The link between the cost of equity and reinsurance purchased by insurers is examined in this study. This work extends the research on the economic value implications of corporate risk management practices. Utilising a framework based on the theory of optimal capital structure, this study puts forward two hypotheses to test empirically the cost of equity – reinsurance relation in the United Kingdom’s non-life insurance market. The first hypothesis tests the effect of the decision to reinsure on the insurers’ cost of equity, whereas the second hypothesis focuses on the link between the extent of reinsurance purchased and the cost of equity. Panel data samples drawn from 469 non-life insurance companies conducting business in the UK insurance market between 1985 and 2010 are used to test these hypotheses. The study employs a modified version of the Rubinstein-Leland (R-L) model to estimate the cost of equity. Both the hypotheses put forward are supported by the empirical evidence obtained through regression analysis. The empirical results suggest that, on average, users of reinsurance have a lower cost of equity than their counterparts who do not reinsure. The results also suggest that the relationship between the cost of equity and the level of reinsurance purchased is non-linear. It is inferred from this result that reinsurance can lower the cost of equity for primary insurers provided the cost of reinsuring is lower than the reduction in frictional costs achieved through reinsurance. This finding validates the use of the theory of optimal capital structure as the appropriate framework to guide this research. Robustness and sensitivity tests confirm that the influence of multicollinearity and endogeneity on the estimates is negligible. This study thus provides new and important insights on the impact of reinsurance (risk management) on firm value through its influence on the cost of equity. These findings are deemed useful to various stakeholders in insurance companies, including investors, managers, regulators, credit rating agencies and policyholder-customers.
|Date of Award||15 May 2014|
|Sponsors||Willis Towers Watson|
|Supervisor||Michael Adams (Supervisor) & Ian Tonks (Supervisor)|
- cost of equity
- United Kingdom