Regulated Firms under Uncertain Price Change: The Case of Property and Liability Insurance Companies. Author's Reply

Abstract

Irrespective of their nature, the author is always pleased to receive Comments. It means that someone has looked at the paper. Mr. D'Arcy raises four issues. He questions (1) the accuracy of book values as a measure of net asset value and (2) aspects of the underlying model. He suggests that alternative hypotheses to that presented in the paper may be equally or more plausible. He also notes typographical errors and the redundant use of T in the equations. Each of these items is discussed below. Mr. D'Arcy correctly states that the accuracy of book value depends among other things upon the validity of the unearned premium and loss reserves. He cites references which the author also examined but was hesitant to use, and which, based upon their publication dates, were seemingly as pertinent for 1966 as for 1976. In the final analysis, it appears that Mr. D'Arcy had the same problem as the author; he was forced to pick a specific figure (namely, 10%) that is arbitrary by its very nature. Mr. D'Arcy wonders why the author failed to look at book value per share for the stock market in general and for the insurance industry as a whole. The case against using book value for the market in general is well known and lies in the nonfinancial character of the assets held. The argument against looking at book value for the insurance industry as a whole lies in the paper's concern with the relation between stock value and book value. Mr. D'Arcy seems to have misinterpreted Equation (lb.). The hypothesis was that, in a competitive environment in which the assets held are essentially financial assets with market values in their own right, book value (BO) and longer-run market value (MT Eo) should be closely related. The process of adequate testing requires that there coexist both competition and meaningful book value in the same industry; such industries are difficult to find. Alternative hypotheses to that set forth by the author are indeed welcome. The author was aware that new firms can enter the insurance business and looked for a somewhat broader explanation that had to do with anti-trust exemption. The author is unimpressed by the growth industry argument advanced by Mr. D'Arcy, since it implies the presence of market imperfections. Finally, the author accepts the blame for typographical errors and laments the fact that they do occasionally get into print. The notation problem is also the responsibility of the author. The Symbol T is used correctly in referring to the number of years of above average growth and to the multiplier (MT) at the end of that period; it should not have been used for the corporate tax rate as well.