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Abstract:
In this paper we have identified the major developments and issues that affect productivity and efficiency in insurance. We have used the designation "Life" to refer to developments and issues affecting life insurers and "P/C" for those affecting property/casualty insurers. The following is a listing of these issues: 1. Marketing, Relationship marketing, Distribution, Electronic data interchange, Market segmentation, Service centers, Point of sale policy illustrations, Unbundling of services, Innovative policies and products 2. Underwriting and expert systems 3. Data processing, General issues, Outsourcing vs. in-house, Centralization vs. decentralization, Mainframe vs. mini vs. workstations, Image systems, Technology, systems, and software, Links between mainframes and pc networks 4. Claims settlement 5. Miscellaneous, Total quality management, Reengineering, Downsizing Mergers and acquisitions, Management reporting 6. Financial risk management, Overview of risk, Balanced view of risk, Perspective on risk, Catastrophic risk, Asset-liability management, Capital budgeting, Derivatives, Regulation

Abstract:
The use of derivatives in corporate risk management has grown rapidly in recent years. In this paper, the authors explore the factors that influence the use of financial derivatives in the U.S. insurance industry. Their objective is to investigate the motivations for corporate risk management The authors use regulatory data on individual holdings and transactions in derivative markets. According to modern finance theory, shares of widely held corporations are held by diversified investors who operate in frictionless and complete markets and eliminate non-systematic risk through their portfolio choices. But this theory has been challenged by new hypotheses that take into account market imperfections, information asymmetries and incentive conflicts as motivations for corporate managers to change the risk/return profile of their firm. The authors develop a set of hypotheses regarding the hedging behavior of insurers and perform tests on a sample of life and property-liability insurers to test them. The sample consists of all U.S. life and property-liability insurers reporting to the NAIC. The authors investigate the decision to conduct derivatives transactions and the volume of transactions undertaken. There are two primary theories about the motivations for corporate risk management - maximization of shareholder value and maximization of managerial utility. The authors discuss these theories, the hypotheses they develop from them , and specify variables to test their hypotheses. They posit the following rationales for why corporations may choose to engage in risk management and also specify variables that help them study the use of these rationales by insurance firms: to avoid the costs of financial distress; to hedge part of their investment default/volatility/liquidity risks; to avoid shocks to equity that result in high leverage ratios; to minimize taxes and enhance firm value by reducing the volatility of earnings; to maximize managerial utility. The authors argue that the use of derivatives for speculative purposes in the insurance industry is not common.

The authors analyze the decision by insurers to enter the market and their volume of transactions. They use probit analysis to study the participation decision and Tobit analysis along with Cragg's generalization of the Tobit analysis to study volume.

The results provide support for the authors' hypothesis that insurers hedge to maximize shareholder value. The analysis provides only weak support for the managerial utility hypothesis. Insurers are motivated to use financial derivatives to reduce the expected costs of financial distress. There is also evidence that insurers use derivatives to hedge asset volatility and exchange rate risks. There is also evidence that there are significant economies of scale in running derivatives operations - only large firms and/or those with higher than average risk exposure find it worthwhile to pay the fixed cost of setting up a derivatives operation. Overall, insurers with higher than average asset risk exposures use derivative securities.

Abstract:
This paper conducts an event study analysis of the impact of operational risk events on the market values of banks and insurance companies, using the OpVar database. We focus on financial institutions because of the increased market and regulatory scrutiny of operational losses in these industries. The analysis covers all publicly reported banking and insurance operational risk events affecting publicly traded U.S. institutions from 1978-2003 that caused operational losses of at least $10 million - a total of 403 bank events and 89 insurance company events. The results reveal a strong, statistically significant negative stock price reaction to announcements of operational loss events. On average, the market value response is larger for insurers than for banks. Moreover, the market value loss significantly exceeds the amount of the operational loss reported, implying that such losses convey adverse implications about future cash flows. Losses are proportionately larger for institutions with higher Tobin's Q ratios, implying that operational loss events are more costly in market value terms for firms with strong growth prospects.

