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

Abstract

The choice of financial structure is appropriately viewed as a complex, multidimensional decision by insurer management. Specific attention is given to traditional theories regarding capital structure, including the tradeoff between the tax benefits and increasing probability of incurring the cost of financial distress associated with leverage, and the tradeoff between protecting franchise or charter value and expropriating value through increasing exposure to interest rate risk. Within this framework, the relation between leverage, interest rate sensitivity and firm value is investigated in the property-liability insurance industry. Equity value, as gauged by Tobin's q, is determined to be related to an insurer's choice of financial structure. It is shown that the market value of equity at first grows but then later declines as leverage increases. Interest rate risk has the opposite effect. Equity value first declines with interest rate risk, but then rises at high levels of interest rate risk. These results are consistent with the prediction that financial institutions will expend scarce resources to control risk in order to protect franchise value and may indeed be signaling the existence of these valuable intangibles via these actions.