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Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry

Forthcoming

49 Pages Posted: 27 May 1998 Last revised: 5 Aug 2014

J David Cummins

Temple University - Risk Management & Insurance & Actuarial Science

Richard D. Phillips

Georgia State University - Risk Management & Insurance Department

Stephen D. Smith

(Deceased)

Multiple version iconThere are 2 versions of this paper

Date Written: August 1, 2000

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.

Keywords: Derivatives, Risk Management, Insurance Companies

JEL Classification: G2, G3, L2

Suggested Citation

Cummins, J David and Phillips, Richard D. and Smith, Stephen D., Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry (August 1, 2000). Forthcoming. Available at SSRN: https://ssrn.com/abstract=92731 or http://dx.doi.org/10.2139/ssrn.92731

J. David Cummins

Temple University - Risk Management & Insurance & Actuarial Science ( email )

Fox School of Business and Management
1801 Liacouras Walk.
Philadelphia, PA 19122
United States
215-204-8468 (Phone)
215-204-4712 (Fax)

Richard D. Phillips

Georgia State University - Risk Management & Insurance Department ( email )

P.O. Box 4036
Atlanta, GA 30303
United States
404-413-7009 (Phone)

HOME PAGE: http://robinson.gsu.edu/profile/richard-d-phillips/

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