (2) and firms with
positive underwriting income in Column (3).

Variable Portfolio Rebalancing

(1) (2) (3)

Pooled Sample Losses Gains

Coef. t-stat Coef. t-stat Coef. t-stat

Intercept 0.012 1.98** 0.016 2.54** 0.018 2.43**

Underwritingt 0.020 1.11 0.029 1.34 0.015 0.91
Underwritingt-1 0.045 2.75*** 0.071 2.66*** 0.064 1.51
IRSI 0.020 5.47*** 0.018 4.45*** 0.016 3.85***

Underwritingt-1* IRSI 0.015 0.62 0.014 0.33 0.085 1.54

Regulatory Compliance 0.000 0.09 0.003 1.31 0.002 0.98

Loss Paid 0.003 0.57 0.005 0.74 0.000 0.05
Investment Risk 0.013 2.92*** 0.013 2.54** 0.014 2.12**
Tax Rate 0.004 3.52*** 0.002 1.53 0.007 2.82***
Growth 0.002 1.08 0.003 1.91* 0.001 0.64
Size 0.001 2.59** 0.002 3.20*** 0.001 2.02**
Clustering Firm? Yes Yes Yes
Clustering Year? Yes Yes Yes
Prob > F 0.0000 0.0000 0.0000
R-Sqr 0.0182 0.0165 0.0142
Obs. 17241 8584 8657

All variables are defined in Table 1. Standard errors are clustered by insurer and year (Peterson, 2009). *, **, and *** indicate significance at the 10%, 5%, and 1% levels,
respectively. All variables are Windsorized using the Belsley-Kuh-Welsch (BKW) test to identify a data point as an influential outlier.
A negative (resp. positive) coefficient means that a greater proportion of investment income is received from tax-exempt (resp. taxable) sources in year t than in year t-1.

Table 5
Fixed effect regression: Sources of investment income.

Estimation of the effects of underwriting income and of investment regulatory stringency (IRSI) on the change in the proportion of realized capital gains originating
from taxable securities as a proportion of total capital gains in Model 1, and on the change in the proportion of investment income originating from taxable
securities but excluding taxable capital gains as a proportion of total investment income but excluding capital gains in Model 2.
The dependent variable in Model 1 is therefore
Realized capital taxablet Realized capital taxablet1
ΔbI t ¼  .
Total Realized capital gainst Total Realized capital gainst1
The dependent variable in Model 2 is
Earned taxablet  Realized capital taxablet Earned taxablet1  Realized capital taxablet1
ΔbI t ¼  .
Total earnedt  Total realized capital gainst Total earnedt1  Total realized capital gainst1

Variable Portfolio Rebalancing

(1) (2)

Capital Gains Only Excluding Capital Gains

Coef. t-stat Coef. t-stat

Intercept 0.024 1.05 0.903 4.47***

Underwritingt 0.055 1.25 0.618 1.61

Underwritingt-1 0.073 1.79* 1.157 2.51**
IRSI 0.002 0.26 0.244 4.51***

Regulatory Compliance 0.015 1.31 0.003 0.03

Loss Paid 0.008 0.84 0.276 1.29
Investment Risk 0.020 1.61 0.212 1.29
Tax Rate 0.005 1.41 0.055 1.43
Growth 0.011 1.58 0.083 1.40
Size 0.001 0.40 0.018 1.06
Clustering Firm? Yes Yes
Clustering Year? Yes Yes
Prob > F 0.0000 0.0000
R-Sqr 0.0011 0.0025

All variables are defined in Table 1. Standard errors are clustered by insurer and year (Peterson, 2009). *, **, and *** indicate significance at the 10%, 5%, and 1% levels,
respectively. All variables are Windsorized using the Belsley-Kuh-Welsch (BKW) test to identify a data point as an influential outlier.
A negative (resp. positive) coefficient means that a greater proportion of investment income is received from tax-exempt (resp. taxable) sources in year t than in year t-1.

