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The Capital Structure of Insurers: Theory and Evidence

Guo, Dajiang and Winter, Ralph A., "The Capital Structure of Insurers: Theory and Evidence" (July 1997). Available at SSRN:


    This paper develops and tests a theory of insurers' choice of the mix of equity and liabilities. We first develop the simplest model of an insurance market with costly equity, in a two-period setting. For equity to have any role in an insurance market there must be aggregate uncertainty, or dependence among insured risks; the absence of a law of large numbers means that equity is necessary to back up promises to pay claims in the event of adverse realizations of aggregate shocks. Accordingly, the key comparative static issue that we focus on is the impact of increasing aggregate uncertainty. We consider separately the cases of aggregate uncertainty in the loss incurred conditional upon an accident and uncertainty in the probability of an accident (i.e. dependence among the events of individual accidents). If the former case, the total equity issued by a competitive insurance market is increasing in the degree of uncertainty (and linear in a parameterized example). In the latter case, equity may be increasing then decreasing as a function of uncertainty. In both cases, the ratio of equity to revenue is increasing in uncertainty. We test the model, as well as implications of recent models of insurance market dynamics, on a cross-section of U.S. property-liability insurers. While the theory is developed for competitive markets, by assuming that each insurer is operating in one or more competitive markets, we can use firm-level data in the tests. This paper uses for the first time, to our knowledge, a sample of 1155 U.S. property- liability stock insurance companies in a study of capital structure. The focus is on tests of two hypotheses. The first is the implication of the static model, that leverage is decreasing in aggregate uncertainty. The second is an implication of previous dynamic models of competitive insurance markets (Gron (1994) and Winter (1994)) that external equity is more costly than internal equity -- specifically that there is a positive cost to the ``round- trip'' of distributing an amount of cash then raising the same amount in external equity. Previous tests of this implication focus on insurance pricing, that the error in premiums as predictors of subsequent claims rather than being white noise should be correlated with the current stock of equity. These tests thus center on the dynamic behavior of insurance premiums. The empirical analysis here is complementary, based not on prices but directly on capital structure decisions. The paper also offers a link between the recent insurance market literature and corresponding empirical results in tests of capital structure for non-financial corporations: Titman and Wessels (1988) and Rajan and Zingales (1994) find negative relationships between leverage and past profitability; an explicit dynamic theory and tests are offered by Fischer, Heinkel and Zechner (1989).
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