The Cost of Capital of Insurance Companies: Comments Author(s): J. David Cummins and David J.

Nye Source: The Journal of Risk and Insurance, Vol. 39, No. 3 (Sep., 1972), pp. 487-491 Published by: American Risk and Insurance Association Stable URL: http://www.jstor.org/stable/251845 . Accessed: 04/12/2013 02:25
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THE COST OF CAPITAL OF INSURANCE COMPANIES: COMMENTS

J. DAVID
CUMMINS AND DAVID J. NYE *

In the June, 1971 issue of this Journwl, t (L + KDt =(1 -T) Professor J. J. Launie published an article (RUt -RCt). (1) concerning the application of the cost of capital concept to insurance companies.' where: Such a topic is clearly a legitimate area KDt = the rate of cost of quasi-debt of investigation and one which is potenduring period t. tially quite rewarding. However, Launie's = the loss on insurance operaOLt article falls short of an adequate prelimitions during period t. nary treatment of the topic and thus leaves LRt = the loss reserve at the end of much of this potential undeveloped. The period t. authors contend that his article is inadeUPRt = the unearned premium reserve quate in two major respects: (1) The at the end of period t. analogy between financial intermediaries the rate of return obtainable RUt upon the investment portfolio and industrial firms is not complete, i.e., during period t if investments the cost of capital concept must be modiare unconstrained by regulacharacterthe of fied to account for some tion. istics of intermediaries, particularly the rate of return obtainable RCt -the interaction between assets and liabilities; upon the investment portfolio and (2) Even if one accepts the interduring period t if investments mediary-industrial firm analogy, the arare constrained by regulation. ticle leaves too many questions unanT = the marginal tax rate on corswered to constitute a successful seminal porate income. treatment of the topic. The remainder of this paper discusses these deficiencies and Launie's discussion is not completely clear regarding whether or not investment inoffers some remedial suggestions. come should be included in computing One example of the errors in Launie's the "loss on operations." Since the use of cost of capital construct is his suggested underwriting gains or losses seems to be procedure for computing the cost of quasi- more in accord with the concept of the debt. For a property-liability company, cost of quasi-debt, that figure alone has he proposes the use of the statistic defined been used here. by (1) to measure this rate. This paper contends that the statistic * J. David Cummins is a Lecturer in Insurin (1) is at best a "quasi-cost" and is not ance, Wharton School of Finance and Commerce, generally useful within an economic deUniversity of Pennsylvania. cision-making context. David J. Nye is an Assistant Professor of Insurance, University of Florida. First, KDt is subject to error if there I J. J. Launie, "The Cost of Capital of Insurare errors in management's estimate of ance Companies," The Journal of Risk and Insurance, Vol. XXXVIII, No. 2 (June, 1971), pp. loss reserves. That such errors arise (either accidentally or otherwise) and are signifi263-68.
( 487 )

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488

The Journal of Risk and Insurance

cant is well documented.2 Professor Forbes found that 29 percent of his sample of incurred loss development ratios were less than 1.0, and 71 percent were greater or equal to 1.0.3 Where the ratio is greater than one, i.e., loss reserves exceed actual losses, underwriting profit (loss) is underestimated (overestimated), and KD, is above its true value. If loss reserve estimates are correct, the incurred loss development ratio is 1.0, and the estimate of KDt is not biased. However, the previously referenced study found that 68.4 percent of the incurred loss development ratios deviated from 1.0 by more than 5 percent.4 A second problem is the use of the unearned premium reserve, since its value is affected by the average policy term. The reserve exists simply because insurance policies must, by necessity, be written for discrete time periods. If the length of that time period is altered, the value of the reserve is altered. But these altered values do not reflect the real changes in the ebb and flow of economic activity which have taken place. For example, if the reserve is of size X at time t for a group of policies whose term is equal to t minus t - 1, then the reserve would fall to X if the term of the pol2 icy were shortened from (t - (t - 1) ) to t (t-1). However, this change in the

of Launie's formula for KD, as an analogue of the industrial firm's cost of capital. For an industrial firm, fixed interest charges are attributable to securities currently outstanding, i.e., interest payments are made on bonds currently held by investors. In the first term in (1), on the other hand, the charges, OLt, are attributable to earned premiums for the period and not to the unearned premiums figure which appears in the denominator. If the firm's size or the by line proportions of its business have not changed substantially over the period, a properly modified version of formula (1) may be a reasonable first approximation to the cost of quasi-debt. However, if such changes are prevalent, the incongruence of the numerator and denominator of the first term in (1) may cause a significant distortion of the true cost of capital. Finally, no mention is made of the equity that exists in the unearned premium reserve. Failure to remove this element results in an erroneous understatement of KD,. The author's technique for approximating the second term in formula (1) is also of questionable validity. This term represents an implicit cost to account for the additional investment income that the firm would earn if unconstrained by state insurance regulations. Launie suggests that this cost can be approximated by considering the return earned by an affiliated mutual fund.5 This comment argues that reserve is not indicative of any change such an approximation disregards the in either the frequency or the severity of portfolio selection practices of insurers the loss distributions. Corresponding tem- and, if carried out, would distort the poral changes in the OL and LR figures firm's cost of capital. Launie seems to imply that, if insurwould rectify the KD figure, but the need for such an adjustment should have been ance regulations did not exist, insurer portfolios would resemble those of mutual pointed out by the author. An additional problem arises in the use funds. Now, although it is true that insurers are constrained by state regula2 Stephen W. Forbes, "Loss Reserving Performance Within the Regulatory Framework," The tions, it is also true that their portfolio

