The Cost of Capital of Insurance Companies

Abstract

The concept of the cost of capital, which is simply a weighted average of the opportunity cost of the debt and equity components of a firm's capital structure, has proved useful for industrial firms. This article shows that the accounting data contained in an insurance company balance sheet can be construed in a conventional cost of capital framework. The funds which are generated through the medium of the insurance operation such as the loss reserve and the unearned premium reserve in a propertyliability insurance company are considered as quasi-debt. The loss on operations is one portion of their imputed cost. The constraints which state insurance regulations place upon the portfolio of an insurer represent another element of imputed cost. While estimation of the cost of equity capital of an insurance enterprise differs little from its industrial counterpart, the imputed cost of quasi-debt is difficult to quantify. The possibilities for the application of cost of capital analysis in the insurance environment are manifold. To a financial analyst, the balance sheet and income statement of a company represent the raw material of his trade. The accounting data contained in these statements provide only a rough approximation of the financial condition of the company. When, however, the financial analyst takes these figures and rearranges them in order that he may perform ratio analysis of the various components of the balance sheet and income statement, a much finer grained and detailed picture of the company emerges. If the company under analysis is an industrial one, the characteristics of the firm's capital structure are considered to be of great importance. The ratios of debt to equity and debt to total assets are primary measures of financial stability. J. J. Launie, Ph.D., is Associate Professor of Finance in San Fernando Valley State College. He was a consultant to the 1968 California Commission on Tax Reform and at the time this paper was written, Dr. Launie was President of the Western Association of Insurance Professors. This paper was presented at the 1970 Annual Meeting of A-BR-TA. The fundamental capital structural components of an industrial firm are debt, preferred stock and common stock or equity. The cost of capital of an industrial firm is simply a weighted average of the opportunity cost of the individual capital structure components. Since in an industrial company the cost of debt and preferred stock are quite explicit, the cost measurement of these components of the capital structure is relatively simple. The opportunity cost of equity is much more difficult to determine. The rate of return which the stockholders require is usually estimated through the capitalization of dividends and earnings growth. There are many formidable statistical problems encountered in this estimation process.' However, in the case of the industrial company the delineation of the capital structure into its various components is clear and the estimation prob'For one approach to estimation see M. J. Gordon, The Investment, Financing and Valuation of the Corporation, Homewood, Illinois: Irwin 1962.