10
M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 6
Financial crisis and natural catastrophic event.

Estimation of the effects of underwriting income, of investment regulatory stringency (IRSI) and the interactive effect of investment stringency (IRSI) on the change in
the proportion of investment income originating from taxable securities (Portfolio Rebalancing). Portfolio Rebalancing is measured as
Earned taxablet Earned taxablet1
ΔbI t ¼  .
Earned taxablet þ Earned non  taxablet Earned taxablet1 þ Earned non  taxablet1
Variable Portfolio Rebalancing

(1) (2) (3) (4)

Before Crisis (until 2006) After Crisis (2009 Before Katrina (until After Katrina (2006 onward)
onward) 2005)

Coef. t-stat Coef. t-stat Coef. t-stat Coef. t-stat

Intercept 0.001 0.20 0.035 6.50*** 0.007 1.72* 0.023 3.09***

Underwritingt 0.063 3.04*** 0.037 1.59 0.076 3.33*** 0.020 1.16

Underwritingt-1 0.034 1.64 0.080 3.09*** 0.024 0.93 0.059 2.95***
IRSI 0.016 3.79*** 0.022 2.68*** 0.015 2.64*** 0.021 4.08***

Regulatory Compliance 0.001 0.44 0.001 0.19 0.000 0.15 0.001 0.42
Loss Paid 0.003 0.36 0.007 4.11*** 0.004 0.42 0.002 0.60
Investment Risk 0.015 2.08** 0.003 1.26 0.016 1.50 0.010 1.85*
Tax Rate 0.003 2.24** 0.002 1.75* 0.004 2.04** 0.004 2.67***
Growth 0.004 2.57** 0.000 0.17 0.003 1.68* 0.001 0.47
Size 0.001 0.93 0.003 6.54*** 0.001 1.76* 0.002 3.16***
Clustering Firm? Yes Yes Yes Yes
Clustering Year? Yes Yes Yes Yes
Prob > F 0.0000 0.0000 0.0000 0.0000
R-Sqr 0.0190 0.0252 0.0217 0.0181
Obs. 8864 5646 6266 9691

All variables are defined in Table 1. Standard errors are clustered by insurer and year (Peterson, 2009). *, **, and *** indicate significance at the 10%, 5%, and 1% levels,
respectively. All variables are Windsorized using the Belsley-Kuh-Welsch (BKW) test to identify a data point as an influential outlier. Before Crisis (resp. Katrina) is
defined as all years from 1993 until 2006 (resp. 2005) onward. After Crisis (resp. Katrina) is defined as all years from 2009 (resp. 2006) onward.

only when the security held is sold. This is not true for other sources of investment income. The question is then “when are insurers more
likely to realize capital gains?” We contend that capital gains are more likely to be realized when losses are greater than expected. If
indeed capital gains are more likely to occur following important losses, then such a source of investment income can hardly be expected
to be related to regulatory stringency. We therefore expect regulatory stringency to be more problematic for those sources of income that
are not directly associated with capital gains and losses. Consequently we expect the IRSIi,t coefficient to be more negative in Model 2
than in Model 1.
Results in Table 5 support our intuition and our hypotheses in many ways. In particular, we see in the case of capital gains only
(Model 1) that none of the independent variables have any power (at the 5% level) in explaining the change in the proportion of total

Table 7
Fixed effect regression: Pooled sample for growth.

Estimation of the effects of underwriting income and of investment regulatory stringency (IRSI) on the change in the insurers' direct premium written.