Operational risk, event study, banking, insurance

Abstract:
This paper reviews the current status of the market for catastrophic risk (CAT) bonds and other risk-linked securities. CAT bonds and other risk-linked securities are innovative financial vehicles that have an important role to play in financing mega-catastrophes and other types of losses. The vehicles are especially important because they access capital markets directly, exponentially expanding risk-bearing capacity beyond the limited capital held by insurers and reinsurers. The CAT bond market has been growing steadily, with record amounts of risk capital raised in 2005, 2006, and 2007. CAT bond premia relative to expected losses covered by the bonds have declined by more than one-third since 2001. CAT bonds now appear to be priced competitively with conventional catastrophe reinsurance and comparably rated corporate bonds. CAT bonds have grown to the extent that they now play a major role in completing the market for catastrophic risk finance and are spreading to other lines such as automobile insurance, life insurance, and annuities. CAT bonds are not expected to replace reinsurance but to complement the reinsurance market by providing additional risk-bearing capacity. Other innovative financing mechanisms such as risk swaps, industry loss warranties, and sidecars also are expected to continue to play an important role in financing catastrophic risk.

securitization, catastrophic risk, CAT bonds, risk swaps, reinsurance

Abstract:
Deregulation of the European financial services market during the 1990s led to an unprecedented wave of mergers and acquisitions (M&As) in the insurance industry. From 1990-2002 there were 2,595 M&As involving European insurers of which 1,669 resulted in a change in control. This paper investigates whether M&As in the European insurance market create value for shareholders by studying the stock price impact of M&A transactions on target and acquiring firms. The analysis shows that European M&As created small negative cumulative average abnormal returns CAARs) for acquirers (generally less than 1%) and substantial positive CAARs for targets (in the range of 12% to 15%). Cross-border transactions were value-neutral for acquirers, whereas within-border transactions led to significant value loss (approximately 2%) for acquirers. For targets, both cross-border and within-border transactions led to substantial value-creation.

Insurance, European insurance industry, mergers, event study

Abstract:
This paper presents a theoretical and empirical analysis of the effects of no fault automobile insurance on fatal accident rates. As a mechanism for compensating the victims of automobile accidents, no fault has several important advantages over the tort system. However, by restricting access to tort, no fault may weaken incentives for careful driving, leading to higher accident rates. We conduct an empirical analysis of automobile accident fatality rates in all U.S. states over the period 1968-1994, controlling for the potential endogeneity of no fault laws. The results support the hypothesis that no fault is significantly associated with higher fatal accident rates than tort.

No fault, insurance, fatality rates

Abstract:
This article presents new evidence on the cost of equity capital by line of insurance for the property-liability insurance industry. To do so we obtain firm beta estimates and then use the full-information industry beta (FIB) methodology to decompose the cost of capital by line. We obtain full-information beta estimates using the standard one-factor capital asset pricing model and extend the FIB methodology to incorporate the Fama-French three-factor cost of capital model. The analysis suggests the cost of capital for insurers using the Fama-French model is significantly higher than the estimates based upon the CAPM. In addition, we find evidence of significant differences in the cost of equity capital across lines.

Abstract:
This paper presents new evidence on estimates of the cost of equity capital by line of insurance for the property-liability insurance industry. To do so we obtain firm beta estimates and then use the recently developed full-information industry beta methodology to decompose the cost of capital by line. We obtain beta estimates using both the standard one-factor CAPM model as well as the Fama-French three-factor cost of capital model. The analysis suggests the cost of capital for insurers using the Fama-French model are significantly higher than estimates based upon the CAPM. In addition, we find evidence of significant differences in the cost of equity capital across lines, indicating that the use of a single company-wide cost of capital is generally not appropriate.

Insurance, Cost of Equity Capital, Full-Information Beta

Abstract:
This paper analyzes the basis risk of catastrophic-loss (CAT) index derivatives, which securitize losses from catastrophic events such as hurricanes and earthquakes. We analyze the hedging effectiveness of these instruments for 255 insurers writing 93 percent of the insured residential property values in Florida, the state most severely affected by exposure to hurricanes. County-level losses are simulated for each insurer using a sophisticated model developed by Applied Insurance Research. We analyze basis risk by measuring the effectiveness of hedge portfolios, consisting of a short position each insurer's own catastrophic losses and a long position in CAT-index call spreads, in reducing insurer loss volatility, value-at-risk, and expected losses above specified thresholds. Two types of loss indices are used ? a statewide index based on insurance industry losses in Florida and four intra-state indices based on losses in four quadrants of the state. The principal finding is that firms in the three largest Florida market-share quartiles can hedge almost as effectively using the intra-state index contracts as they can using contracts that settle on their own losses. Hedging with the statewide contracts is effective only for insurers with the largest market shares and for smaller insurers that are highly diversified throughout the state. The results also support the agency-theoretic hypotheses that mutual insurers are more diversified than stocks and that unaffiliated single firms are more diversified than insurers that are members of groups.

