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The momentum effect on estimating the cost of equity capital for property-liability insurers

The momentum effect on estimating the cost of equity capital for property-liability insurers. Jennifer L. Wang (National Chengchi University) Joseph Tien (Tamkang University). Outline. (1) Introduction: Motivation and Literature (2) Data Resource and Empirical Model (3) Empirical Results

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The momentum effect on estimating the cost of equity capital for property-liability insurers

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  1. The momentum effect on estimating the cost of equity capital for property-liability insurers Jennifer L. Wang (National Chengchi University) Joseph Tien (Tamkang University) NTUICF, 10/DEC/2010

  2. Outline • (1) Introduction: Motivation and Literature • (2) Data Resource and Empirical Model • (3) Empirical Results • (4) Conclusions NTUICF, 10/DEC/2010

  3. Motivation(1/2) • Cost of capital estimation is becoming important for insurers especially after financial crisis in 2008. • Moreover, insurers need more equity capital if International Financial Reporting Standards (IFRS) is executed. • More applications of financial models are used in pricing, reserving, ALM for insurance companies. NTUICF, 10/DEC/2010

  4. Motivation(2/2) • Fama-French(1997) suggest that the cost of capital varies across industries due to heterogeneity of the risks facing in various sectors of the economy. There is a significant factor for insurance. • The supervisor needs the reasonable cost of capital to enact the regulations. • Few literature discussed how to estimate costs of capital for insurers with different business line compositions. NTUICF, 10/DEC/2010

  5. Literature Process Possible reasons to explain Size, B/M and Momentum 1970 1980 1990 Global market, Different industries S(1964),L(1965),B(1972) -- CAPM Most Results support CAPM Fama-French Three Factor Model Refining Beta Estimation Adding different possible factors to explain returns Jegadeesh and Titman(1993) --Momentum NTUICF, 10/DEC/2010

  6. Literature(1/2) • Cummins and Harrington(1985)suggest that beta of property-liability insurers were unstable and conformed to the CAPM in the 1980’s but not in the 1970’s. • Cummins and Lamm-Tennant(1994) figure an additional factor, leverage, for empirical models. Their results suggest that the long-tail commercial lines of property-liability insurance tend to have higher costs of capital than short-tail lines. NTUICF, 10/DEC/2010

  7. Literature(2/2) • Lee and Cummins(1998)propose that APT and the Wei(1988) model perform better than the CAPM in forecasting the cost of capital for insurers. • Using the Fama-French model, Cummins and Phillips(2005) suggest the cost of capital for insurers are significantly higher than estimation based upon the CAPM. • Wang et al. (2008) use Rubinstein-Leland (RL) model to improve the cost of equity estimates of insurance companies due to the highly skewed and heavy-tailed distributions associated with the insurance claims process. NTUICF, 10/DEC/2010

  8. Purposes • (1) To test whether the momentum factor plays the significant role in estimating the cost of equity capital for PL insurers. • (2) Moreover, we further use FIB method to calculate the capital cost for different lines of business. • (3) Finally, the sum-beta approach is adopted to adjust the infrequent trading. NTUICF, 10/DEC/2010

  9. Data and Sample Selection(1/3) To select property/casualty insurance (NAICS code 524126) sample by North American Industry Classification System (NAICS). The stock return of insurance companies were obtained from CRSP. To follow Fama-French’s(1992,1997) screening rules (a) To eliminate firms didn’t have at least 36 consecutive months of return information during estimation period (b) The beta coefficients greater than 5 in absolute value. NTUICF, 10/DEC/2010

  10. Data and Sample Selection(2/3) • Excess return data for market systematic risk , size, financial distress (B/M ratio), and momentum factor were obtained from Kenneth French’s website. • Consequently, we obtained data on insurance revenue by product lines from the NAIC annual statement CD-ROMs. NTUICF, 10/DEC/2010

  11. Data and Sample Selection(3/3) • Estimate betas Period: 1993-2001 • We abstracted monthly return data from CRSP and use excess return data for market systematic risk , size, financial distress (B/M ratio), and momentum factor to proceed the regression. • Estimate the cost of equity: 1999-2001 NTUICF, 10/DEC/2010

  12. Estimation Methodology (1/4)-- CAPM Method ：the return on stock I in period t ：the risk-free rate in period t(30-day Treasury bill yield) ：the returm on the market portfolio in period t ：the CAPM beta coefficient for firm i ：overall beta estimate for firm i ：net premiums weight for firm I in business lines k ：full-information beta of type j for business line k NTUICF, 10/DEC/2010