Growth Measure

Variable ΔDPW

Coef. t-stat

Intercept 0.214 7.50***

Underwritingt 0.049 0.45

Underwritingt-1 0.588 3.80***
IRSI 0.055 3.20**

Regulatory Compliance 0.054 2.07**

Loss Paid 0.314 7.67***
Investment Risk 0.187 5.53***
Tax Rate 0.047 4.94***
Size 0.003 1.05
Clustering Firm? Yes
Clustering Year? Yes
Prob > F 0.0000
R-Sqr 0.0216
Obs. 16587

All variables are defined in Table 1. Standard errors are clustered by insurer and year (Peterson, 2009). *, **, and *** indicate significance at the 10%, 5%, and 1% levels,
respectively. All variables are Windsorized using the Belsley-Kuh-Welsch (BKW) test to identify a data point as an influential outlier.
A negative (resp. positive) coefficient means that a greater proportion of investment income is received from tax-exempt (resp. taxable) sources in year t than in year t-1.

11
M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

taxable capital gain investment income, which be due to the fact that more than half of the sample firms report exactly zero in tax-
exempt capital gains. In contrast, when all capital gains are discarded from the calculation of taxable and non-taxable investment in-
come (Model 2), the effect of regulatory stringency on portfolio rebalancing remains negative and significant. Taken together, the results
in Table 5 tell us that stringent investment allocation regulation reduces the proportion of investment income coming from taxable
sources, and that this reduction is not attributable to changes in realized capital gains. This is essentially the same result we had before
when we were examining all sources of investment income together: The more regulatory stringent is the investment environment, the
more likely will an insurer's investment income originate from tax-exempt sources. We also partitioned the data based on underwriting
performance to examine if having had underwriting gains or losses has any effect on the source of investment income. Results (unta-
bulated) essentially remain the same: IRSIi,t is only significant in explaining the proportion of taxable investment income from sources
other than capital gains.
We present in Table 6 results based on the same regression models as in Table 3, but after partitioning the data as a function of two
major shocks that befell the economy in general on the one hand, and the P&C insurance industry specifically on the other hand. More
specifically, the first (resp. second) result column in Table 6 uses data points prior (posterior) to the financial crisis, whereas the third
(resp. fourth) result column uses data points prior (posterior) to hurricane Katrina. The results are essentially the same in the different
partitions and are similar to those found in our primary analysis. Therefore, there does not appear to be important changes in the way
regulation affects investment income following important catastrophes. Although it is true that the coefficient on IRSIit becomes more
negative after each event, the difference does not seem to be statistically significant.
The last table (Table 7) examines whether investment regulatory stringency has any effect on firm growth. The logic is that if insurers
are forced to hold a suboptimal portfolio, then firm growth should be impeded because investment returns will not be high enough to
fuel firm capital growth. This hypothesis is validated in Table 7 as the negative and significant coefficient on IRSIit confirms that in-
vestment regulation impedes a firm's growth in direct premiums written.
The “robustness” verifications we presented in the last three tables of the paper confirm our initial analysis that regulatory
constraints on asset allocation have a significant economic impact on how insurers generate investment income. This means that it
is quite possible that an insurer would have chosen a different asset allocation if regulation was not there to limit insurers’ asset
allocation.