Abstract:
We provide evidence on the validity of the conglomeration hypothesis versus the strategic focus hypothesis for financial institutions using data on U.S. insurance companies. We distinguish between the hypotheses using profit scope economies, which measures the relative efficiency of joint versus specialized production, taking both costs and revenues into account. The results suggest that the conglomeration hypothesis dominates for some types of financial service providers and the strategic focus hypothesis dominates for other types. This may explain the empirical puzzle of why joint producers and specialists both appear to be competitively viable in the long run.

Abstract:
One of the most significant economic developments of the past decade has been the convergence of the financial services industry, particularly the capital markets and (re)insurance sectors. Convergence has been driven by the increase in the frequency and severity of catastrophic risk, market inefficiencies created by (re)insurance underwriting cycles, advances in computing and communications technologies, the emergence of enterprise risk management, and other factors. These developments have led to the development of hybrid insurance/financial instruments that blend elements of financial contract with traditional reinsurance as well as new financial instruments patterned on asset backed securities, futures, and options that provide direct access to capital markets. This paper provides a survey and overview of the hybrid and pure financial markets instruments and provides new information on the pricing and returns on contracts such as industry loss warranties and CAT bonds.

CAT bonds, catastrophic risk, insurance-linked securities, industry loss warranties, CAT options

Abstract:
This paper provides new information on the effects of deregulation and consolidation in financial services markets by analyzing the Spanish insurance industry. The sample period 1989-1998 spans the introduction of the European Union?s Third Generation Insurance Directives, which deregulated the EU insurance market. Deregulation has led to dramatic changes in the Spanish insurance market; the number of firms declined by 35 percent and average firm size increased by 275 percent. We analyze the causes and effects of consolidation using modern frontier efficiency analysis to estimate cost, technical, and allocative efficiency, as well as using Malmquist analysis to measure total factor productivity change. The results show that many small, inefficient, and financially under-performing firms were eliminated from the market due to insolvency or liquidation and that acquirers in the mergers and acquisitions market prefer relatively efficient target firms. As a result, the market experienced significant growth in total factor productivity over the sample period. Consolidation reduced the number of firms operating with increasing returns to scale but also increased the number operating with decreasing returns to scale. Hence, many large firms should focus on improving efficiency rather than on further growth.

Abstract:
This paper analyzes the efficiency of stock and mutual organizational forms in the property-liability insurance industry using nonparametric frontier efficiency methods. We test the managerial discretion hypothesis, which predicts that the market will sort organizational forms into market segments where they have comparative advantages in minimizing the costs of production, including agency costs. Both production and cost frontiers are estimated. The results indicate that stocks and mutuals are operating on separate production and cost frontiers and thus represent distinct technologies. The stock technology dominates the mutual technology for producing stock output vectors and the mutual technology dominates the stock technology for producing mutual output vectors. However, the stock cost frontier dominates the mutual cost frontier for the majority of both stock and mutual firms. Thus, the mutuals' technological advantage is eroded because they are less successful than stocks in choosing cost minimizing combinations of inputs. The finding of separate frontiers and organization specific technological advantages is consistent with the managerial discretion hypothesis, but we also find evidence that stocks are more successful than mutuals in minimizing costs.

Abstract:
Risk management is now present in many economic sectors. This paper investigates the role of risk management in creating value for financial institutions by analyzing U.S. property-liability insurers. Property-liability insurers are financial intermediaries whose primary role in the economy is risk pooling and risk bearing. The risk pooling and risk bearing functions performed by insurers are the primary determinants of the need for risk management. The main goal of this paper is to test how risk management and financial intermediation activities create value for insurers by enhancing economic efficiency. Insurer cost efficiency is measured relative to an econometric cost frontier. Since the prices of risk management and financial intermediation services are not observable, we consider these two activities as intermediate outputs and estimate their shadow prices. The shadow prices isolate the contributions of risk management and financial intermediation to insurer cost efficiency. The econometric results show that both activities significantly increase the efficiency of the property-liability insurance industry.

Risk management, US property-liability insurer, risk pooling, financial intermediation, economic efficiency, intermediate output, shadow price, cost function, translog approximation

Abstract:
This paper examines the role of the federal government in the market for terrorism reinsurance. We investigate the stock price response of affected industries to a sequence of thirteen events culminating in the enactment of the Terrorism Risk Insurance Act (TRIA) of 2002. In the industries most likely to be affected by TRIA - banking, construction, insurance, real estate investment trusts, transportation, and public utilities - the stock price effect was primarily negative. The Act was at best value-neutral for property-casualty insurers because it eliminated the option not to offer terrorism insurance. The negative response of the other industries may be attributable to the Act's impeding more efficient private market solutions, failing to address nuclear, chemical, and biological hazards, and reducing market expectations of federal assistance following future terrorist attacks.

