Equity Capital, Internal Capital Markets, and Optimal Capital Structure in the U.S. Property-Casualty Insurance Industry

Abstract

This paper reviews the most pertinent literature on the sources and uses of equity capital in the U.S. property-casualty (P-C) insurance industry. P-C insurers serve a risk management and risk bearing function in the economy. Insurers create diversified risk pools consisting of large numbers of exposures. However, even in the most highly diversified risk pools, uncertainty is not reduced to zero; and insurers must hold equity capital to credibly promise that claims will be paid even if losses are higher than expected. We begin with a financial overview of the industry. Insurers are shown to be well capitalized and financially stable, withstanding large catastrophic events and economic crises. Next, an analysis of capital regulation shows that regulation is not binding for the vast majority of insurers. We then review the theoretical and empirical evidence on the most important economic phenomena impinging on capital in P-C insurance: underwriting cycles, internal capital markets (ICMs), and optimal capital structure. P-C insurers are shown to be heavy users of ICMs, and insurer ICM transactions are shown to be efficient. The available evidence supports the view that P-C insurers have optimal capital structures and behave according to the tradeoff theory of capital structure.