6. Final remarks

In this paper, we analyzed the investment behavior of property and casualty insurers in an environment where they do not have full
liberty to invest collected premiums in all asset classes to generate cash flows to cover future losses. Our analysis of a large sample of P&C
insurers indicated that the level of regulatory stringency on P&C insurers’ investment portfolios favored the holding of tax-exempt
securities to the detriment of taxable securities, at least inasmuch as investment income is a proxy for investment holdings. The eco-
nomic effect of investment regulatory stringency was essentially the same whether insurers experienced underwriting gains or losses and
whether we looked at all the sources of investment income or only at some subset (capital gains or non-capital gains). Moreover, insurer
behavior with respect to regulatory stringency did not change following major catastrophes such as the 2009 financial crisis or hurricane
Katrina in 2005. To our knowledge, no study has ever documented the effect of investment regulatory constraints on portfolio reba-
lancing strategies.
Our results also tell us that insurers respond to tax incentives by receiving more income from taxable sources when underwriting
performance is poor. The effect of underwriting performance on the insurers’ investment strategy, although significant, is
economically smaller than that of regulatory restrictions in the nature of the securities that P&C insurers are allowed to hold.
A few caveats are necessary before drawing far-reaching inferences. The first is that our portfolio rebalancing proxy measures
the change in investment income instead of the actual holdings of securities. It is possible that the associations we found between
investment regulatory constraints and investment income have more to do with factors related to the magnitude of returns on
taxable investment rather than P&C insurers' decisions to rebalance. The second caveat is that our flexibility variable was derived
based on insurers' potential regulatory environments, not necessarily their actual environments. This proxy was again a second
best, given that the information we had access to did not provide enough detail to itemize P&C insurers’ actual investment
portfolios.
Our contribution to the body of knowledge in financial and insurance economics goes beyond the simple acknowledgement that
regulation reduces insurers' freedom to choose what would have been their “preferred” asset allocation. The fact that more
stringently regulated insurers invest a higher fraction of their portfolios in non-taxable securities raises the question of whether
their resulting asset allocation is dangerously suboptimal given their operations. Even more dangerous is the fact that regulatory
stringency may lead to insurers holding a portfolio that is under-diversified. If it is indeed the case that insurers hold a sub-optimal
portfolio, then either they are bearing more risk of insolvency in the event that a major loss occurs, or they will be forced to
increase premiums to maintain an acceptable level of insolvency risk. Another possibility is that as insurers are disproportionately
holding non-taxable securities, which are less numerous than taxable securities, it increases their systemic risk since a shock to the
non-taxable securities market will affect all stringently regulated insurers in a way that regulators may not have foreseen (see in
particular Chaderina, Mürmann, & Scheuch, 2018). This is a potential cost to all taxpayers if they are asked to foot the bill of
insolvent insurers. Finally, the fact that regulated insurers are holding more tax-exempt securities means that they are paying less in
income tax, which, in a general equilibrium sense and in addition to the cost to taxpayers of insurer insolvency, increases the
taxpayers’ overall burden.

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M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

Acknowledgements

We thank the Social Sciences and Humanities Research Council of Canada (grant # 435-2018-1536) for partially financing this
project, which was started when the third author was a visiting scholar in the Department of Finance at HEC Montr
eal. The first author
wishes to acknowledge the continuing support of the Direction de la recherche at HEC Montr
eal and of CIRANO.

Appendix

Examples: Limitations on Insurers' Investments – (Flexible or Non-Flexible), excluding restrictions related to tax-exempt securities.