Abstract:
This paper examines the role of the federal government in the market for terrorism reinsurance. We investigate the stock price response of affected industries to a sequence of thirteen events culminating in the enactment of the Terrorism Risk Insurance Act (TRIA) of 2002. In the industries most likely to be affected by TRIA - banking, construction, insurance, real estate investment trusts, transportation, and public utilities - the stock price effect was primarily negative. The Act was at best value-neutral for property-casualty insurers because it eliminated the option not to offer terrorism insurance. The negative response of the other industries may be attributable to the Act's impeding more efficient private market solutions, failing to address nuclear, chemical, and biological hazards, and reducing market expectations of federal assistance following future terrorist attacks.

Terrorism, insurance, reinsurance, event study

Abstract:
This paper analyzes the productivity and efficiency effects of mergers and acquisitions (M&As) in the U.S. property-liability insurance industry during the period 1994-2003 using data envelopment analysis (DEA) and Malmquist productivity indices. We seek to determine whether M&As are value-enhancing, value-neutral, or value-reducing. The analysis examines efficiency and productivity change for acquirers, acquisition targets, and non-M&A firms. We also examine the firm characteristics associated with becoming an acquirer or target through probit analysis. The results provide evidence that M&As in property-liability insurance were value-enhancing. Acquiring firms achieved more revenue efficiency gains than non-acquiring firms, and target firms experienced greater cost and allocative efficiency growth than non-targets. Factors other than efficiency enhancement are important factors in property-liability insurer M&As. Financially vulnerable insurers are significantly more likely to become acquisition targets, consistent with corporate control theory, and we also find evidence that M&As are motivated to achieve diversification. However, there is no evidence that scale economies played an important role in the insurance M&A wave.

mergers, acquisitions, insurance, efficiency, data envelopment analysis, corporate control theory

Abstract:
U.S. insurers are heavily dependent on global reinsurance markets to enable them to provide adequate primary market insurance coverage. This paper reviews the response of the world's reinsurance industry to recent mega-catastrophes and provides recommendations for regulatory reforms that would improve the efficiency of reinsurance markets. The paper also considers the supply of insurance and reinsurance for terrorism and makes recommendations for joint public-private responses to insuring terrorism losses. The analysis shows that reinsurance markets responded efficiently to recent catastrophe losses and that substantial amounts of new capital enter the reinsurance industry very quickly following major catastrophic events. Considerable progress has been made in improving risk and exposure management, capital allocation, and rate of return targeting. Insurance price regulation for catastrophe-prone lines of business is a major source of inefficiency in insurance and reinsurance markets. Deregulation of insurance prices would improve the efficiency of insurance markets, enabling markets to deal more effectively with mega-catastrophes. The current inadequacy of the private terrorism reinsurance market suggests that the federal government may need to remain involved in this market, at least for the next several years.

reinsurance, catastrophic risk, cat bonds, terrorism, insurance regulation

Abstract:
Corporate finance theory predicts that firms' characteristics affect agency costs and hence their efficiency. Cummins et al (2006) have proposed a cost function specification that measures separately insurer efficiency in handling risk pooling, risk management, and financial intermediation functions. We investigate the insurer characteristics that determine these efficiencies. Our empirical results show that mutuals outperform stock insurers in handling the three functions. Independent agents and high capitalization reduce the cost efficiency of risk pooling. Certain characteristics such as being a group of affiliated insurers, handling a higher volume of business in commercial lines, assuming more reinsurance, or investing a higher proportion of assets in bonds, do significantly increase insurers' efficiency in risk management and financial intermediation.

Risk pooling, risk management, financial intermediation, property-liability insurance, efficiency, agency costs.

Abstract:
Purchasing reinsurance reduces insurers insolvency risk by stabilizing loss experience, increasing capacity, limiting liability on specific risks, and/or protecting against catastrophes. Consequently, reinsurance purchase should reduce capital costs. However, transferring risk to reinsurers is expensive. The cost of reinsurance for an insurer can be much larger than the actuarial price of the risk transferred. In this article, we analyze empirically the costs and the benefits of reinsurance for a sample of U.S. property-liability insurers. The results show that reinsurance purchase increases significantly the insurers costs but reduces significantly the volatility of the loss ratio. With purchasing reinsurance, insurers accept to pay higher costs of insurance production to reduce their underwriting risk.

