Capital structure and the cost of equity capital in the property-liability insurance industry

Abstract

Financial pricing models are now widely used in insurance pricing and price regulation. However, most practical applications of these models have not taken into account either the effects of firm capital structure or the differences in financial risk across lines of insurance. The objective of this paper is to provide a first step towards remedying these deficiencies by providing theoretical and empirical evidence on the effects of capital structure and line of business risk on the cost of equity capital in property-liability insurance. A theoretical model is developed that expresses the cost of capital as a function of both insurance leverage (the ratio of policy reserves to assets) and financial leverage (the ratio of financial debt to assets). The model is tested using data on traded stock property-liability insurers over the period 1980–1989. The results indicate that the cost of equity capital is sensitive to both insurance and financial leverage and that the cost of equity is higher for firms writing long-tail commercial lines such as general liability and workers' compensation. Thus, both leverage and line of business specialization should be taken into account in using the cost of equity capital in pricing property-liability insurance.