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Estimating the Cost of Equity for Property‐Liability Insurance Companies
Author(s) -
Wen MinMing,
Martin Anna D,
Lai Gene,
O'Brien Thomas J.
Publication year - 2008
Publication title -
journal of risk and insurance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.055
H-Index - 63
eISSN - 1539-6975
pISSN - 0022-4367
DOI - 10.1111/j.1539-6975.2007.00250.x
Subject(s) - portfolio , skewness , econometrics , capital asset pricing model , actuarial science , equity (law) , leverage (statistics) , economics , market portfolio , liability , business , financial economics , finance , statistics , political science , law , mathematics
Due to the highly skewed and heavy‐tailed distributions associated with the insurance claims process, we evaluate the Rubinstein‐Leland (RL) model for its ability to improve the cost of equity estimates of insurance companies because of its distribution‐free feature. Our analyses show that there is as large as a 94‐basis‐point difference in the estimated cost of insurance equity between the RL model and the capital asset pricing model (CAPM) for the sample of property‐liability insurers with more severe departures from normality. In addition, consistent with our hypotheses, significant differences in the market risk estimates are found for insurers with return distributions that are asymmetrically distributed, and for small insurers. Third, we find significant performance improvements from using the RL model by showing smaller values of excess return of the expected return of the portfolio to the model return for a portfolio of insurers with returns that are more skewed and for a portfolio of small insurers. Finally, our panel data analysis shows the differences in the market risk estimates are significantly influenced by firm size, degree of leverage, and degree of asymmetry. The implication is that insurers should use the RL model rather than the CAPM to estimate its cost of capital if the insurer is small (assets size is less than $2,291 million), and/or its returns are not symmetrical (the value of skewness is greater than 0.509 or less than −0.509).