Reinsurance, insolvency risk, risk management, financial intermediation, cost functions, panel data

Abstract:
Although an extensive literature has developed on modeling the loss reserve runoff triangle, the estimation of severity distributions applicable to claims settled in specific cells of the runoff triangle has received little attention in the literature. This paper proposes the use of a very flexible probability density function, the generalized beta of the 2nd kind (GB2) to model severity distributions in the cells of the runoff triangle and illustrates the use of the GB2 based on a sample of nearly 500,000 products liability paid claims. The results show that the GB2 provides a significantly better fit to the severity data than conventional distributions such as the Weibull, Burr 12, and generalized gamma and that modeling severity by cell is important to avoid errors in estimating the riskiness of liability claims payments, especially at the longer lags.

Loss distributions, loss reserves, generalized beta distribution, liability insurance

Abstract:
Under perfect market conditions, standard capital budgeting theory predicts that the discount rates on projects should reflect only non-diversifiable risk and be constant across firms. However, theoretical research by Froot and Stein (1998), among others, suggests that when firms invest in non-hedgeable assets under conditions where capital is costly, project pricing should reflect the covariability of the project with the firm's existing portfolio, even if this covariability represents non-systematic risk. They argue that their theory is especially applicable to financial institutions pricing intermediated risks. Theoretical research also suggests that the prices of intermediated risks will reflect the capital strain that such risks place on the intermediary and hence reflect implicit allocations of capital to the intermediary's business lines (Myers and Read 2001, Zanjani 2002). We test these theoretical predictions by analyzing the prices of insurance risks for U.S. property-liability insurers over the period 1997-2004. Specifically, we regress insurance price variables on capital allocations by line, measures of insurer insolvency risk, and other risk and control variables. The results provide strong support for theoretical predictions that prices of intermediated risks vary across firms to reflect insolvency risk, marginal capital allocations, and non-systematic covariability.

Capital allocation, Insurance, Prices

Abstract:
This paper presents an event study analysis of the market value impact of operational risk events on non-announcing firms in the U.S. banking and insurance industries. We seek evidence of positive or negative intra or inter-sector spillover effects on stock prices in the commercial banking, investment banking, and insurance industries. The rationale for anticipating inter-sector spillovers is the integration of the previously fragmented markets for financial services that has occurred over the past twenty-five years. We find that operational risk events cause significant negative intra and inter-sector spillover effects. Regression analysis reveals that the spillovers are information-based rather than purely contagious.

operational risk, banks, insurance, event study, contagion, spillovers

Abstract:
This paper studies the usage of two common hedging tools, reinsurance and derivatives, by property and casualty insurance companies. In a simple mean-variance efficient optimization model, the two hedging tools display substitutive effect when asset and liability do not display strong natural hedging. I verify this relationship using a six-year insurance company firm-level data on reinsurance usage and off-balance sheet derivative trading recorded between 2000 and 2005. Controlling for firm specific variables, such as size, return and credit rating, such substitution effect indeed exists in the insurance companies' hedging decisions under a two-stage simultaneous equation framework.

Hedging, Derivatives, Insurance, Reinsurance

Abstract:
This paper presents a theoretical and empirical analysis of the effects of no-fault automobile insurance on accident rates. As a mechanism for compensating the victims of automobile accidents, no-fault has several important advantages over the tort system. However, by restricting access to tort, no-fault may weaken incentives for careful driving, leading to higher accident rates. We conduct an empirical analysis of automobile accident fatality rates in all U.S. states over the period 1982-1994, controlling for the potential endogeneity of no-fault laws. The results support the hypothesis that no-fault is significantly associated with higher fatal accident rates than tort.

Abstract:
Minimum interest rate guarantees are included in life insurance products in most countries, but the exact implementations of the guarantees vary significantly across countries. In this paper we develop models of interest rate guarantees in Denmark, Germany, Norway, the U.K., and the U.S. by constructing contracts designed to capture practices in each country. The European contracts include rather sophisticated investment surplus distribution mechanisms, whereas the U.S. contracts are simpler and do not involve an explicit bonus account. The models are compared empirically using simulation analysis. For low volatilities, the payoffs from the Danish, German and U.K. contracts are surprisingly similar to the payoff from the market index. However, for higher levels of volatility the contracts noticeably truncate the lower tail of the index return distribution. The U.S. and Norwegian contracts offer the lowest risk of all contracts but also have the lowest expected returns. Thus, investors in life insurance products encounter significantly different risk-return profiles depending on country of origin.