Journal of Risk and Insurance, Vol. No. 4 (December, 1970), pp. 527-38. 3 Ibid., p. 534.
4Ibid.

XXXVII,

5 Launie, op. cit., p. 265. This comment assumes that Professor Launie is referring to a diversified common stock fund rather than to a bond-stock or a bond fund.

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Communications
configurations are based on sound economic criteria. For example, it is no accident that life insurer assets and liabilities are both primarily long term obligations. Comparable arguments could be advanced with regard to property-liability investment portfolios. In other words, the portfolio selection process of insurance companies takes account, either explicitly or implicitly, of the risk-return characteristics of the firms' assets and liabilities and of the covariance relationships among them. As one researcher has noted, "For each financial institution, the nature of the liability contract by which the funds are received is different; hence each institution has a somewhat different demand function for securities."6 It is thus possible that removal of all investment regulations on insurers would not change drastically the portfolio compositions of the firms.7 Some change would occur, of course, but it is questionable to argue that insurer portfolios would approach those of mutual funds. The implicit cost for the effects of regulation is probably a valid concept, but it would not be as large a factor as Launie implies and should not be approximated as he suggests. A final major inadequacy of the article is its failure to justify properly the use of the cost of capital concept for insurance companies. In the abstract of the article, Launie notes that "The possibilities for the application of cost of capital analysis in the insurance environment are manifold."8 This assertion may be true, but the discussion of the "Significance of the Cost
6 Leroy S. Wehrle, "Life Insurance Investment: The Experience of Four Companies," in Donald D. Hester and James Tobin, eds., Studies of Portfolio Behavior (New York: John Wiley & Sons, Inc., 1967), p. 191. a At any rate, since research on the effects of regulatory constraints on insurer portfolios has not been conclusive, Professor Launie's approximation should be used with extremecaution until more definitive results are available.

489

of Capital" on p. 268 does little to prove the point. For example, Professor Launie advocates as a decision rule for insurance companies the investment in securities earning no less than the company's cost of capital. Setting aside the rather profound (and undiscussed) implications of such a rule for an insurer, it is readily seen that, in most cases, the rule operates only as a remote lower bound on investment returns, i.e., it might better be described as a "non-rule." For property-liability firms, Launie has noted that a negative cost of quasi-debt is a probable occurrence in some eras."9 Since the quasi-debt to equity ratio for property-liability firms is generally greater than 1.0, Launie's cost of capital for such firms is likely to be considerably below the rate of return obtainable in current money markets, i.e., the relatively greater weight of the negative or small positive cost of quasi-debt may counteract the positive cost of equity capital. This should be true even after adjustment for the implicit costs of regulation. In such cases, the rule merely instructs the firm not to invest in a low yielding security when a comparable high yielding security is available; but is a complicated cost of capital computation needed to arrive at such a conclusion?1' An alternative way of viewing this argument is to note that the insurance firm does not face a schedule of potential investments, earning progressively smaller rates of return, such as that usually postulated for an industrial firm. Because its cost of quasi-debt is almost always positive, Launie's decision rule may be somewhat more realistic for a life insurer, but his cost of capital is still likely to fall far below the interest rates available in the
9 Ibid., p. 265. 10For example, the rule would advise the firm to curtail the amount of insurance written if it cannot earn a rate of return greater than its cost of capital.

8 Launie, op. cit., p. 263.

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490

The Journal of Risk and Insurance enterprise is protection against adverse fluctuations in losses due to the risks assumed by the firm.15Of course, this function of equity funds is implicitly recognized in the industrial firm in the form of "financial risk," i.e., the risk of insolvency due to the inability to meet fixed charges. Insurance managers are more conscious of this "contingency reserve" function and less aware of purely financial considerations than are their industrial counterparts. It may be true that optimization of capital structure according to an appropriate cost of capital criterion would also yield an optimal surplus from a loss fluctuation standpoint. If so, the author should have attempted to justify this equivalence or at least have alluded to the different emphasis placed on the accumulation of surplus in an insurance context. The other insurance oriented uses for cost of capital to which the author refers are either quite minor or are discussed in such a cursory manner as to leave the reader essentially uninformed. It is thus clear that the author has not substantiated his claim that "benefits to be gained from further research in this field should far outweigh

