Hung-Gay Fung College of Business Administration University of Missouri-St. Louis Min-Ming Wen

1. Will the Use of Credit Default Swaps Affect Firm Risk and Value?Evidence from U.S. Life and Property/Casualty Insurance Companies Hung-Gay Fung College of Business Administration University of Missouri-St. Louis Min-Ming Wen College of Business and Economics California State University, Los Angeles Gaiyan Zhang College of Business Administration University of Missouri-St. Louis

2. Motivation • Financial Crisis in 2008 • AIG was on the edge of falling apart  the (ab)use of CDS? • Insurance companies have been among the most active market participants in the credit derivatives market • According to British Bankers’ Association (2006), insurers worldwide held an 18% market share for selling CDS protection; 6% of the CDS market for buying credit protection. • This study examines the use of CDS in the pre-crisis period. (from 2001-2007)

3. CDS trading motives • Why do insurers sell CDS? • income generation (for taking credit risks) • replication (similar to bond holdings for receiving fixed payment by taking credit risks; but with a more flexible choice in maturity) • speculation (simply for transaction purpose) • Why do insurers buy CDS? • hedging (managing credit risks embedded in bond portfolios) • speculation (simply for transaction purpose)

4. CDS and Risk: Literature Review • Existing studies on CDS usage have primarily focused on risk-hedging and/or risk-taking behaviors by banks and hedge funds. • Credit derivatives use by banks (Minton, Stulz and Williamson (2009), Shao (2010))  Shao (2009) finds an increase in the risk profiles for bank protection sellers but no evidence that bank protection buyers have higher risk.  Instefjord (2005) risk-sharing benefits from credit derivatives may encourage banks to take more risk  Morrison (2005) finds that credit derivatives can reduce banks’ incentives to monitor their loan portfolios.

5. CDS and Risk • Credit derivatives use by hedge funds (Chen, 2010)  the use of credit derivatives decreases total risk for hedge funds. • Derivative use by insurers (Colquitt and Hoyt 1997; Cummins, Phillips, and Smith 1997, 2001).  not CDS specifically!

6. Research Questions • CDS Buy position reduces credit risk if it is for hedging purpose  can this be transferred to risk-reduction as a whole? • CDS Buy position carries investment risk if it is for transaction purpose  how does it affect firm’s risks? • CDS sell position increases credit risk if it is for income generation purpose  how does it affect firm’s risks? • CDS sell position reduce asset-liability duration risk  can it be transferred to the reduction of firm’s risks? • How does the use of CDS affect firm risks? • How are the effects of CDS use on firm risks transferred to the effects on firm value?

7. Research Design • CDS use  Buyers v.s. sellers • Risk Measures  total risk, market risk, and idiosyncratic risk • Firm value measure  Tobin’s Q (market-based measure), ROA (accounting-based measure)

8. Main Findings: CDS & Risk

9. Main Findings: CDS & Firm Value

10. Data • Data sources: the merge of NAIC derivative data, CompuStat and CRSP. • Data uniqueness: the detailed nature of the data on credit derivatives use reported by insurance companies to NAIC • Our focus: the behaviors of 44 distinct insurers who participate in the CDS market and have CompuStat and CRSP data available. • 33 Life insurers and 11 PC insurers. • firm-year observations are 427 (Life) and 666 (PC). • the total number of transaction observations: 4,889 (Life) and 1,639 (PC) • CDS non-users: 212 publicly-listed insurers including 85 (Life) 127 (PC).

11. Methodology and Empirical Results • Simultaneous Equation Model on Risk Analysis: potential endogeneity between risk and derivative use (Graham and Rogers, 2002)

12. Table 1. Summary of CDS Transactions for Life and PC Insurers • 2010Taiwan_Presentation_Tables.doc

13. Table 2. Descriptive Statistics for the Entire Sample (CDS_users & Non_CDS Users) • Table 2 presents the descriptive statistics of risk, firm value, and other control variables used in the analysis. • Panels A and B are for the samples of Life and PC insurers, respectively. • 2010Taiwan_Presentation_Tables.doc

14. Table 3. • Table 3 compares medians and means of risk, firm value, and other firm characteristic variables between insurers – CDS users, CDS net buyers, CDS net sellers – and those non-CDS users. • 2010Taiwan_Presentation_Tables.doc • Life insurers with CDS transactions: have a larger systematic risk, lower idiosyncratic risk, and lower total risk than those of non-CDS users. • Bothnet buyers and net sellers have significantlyhigher systematic risk,lower idiosyncratic risk, and lower total risk than non-CDS users.

15. Table 3 • Life Insurers: non-CDS users have larger Tobin’s Q, market-to-book value of equity, and return on asset than CDS users, net buyers, net sellers. • PC Insurers: • No significant difference intotal riskbetween CDS users and non-users. • CDS users have higher systematic risk and lower idiosyncratic risk than those of non-CDS users. • Net buyers have significantly higher systematic risk and lower idiosyncratic risk than non-CDS users. • No significant difference in total risk between net buyers and non-users. • Net sellers show significantly higher market risk and higher idiosyncratic risk than non-users, • No significant difference in total risk between net sellers and non-users. • CDS users have lower Tobin’s Q, lower market-to-book equity value, and lower ROA than non-users. • CDS net buyers and net sellers also have lower Tobin’s Q, market-to-book equity value, and ROA than non-users.

16. Summary of Univariate Analysis • Life and PC CDSusers (regardless of their positions as net buyers or net sellers) have higher market risk than non-users  a positive relation between the market risk of insurers and their participation in the CDS market. • Second, Life CDS users have lower idiosyncratic risk and total risk than non-users. • Finally, Life and PC CDS users have lower firm values.

17. Table 4. Risk Models

18. Table 4. Risk Models • 2010Taiwan_Presentation_Tables.doc • Panel A1: (risk equation, Life insurers): participation in CDS transactions significantly increases total risk; Net sellers dummy variable significantly increase total risk  writing CDS contracts increases Life insurers’ total risk.  buying CDS protection has insignificant effects on Life insurers’ total risk. • In the CDS equation: CDS use and participation positions are positively and significantly related to total risk.  those insurers with higher total risk are more likely to engage in CDS transactions, both as net sellers and as net buyers, holding other things constant. • Panel B1 (PC insurers) are quite similar to those for Life insurer sample; • both net buyers and net sellers have significantly higher total risk.

19. Table 5: Regression Model on Firm Performance

20. Table 5: Regression Model on Firm Performance • 2010Taiwan_Presentation_Tables.doc

21. Table 5: Regression Model on Firm Performance

22. Contributions • We extend a series of studies on derivative usage by insurance companies by focusing on credit derivatives, credit default swaps on particular • Our paper complements the study on bank and hedge fund use of credit derivatives • Shed light on the opaque and largely unregulated CDS market • This study shows: • CDS utilization alters the risk profile of both Life and PC insurers by increasing each dimension of risk. • CDS utilization deterioratesthe financial performance. • Our findings support the effort of the NAIC working with the insurance regulators tomonitor more closely how insurance companiesengage in derivative transactions.