life insurance, interest rate guarantees, universal life, bonus account, Sharpe ratios

Abstract:
The paper examines efficiency, productivity and scale economies in the U.S. property-liability insurance industry over the period 1993-2006. Productivity change is analyzed using Malmquist indices, and efficiency is estimated using data envelopment analysis (DEA). The results indicate that the majority of firms below median size in the industry are operating with increasing returns to scale, and the majority of firms above median size are operating with decreasing returns to scale. However, a significant number of firms in each size decile have achieved constant returns to scale. Over the sample period, the industry experienced significant gains in total factor productivity, and there is an upward trend in scale and allocative efficiency. However, cost efficiency and revenue efficiency did not improve significantly over the sample period. Regression analysis shows that efficiency and productivity gains have been distributed unevenly across the industry. More diversified firms, stock insurers, and insurance groups were more likely to achieve efficiency and productivity gains than less diversified firms, mutuals, and unaffiliated single insurers. Higher technology expenditures increase the probability of achieving optimal scale for direct writing insurers but not for independent agency firms.

Efficiency, Productivity, Scale Economies, Property-Liability Insurance, DEA, Malmquist indices

Abstract:
This paper examines the relationship between firm efficiency and stock market reaction to acquisitions and divestitures in the US property-liability insurance industry during the period 1997-2003. We use data envelopment analysis (DEA) to estimate firm cost and revenue efficiency. Abnormal returns are measured using the standard market model event study methodology. We then conduct multiple regression analysis with cumulative abnormal returns as dependent variables and efficiency and control variables as regressors. The results show that efficient acquirers and targets have higher cumulative abnormal returns but inefficient divesting firms have higher cumulative abnormal returns. The findings are consistent with insurance acquisitions and divestitures being driven primarily by value-maximizing motivations and also show that frontier efficiency provides relevant information for value-maximizing managers.

Insurance, data envelopment analysis, acquisitions, divestitures, event study

Abstract:
The objective of this paper is to estimate the expected annual costs to taxpayers of federal disaster-related expenditures to provide guidance to federal policymakers in budgeting and formulating disaster relief policy. Our estimates take into account recent trends in the generosity of federal disaster policy as well as statistical data on the frequency and severity of losses from natural catastrophes. Our estimates of the costs of disasters are based on two sources: (1) simulation analysis by Applied Insurance Research, a leading catastrophe modeling firm, and (2) historical data on insured catastrophe losses from Property Claims Services, an insurance industry statistical firm. We estimate the average expected federal expenditures for disaster assistance related to hurricanes, earthquakes, thunderstorms, and winter storms to be about $20 billion a year. In a bad year, corresponding to a catastrophic event of severity expected only once every century, the bill could exceed $100 billion. Given the current approach to disaster relief funding, we project an unfunded liability for disaster assistance over the next 75 years comparable to that of Social Security. The magnitude of the projected liability strongly suggests that government should adopt a proactive, ex ante approach to disaster relief policy rather than the current ad hoc reactive approach.

catastrophes, disaster relief, federal budget, loss distributions

Abstract:
The demand for insurance is examined when the indemnity schedule is subject to an upper limit. The optimal contract is shown to display full insurance above a deductible up to the cap. Some results derived in the standard model with no upper limit on coverage turn out to be invalid; the optimal deductible of an actuarially fair policy is positive and insurance may be a normal good under decreasing absolute risk aversion. An increase in the upper limit would induce the policyholder with constant absolute risk aversion to reduce his or her optimal deductible and therefore this would increase the demand for insurance against small losses.

Abstract:
This article analyzes the economic functions of independent insurance intermediaries (brokers and independent agents), focusing on the commercial propertycasualty insurance market. The article investigates the functions performed by intermediaries, the competitiveness of the market, the compensation arrangements for intermediaries, and the process by which policies are placed with insurers. Insurance intermediaries are essentially market makers who match the insurance needs of policyholders with insurers who have the capability of meeting those needs. Intermediary compensation comprises premium-based commissions, expressed as a percentage of the premium paid, and contingent commissions based on the profitability, persistency, and/or volume of the business placed with the insurer. Empirical evidence is provided that premium-based and contingent commissions are passed on to policyholders in the premium. However, contingent commissions can enhance competitive bidding by aligning the insurer's and the intermediary's interests. This alignment of interests gives insurers more confidence in the selection of risks and thus helps to break the "winner's curse" and encourages insurers to bid more aggressively. Independent intermediaries also help markets operate more efficiently by reducing the information asymmetries between insurers and buyers that can cause adverse selection.

