Decomposing diversification effect: evidence from the U.S. property-liability insurance industry

Prior literature suggests that diversified property-liability (P/L) insurers underperform their focused counterparts. While most studies focus on insurers’ overall performance, there is an absence of evidence regarding whether the underperformance is driven by underwriting or investment profitability. The authors develop and test hypotheses of diversification’s separate effect on underwriting and investing in the U.S. property-liability (P/L) insurance industry. It is found that diversified insurers outperform their focused counterparts in terms of investment return, but that they underperform in terms of underwriting profitability. The results are robust to corrections for endogeneity bias and a matched sample analysis

Market Reaction to Regulatory Capture and Political Risk in a Highly-Salient Environment

The catastrophic losses from the combined 2004 and 2005 hurricane seasons resulted in significant price increases and mass non-renewals in the residential property insurance market in Florida. The public outcry to these insurer decisions yielded a highly salient insurance pricing environment. On November 29, 2006, Governor-elect Crist called for a special legislative session to provide relief to Florida residents and businesses, making good on his campaign pledge of addressing high insurance costs. We hypothesize that the call for the special session was indicative of consumer groups having captured the regulatory/legislative process, to the detriment of the insurance industry. The apparent shift in regulatory capture from the insurance industry to consumers implies an increase in political risk. Consistent with our hypothesis, we find that publicly traded homeowners’ and commercial multi-peril insurers with Florida exposure experienced a negative stock price reaction to the announcement of the special session

Effects of Corporate Diversification: Evidence From the Property-Liability Insurance Industry

Using a sample of property-liability insurers over the period 1995-2004, we develop and test a model that explains performance as a function of line-of-business diversification and other correlates. Our results indicate that undiversified insurers consistently outperform diversified insurers. In terms of accounting performance, we find a diversification penalty of at least 1 percent of return on assets or 2 percent of return on equity. These findings are robust to corrections for potential endogeneity bias, alternative risk measures, alternative diversification measures, and an alternative estimation technique. Using a market-based performance measure (Tobin's Q) we find that the market applies a significant discount to diversified insurers. The existence of a diversification penalty (and diversification discount) provides strong support for the strategic focus hypothesis. We also find that insurance groups underperform unaffiliated insurers and that stock insurers outperform mutuals. Copyright (c) The Journal of Risk and Insurance, 2008.

Hedging, Cash Flows, and Firm Value: Evidence of an Indirect Effect

This paper extends and tests the predictions of Froot, Scharfstein, and Stein's (1993) model of the relation between hedging, cash flows, and firm value. Specifically, we model the impact of derivatives hedging on firm value both directly and also indirectly through its effect on cash flow volatility. We test the model's predictions using a sample of publicly traded life insurers who report detailed information on both the extent and purpose of derivatives use. We find that both derivatives hedging and cash flow volatility are negatively related to firm value. However, consistent with our theoretical predictions, we find that hedging mitigates the negative value effect of cash flow volatility