Rebalancing Target Capital in the Financial Sector: The Case of Life Insurance

Abstract

Capital structure studies have been occupied for several years with the questions of whether firms have targets for their capital structure and whether they rebalance actual capital structure towards those targets. Such studies routinely exclude the financial sector from their purview. In this article, we extend the scope of these studies by analyzing the capital structure targeting practices of a large financial subsector, the U.S. life insurance industry. We find that life insurers have targets and close the gap between actual and targeted values within a single year. This is the fastest reversion rate known to us in the literature. In obtaining these results, we adopt the common practice of estimating targets from regression-type models. However, we adopt an innovative nonlinear simultaneous equation model (SSEM), based upon a semiparametric Bayesian methodology, to provide those targets. We argue that the special circumstances of life insurers suggest that they simultaneously target both capital and asset risk. In addition to estimating targets, SSEM also provides insights into theories of life insurer behavior and provides bench-marking tools for managers. In particular, our analysis suggests that hypotheses that insurers act to limit risk or use excessive risk are both right - but for different insurers, depending upon insurer location on the risk curve. Such insights would be obscured by linear models.