Abstract:
Capitalization levels in the property-liability insurance industry have increased dramatically in recent years - the capital-to-assets ratio rose from 25% in 1989 to 35% by 1999. This paper investigates the use of capital by insurers to provide evidence on whether the capital increase represents a legitimate response to changing market conditions or a true inefficiency that leads to performance penalties for insurers. We estimate "best practice" technical, cost, and revenue frontiers for a sample of insurers over the period 1993-1998, using data envelopment analysis, a non-parametric technique. The results indicate that most insurers significantly over-utilized equity capital during the sample period. Regression analysis provides evidence that capital over-utilization primarily represents an inefficiency for which insurers incur significant revenue penalties.

Data envelopment analysis, capital structure, efficiency, property-liability insurance, organizational form

Abstract:
The 1990s witnessed an unprecedented decline in leverage ratios in the United States property-liability insurance industry. The premiums-to-surplus ratio, the most commonly used leverage ratio in the industry, fell from its historical average of 2.0 to less than 1.0 by the end of 2000; and the industry-wide capital-to-asset ratio increased from an historical average of about 25% to 35%. The international reinsurance industry also experienced significant capital increases and leverage declines during the 1990s (Cummins and Weiss, 2000) These unusual trends raised widespread concerns that the property-liability insurance industry had become over-capitalized (The Economist, 1999; Bowers, 2001; Seifert, 2001). To investigate the growth in capitalization and its potential causes, the Conference on Capitalization in the Property-Liability Insurance Industry was held at the Wharton School in September 2000 under the joint sponsorship of the Wharton Financial Institutions Center and AON. Selected papers from the conference comprise this issue of the Journal of Financial Services Research (JFSR).

Capital structure, property-liability insurance, organizational form, insolvency risk, financial ratings, efficiency

Abstract:
The insurance futures contracts introduced in December 1992 by the Chicago Board of Trade offer insurers an alternative to reinsurance as a hedging device for underwriting risk. These instruments have the usual features of liquidity, anonymity and low transactions costs that characterize futures contracts. This paper addresses the issue of pricing insurance futures contracts in an arbitrage-free framework as the expectation under the risk-neutral probability measure of the terminal cash flow provided, for instance, by a long position in a futures contract. Since by definition of the contract the terminal cash flow is related to the aggregate claims incurred during a calendar quarter, the valuation problem is of the same type as the one that arises in the pricing of zero-exercise price Asian options. We propose a solution to this problem using the exact approach developed by Geman and Yor (1992, 1993).

Abstract:
This paper develops a pricing methodology and pricing estimates for the proposed Federal excess-of- loss (XOL) catastrophe reinsurance contracts. The contracts, proposed by the Clinton Administration, would provide per-occurrence excess-of-loss reinsurance coverage to private insurers and reinsurers, where both the coverage layer and the fixed payout of the contract are based on insurance industry losses, not company losses. In financial terms, the Federal government would be selling earthquake and hurricane catastrophe call options to the insurance industry to cover catastrophic losses in a loss layer above that currently available in the private reinsurance market. The contracts would be sold annually at auction, with a reservation price designed to avoid a government subsidy and ensure that the program would be self supporting in expected value. If a loss were to occur that resulted in payouts in excess of the premiums collected under the policies, the Federal government would use its ability to borrow at the risk-free rate to fund the losses. During periods when the accumulated premiums paid into the program exceed the losses paid, the buyers of the contracts implicitly would be lending money to the Treasury, reducing the costs of government debt. The expected interest on these "loans" offsets the expected financing (borrowing) costs of the program as long as the contracts are priced appropriately. By accessing the Federal government's superior ability to diversify risk inter-temporally, the contracts could be sold at a rate lower than would be required in conventional reinsurance markets, which would potentially require a high cost of capital due to the possibility that a major catastrophe could bankrupt some reinsurers. By pricing the contacts at least to break even, the program would provide for eventual private-market "crowding out" through catastrophe derivatives and other innovative catastrophic risk financing mechanisms.

We develop prices for the contracts using two samples of catastrophe losses: (1) historical catastrophic loss experience over the period 1949-1994 as reported by Property Claim Services; and (2) simulated catastrophe losses based on an engineering simulation analysis conducted by Risk Management Solutions. We used maximum likelihood estimation techniques to fit frequency and severity probability distributions to the catastrophic loss data, and then used the distributions to estimate expected losses under the contracts. The reservation price would be determined by adding an administrative expense charge and a risk premium to the expected losses for the specified layer of coverage. We estimate the expected loss component of the government's reservation price for proposed XOL contracts covering the entire U.S., California, Florida, and the Southeast. We used a loss layer of $25-50 billion for illustrative purposes.