current securities markets. Since each company can invest its entire cash flow without appreciably affecting market rates, the rule is again inoperable. When interest rates are low, the rule may make some sense for a property-liability insurer; but life insurers are more likely to adjust downwards the interest assumption in their premium calculations (thus changing the major component of their cost of debt capital) than to adhere to a rigid investment cut-off point, which would instruct the firm to cease writing new business.1' For funds generated by life insurance policies already in effect when market rates fall below the cost of capital, the decision rule again appears to be inapplicable. Furthermore, the decision rule apparently ignores covariance effects among securities and thus is contrary to portfolio selection theory. Perhaps Launie intended a diffeernt interpretation of his decision rule; if so, however, his discussion should have been more explicit. Another possibility suggested by the author for the use of the cost of capital in an insurance context concerns the determination of an optimum capital structure for the firm. Although Launie does not specify how such a structure is to be determined, presumably he is referring to a procedure by which the firm finances in such a way that "the marginal real cost of each available method of financing is the same." 12 This concept is a legitimate one for industrial firms, and methods are available to apply it in practical situations.'3 However, this type of analysis should explicitly recognize that a primary justification for surplus 14 in the insurance
11A temporary decrease in sales effort might take place until the interest adjustmentcould be made. 12 James C. Van Horne, Financial Management and Policy (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1968), p. 167. '3 Ibid., pp. 168-69. 14 Surplus represents a large proportionof total equity even for a stock insurer.

the costs."16
Many of the problems cited above stem from the fact that Launie has rooted his paper in an analogy of the weighted cost of capital of an insurance firm to that of an industrial firm. This paper contends that the analogy has been pushed too far. To attempt to develop a viable theory of the behavior of an insurance firm based solely upon an analogy to an industrial firm will be an unrewarding task. An insurance company is a financial intermediary. Consequently, research efforts
1' See C. L. Trowbridge, "Theory of Surplus in a Mutual Insurance Organization," Transactions of the Society of Actuaries, Vol. XIX, Pt. 1 (1967), p. 218. Mr. Trowbridge's article refers to life insurers, but a similar point could be made with regard to property-liability companies. 16 Launie, op. cit., p. 268.

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Communications should be focused upon adapting recent developments in the theory of financial intermediation to the insurance situation. For example, Pyle has recently published a paper in which he states that his objective is to investigate the question ". . . under what circumstances would a firm be willing to sell a given deposit liability (e.g., savings deposits) and use the proceeds to purchase a given type of financial asset (e.g., home mortgages)." 17 One has only to substitute the words "insurance policies" for "savings deposits," and the relevance of Pyle's question for
17 David H. Pyle, "On the Theory of Financial Intermediation,"Journal of Finance, Vol. XXVI, No. 3 (June, 1971), pp. 737-47.

491

the insurance environment is immediately obvious. The recent work by Haugen and Kroncke is also a step in the right direction.18 Of course, such theoretical treatments are not adequate substitutes for practical analytical tools such as cost of capital analysis. However, if a satisfactory practical decision rule is to be developed for insurers, analysts must place more reliance on the theory of financial intermediation and less on comparisons with unrelated industries.
18 Robert A. Haugen and Charles 0. Kroncke, "Optimizing the Structure of Capital Claims and Assets of a Stock Insurance Company," The Journal of Risk and Insurance, Vol. XXXVII, No. 1 (March, 1970), pp. 41-48.

FURTHER COMMENT
STEPHEN

W.

FORBES*

In a recent article in this Journal, Professor J. J. Launie purports to present a unique concept of the cost of capital applicable to insurance companies.' He states in the Abstract to his article that "The funds which are generated through the medium of the insurance operation such as the loss reserve and the unearned premium reserve in a property-liability 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." Launie then goes on to state in his Abstract that "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."
* Associate Professor of Finance, University of Illinois at Urbana-Champaign. 1 J. J. Launie, "The Cost of Capital of Insurance Companies," The Journal of Risk and Insurance, XXXVIII (June, 1971), pp. 263-68.

The cost of capital is simply the cost of the funds available to finance an investment project. It is the purpose of this comment to suggest that nonlife insurance company reserves should be entirely disregarded in the cost of capital calculations since they represent a by-product of the insurance transaction and have no cost as far as the insurer is concerned. If there is a loss from the insurance operation, it should be recognized in the calculations of the discounted net cash flows accruing to the insurer's shareholders. To recognize such a loss also as a cost of capital is to engage in double accounting. Furthermore, such a recognition defeats the purpose of the cost of capital calculation, which is to provide a cutoff rate of return to be used in deciding whether or not to invest funds in a project. The cost of capital for a stock nonlife insurer is simply an opportunity cost, which attempts to measure what the shareholder could earn if he were to place his funds in the next best venture of equal

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