Flexible Non-Flexible

Government/Corporate Bonds
1) Not addressed. 1) Combination of corporate obligations and leased property shall not exceed
40% admitted assets.
2) No provision. 2) No more than 65% of admitted assets in obligations and real estate.
3) Insurer may invest in obligations of the United States; may invest in cities and 3) Government obligations 40% of admitted assets; 10% in one fund.
states' obligations.
Common and Preferred Stock
1) Not addressed. 1) Greater of 25% admitted assets or 100% of insurer's surplus policyholders;
preferred stock 20%.
2) For common stock, may invest in any non-assessable ones of any solvent 2) For common or preferred stock, 15% admitted assets, but for common stock,
institutions under the US; for preferred or guaranteed stock, must have 10% admitted assets.
investment grade rating approved by director.
3) For preferred or guaranteed shares, business may not been in default on its 3) For preferred or guaranteed stock, 25% of admitted assets, and for any one
obligations in preceding five years. issue, 2% admitted assets. Insurer shall not invest in common stock other than
guaranteed stock, except otherwise provided, and shall not invest in own stock.
Real Estate Mortgage Loan
1) Insurer may invest in loans secured by mortgages, trust deeds, or security 1) Insurers may invest in real estate mortgage or deeds of trust not exceeding
interests in tangible property secured by insurance against default. 80% fair market value of the security unless the excess is guaranteed or insured.
2) For obligations secured by real property mortgages, trust deeds, and similar
encumbrances of real property, 35% of admitted assets.
3) Total investment shall not exceed 25% admitted assets; 2% admitted assets on
other than first mortgage. Investment in any one property shall not exceed
greater of $30,000 and 2% admitted assets.
Real Estate Investments
1) Not addressed. 1) Concerning allowable real estate investments; for business purposes, 10%
admitted assets; for production of income, 10% admitted assets; for properties
under development, 5% but no more than 2% admitted assets in one parcel. For
all other categories and purposes, 20% admitted assets.
2) Limits vary with type of real estate. 2) Insurer may acquire, invest in, and improve enumerated real estate item, but
shall not exceed, where noted, 10% of admitted assets.
3) Insurer permitted to acquire or convey real estate, including leaseholds, 3) For business-related real estate, 15% admitted assets, but amount may be
business-related property, and real estate obtained in satisfaction of debts. increased with commissioner permission. For income-producing real estate,
20% admitted assets. Total of real estate investment shall not exceed 35%
admitted assets.
Contract Loans
1) Not addressed. 1) No loan upon pledge of securities shall exceed 90% market value of collateral
pledged.
2) Generally, without notification to and approval of director, an insurer may not 2) Insurer may make loans not expressed permitted under this chapter, if the
engage in transaction in which an officer or director has a financial interest, loan qualifies as a second investment, and in an aggregate amount such loans do
including loans. However, insurer may make policy loans, advances for not exceed 10% of the insurer's assets.
reasonable business expenses, and loans with relocation. 3) For investments not specifically prohibited, greater of unrestricted surplus
and lesser surplus and lesser of 10% admitted assets or 50% surplus as regards
policyholders.
Cash, Cash Equivalents and Short-Term Investments*
1) Not addressed. 2) Not addressed.
Derivatives Instruments
1) Not addressed. 1) For hedging transactions, 7.5% admitted assets in total statement value of
options, caps, floors, and warrants not attached.
2) No provision. 2) Insurer may engage in certain hedging transactions, but an insurer shall not
devote more than 10% of the excess of its capital and surplus over the minimum
requirements of a new stock or mutual company to qualify for a certificate of
authority to the hedging transaction.
3) Insurer may purchase or sell financial futures contract for the purpose of 3) No hedging transactions.
hedging against economic risk associated with a company asset or liability.
Other Invested Assets
1) Not specifically addressed. 1) For investments not specifically prohibited, greater of unrestricted surplus
and lesser of 10% admitted assets or 50% surplus as regards policyholders.
2) Except as otherwise prohibited, insurer may make investment that are prudent 2) For loans or investments not expressly prohibited, 10% admitted assets; 75%
with respect to business and diversification assets. of total capital and surplus; with specific exemptions.
(continued on next page)

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M.M. Boyer et al. International Review of Economics and Finance xxx (xxxx) xxx

(continued )

Flexible Non-Flexible

3) After satisfying minimum investment requirements, insurer may make 3) For loans or other investments permitted, in total amount not exceeding 10%
investments not otherwise prohibited, without limitation. admitted assets.
Write-in for Investments*
1) Not addressed. 1) Not addressed.
Note: The table presents limits on investments and the determining factor of whether it should be classified as flexible or non-flexible. Based on my criteria, there are
multiple states that changed their investing limitations from flexible to non-flexible and vice versa. For example, from 2008 to 2009 the state of Illinois went from a
flexible investment state concerning their US Government, Tax-free, and Other Bonds to non-flexible investment state since the state of Illinois (Department of Insurance)
decided to place boundaries investment limit on how much a P&C insurer can allocate to “admitted assets”. In addition, some states only allow quality debt securities
holding or place a limit on how much low quality debt securities an insurer can invest in as rated by the NAIC. Source: NAIC's Compendium of State Laws - Limitations on
Insurers' Investment.

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