Abstract:
This paper examines the relationship between mergers and acquisitions, efficiency, and scale economies in the U.S. life insurance industry. We estimate cost and revenue efficiency for life insurers representing 80 percent of industry assets over the period 1988-1995 using data envelopment analysis (DEA) and decompose cost efficiency into pure technical, scale, and allocative efficiency. The Malmquist index methodology is used to measure changes in efficiency and productivity over time. The results support the hypothesis that acquired firms achieve greater efficiency gains than firms that have not engaged in merger or acquisition activity. We also find evidence that firms operating with non-decreasing returns to scale are more likely to be acquisition targets than firms operating with decreasing returns to scale. Firms with higher revenue efficiency are more likely to be acquired than firms with lower revenue efficiency, but we find no relationship between other types of efficiency and the probability that a firm is acquired. Financially vulnerable firms are more likely to be acquired than stronger firms. The overall conclusion is that mergers and acquisitions in the life insurance industry appear to be driven for the most part by economically sound objectives and have had a beneficial effect on efficiency in the industry.

Abstract:
This paper develops a financial pricing model to determine prices by line of business in a multiple line insurer subject to default risk. The model implies that it is not appropriate to allocate equity capital by line; rather, the price in a given line depends upon the overall default risk of the firm. Thus, prices should not vary by line within a given insurer after controlling for line-specific liability growth rates. This result is modified somewhat for groups of insurers under common ownership. Corporation law gives the owners of the group the option to allow individual subsidiaries to fail, and claimants against the subsidiary cannot reach the assets of other group members unless they succeed in "piercing the corporate veil." Thus, insurers that concentrate their business in one or a few corporate entities are predicted to command higher prices than otherwise similar insurers where business is widely dispersed among group members. Empirical tests based on publicly traded property-liability insurers support the hypotheses: prices vary across firms depending upon overall-firm default risk and the concentration of business among subsidiaries; but within a given firm, prices do not vary by line after adjusting for line-specific liability growth rates.

Abstract:
Property-liability insurance is distributed by independent agents, who represent several insurers, and exclusive agents, who represent only one insurer. The independent agency system is known to have higher costs than the exclusive agency system. The market imperfections hypothesis attributes the coexistence of the two systems to impediments to competition, while the product quality hypothesis holds that independent agents provide higher quality services. We measure both profit efficiency and cost efficiency for a sample of property-liability insurers and find strong support for the product quality hypothesis. The data are consistent with a higher quality of output for independent agency insurers that is rewarded with additional revenues.

Abstract:
This paper presents a comparative analysis of frontier cost efficiency methodologies by applying a wide range of econometric and mathematical programming techniques to a data set consisting of 445 life insurers over the period 1988-1992. The primary objective is to provide new information on the effects of choice of methodology on efficiency estimates. We also investigate some classic industrial organization issues in the life insurance industry. The alternative methodologies give significantly different estimates of efficiency for the insurers in our sample. The efficiency rankings are quite well-preserved among the econometric methodologies, but the rank correlations are lower between the econometric and mathematical programming categories and between alternative mathematical programming methodologies. Thus, the choice of methodology can have a significant effect on the results. Most of the insurers in the sample display either increasing or decreasing returns to scale, and stock and mutual insurers are found to be equally efficient after controlling for firm size.

Abstract:
In this paper we investigate the extent to which insurance companies utilize financial derivatives contracts in the management of risks. The data set we employ allows us to observe the universe of individual insurer transactions for a class of contracts, namely, those normally thought of as off-balance-sheet (OBS). We provide information on the number of insurers using various types of derivatives contracts and the volume of transactions in terms of notional amounts and the number of counterparties. Life insurers are most active in interest rate and foreign exchange derivatives, while property-casualty insurers tend to be active in trading equity option and foreign exchange contracts. Using a multivariate probit analysis, we explore the factors that potentially influence the existence of OBS activities. We also investigate questions relating to whether certain subsets of OBS transactions (e.g., exchange traded) are related to such things as interest rate risk measures, organizational form, and other characteristics that may discriminate between desired risk/return profiles across a cross-section of insurers. We find evidence consistent with the use of derivatives by insurers to hedge risks posed by guaranteed investment contracts (GICs), collateralized mortgage obligations (CMOs), and other sources of financial risk.