The Time-Variation of Risk Premiums on Insurer Stocks

Abstract

Introduction This article studies the economic determinants of risk premiums on insurer stocks. Using a life insurance stock index, a property-liability insurance stock index, and some financial and real estate variables, we address the following question: How do changing economic conditions affect the risk premiums on insurance stocks? It is important for insurers to understand the determinants of equity risk premiums since risk premiums affect not only their investment decisions but also their financing decisions. As is well known in the corporate finance literature, the weighted average cost of capital is a weighted average of the cost of debt and the cost of equity. The higher the equity risk premium, the higher the required rate of return on equity; thus, the higher the weighted average cost of capital. Higher equity risk premiums should lead to reductions in the promised minimum rates of return paid to some universal/variable policyholders since certain profit levels must be maintained in order to ensure risk-adjusted returns to shareholders. The variation of risk premiums is also of interest to regulators because it contains information about market perceptions of insurer risk and cost of capital. Thus, in states where policy premiums are regulated, regulators should allow for higher policy premium increases if there is substantial increase in the equity risk premium. Our study finds substantial variation in risk premiums on insurance stocks that is predictably based on a small set of economic variables. We also find that the risk premiums (expected excess returns) on insurer stocks and equity real estate investment trusts (REITs) have behaved in similar fashion. Preliminary evidence indicates that insurers have been perceived by the market to have increased their real estate risk exposure in the 1980s due to a turbulent real estate market, despite the fact that their actual holdings, as a percentage of assets, remained relatively unchanged during the period. We also find that the time variation in risk premiums could be explained by the changing price of risk of one or two systematic factors. This study employs a multifactor latent-variable model widely used in the finance literature to study the risk premium of market indices. The risk premium of insurance stocks has not been examined using this method. This methodology, which is designed to capture the movement in expected excess returns due to a changing economic environment, is appropriate for our purpose because it allows for time-varying risk premiums. Specifically, it provides a concise framework to study the co-movement of insurance stocks and real estate market returns. The next two sections outline the asset pricing framework and estimation procedure. They are followed by a description of our data set and an empirical study of the time variation in risk premiums on insurance stocks. A final section summarizes the results. The Asset Pricing Framework Using the multifactor latent-variable model of Campbell (1987), Campbell and Hamao (1992), and Ferson (1989), we begin by assuming that asset returns are generated by the following K-factor model: |Mathematical Expression Omitted~ where |Mathematical Expression Omitted~ is the return on asset i held from time t to time t+1, in excess of the Treasury bill rate. |Mathematical Expression Omitted~ is the expected excess return on asset i, conditional on information known to investors at the end of time period t. The unexpected return on asset i equals the sum of K factor realizations |Mathematical Expression Omitted~ times their betas or factor loadings ||Beta~.sub.ik~, plus an idiosyncratic error |Mathematical Expression Omitted~. We assume that |Mathematical Expression Omitted~, and |Mathematical Expression Omitted~. Here, the conditional expected excess return, |Mathematical Expression Omitted~, is allowed to vary over time according to investors' conditional information set at time t. …