The Relation between Capital Structure, Interest Rate Sensitivity, and Market Value in the Property-Liability Insurance Industry: Comment

Abstract

pirically examine the relationship between interest rate risk and market value for firms operating in the insurance industry. Intuitively, firms with greater interest rate risk are expected to have lower market values when compared to firms with less risk exposure. And Staking and Babbel find that the expected relationship holds over low levels of risk. However, at higher levels of exposure, they find a positive relationship between interest rate risk and market value (as measured by Tobin's q). According to the authors, the direct relationship is a consequence of the ability of the firm to increase variability in asset value without fully suffering the consequence of reduced insurance premiums. Increased interest rate risk may increase shareholder value as long as the greater risk is not accurately priced in insurance contracts. Inaccurate pricing can be the result of poor information held by policyholders that might exist for a variety of reasons, including the presence of guarantee funds that make policyholders less interested in the financial condition of the primary insurer (assuming that the guarantee fund charges premiums that are not risk based). This comment offers an additional explanation for the observed relationship between interest rate risk and market value. The authors' explanation may be part of the story, and is not quarreled with here. Rather, the purpose of this comment is to clarify the definition of interest rate risk and present another factor that is contributing to Staking and Babbel's findings.