  13. Estimation Methodology (2/4)-- FF3F Model ：the market risk premium for firm size in period t ：the market risk premium for financial distress in period t ：overall beta estimate of type j for firm i，j=m, s, v ：net premiums weight for firm I in business lines k ：full-information beta of type j for business lines k ，j=m, s, v NTUICF, 10/DEC/2010

  14. Estimation Methodology (3/4)-- Momentum Model ：the momentum factor in the period t ： overall beta estimate of type j for firm i，j=m, s, v, mo ：net premiums weight for firm I in business lines k ：full-information beta of type j for business lines k ， j=m, s, v, mo NTUICF, 10/DEC/2010

  15. Estimation Methodology (4/4)-- Sum-Beta Approach In order to correct for the bias created by infrequent trading, we utilize the sum-beta approach that has become standard in this type of analysis ( e.g., Scoles and Williams(1977), Dimson(1979)) Adding the lagged value of variable in model: The estimated sum beta coefficient is NTUICF, 10/DEC/2010

  16. To Estimate Cost of Equity (1/2) = the cost of capital of CAPM for firm i, = estimated beta coefficient in first regression for firm i, = the expected return of the risk-free asset, the expected return on the market portfolio, excess return on NYSE/AMEX/Nasdaq stocks from 1926 until June of 2001 NTUICF, 10/DEC/2010

  17. To Estimate Cost of Equity (2/2) = the expected excess premium for size factor, = the expected excess premium for financial factor, = the expected excess premium for momentum factor NTUICF, 10/DEC/2010

  18. Empirical Results of Beta Estimations (1/2) (1) The quartile results do not show that large insurers consistently have smaller beta than small insurers. (2) The sum-beta estimates are constantly than the ordinary beta coefficients because infrequent trading. NTUICF, 10/DEC/2010

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  22. Empirical Results of Beta Estimations (2/2) • (3) The market beta estimated in FF3F is larger than in CAPM. • (4) The market beta estimated in momentum model is larger than in FF3F. • (5) Generally, the market beta or B/M beta is larger than the size beta, the momentum beta is smallest. NTUICF, 10/DEC/2010

  23. Empirical ResultsOverall cost of equity (1/2) NTUICF, 10/DEC/2010

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  26. Empirical ResultsOverall cost of equity (2/2) • The cost of equity estimated with sum-beta adjustment is larger than without sum-beta method. • The cost of equity estimated from FF3F is larger than from CAPM. (CAPM:10.5%, FF3F:16.3%) • The cost of equity estimated from momentum model is larger than from FF3F. (Momentum:22.56%) NTUICF, 10/DEC/2010

  27. Comparing with Cummins and Phillips (2005) • Financial distress betas are substantially larger than the parameters in the Fama-French all industry average. (0.02) • Financial distress factor is significant in estimating the cost of equity for property-liability insurers. NTUICF, 10/DEC/2010

  28. Our New Findings • Although the momentum beta could be the smallest of all beta estimations, the momentum effect still plays a significant role in estimating cost of equity. • The estimations of beta and cost equity are dropped sharply in 2001. NTUICF, 10/DEC/2010

  29. Empirical Results for different lines of business • (1) Long-tail and Short-tail • (2) Commercial and Personal • (3) Workers’ Compensation, Automobile Insurance and All Other Property-Liability Insurance NTUICF, 10/DEC/2010

  30. Results of Long-tail and Short-tail • Long-tail – other liability , products liability (occurrence, claim made), private passenger auto liability, aircraft, commercial auto liability. • Short-tail – fire, allied lines, homeowners, multiperil, automobile physical damage, accident and health coverage, fidelity, surety, mortgage guaranty. NTUICF, 10/DEC/2010

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  32. Empirical Results of Commercial and Personal (1/2) • Personal Line- Homeowner, Framowner, Earthquake, Personal Auto Liability, Personal Auto Damage • Commercial Line- All other lines of insurance are considered commercial lines. NTUICF, 10/DEC/2010

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  34. Empirical Results of Commercial and Personal (2/2) • Generally Speaking, equity cost in commercial lines is larger than in personal lines. Shareholders ask more risk compensation for operating the commercial line products. NTUICF, 10/DEC/2010

  35. Results of Workers’, Auto and All other (1/2) NTUICF, 10/DEC/2010

  36. Results of Workers’, Auto and All other (2/2) • (1) The equity cost of worker compensation is slightly larger than automobile. But the equity cost of other P&L is largest among these three categories. NTUICF, 10/DEC/2010

  37. Conclusions (1/2) • (1) The cost of equity capital estimation based the FF3F (mometum) method is significantly higher than the estimation based on the CAPM (FF3F). • (2) It is important to adjust infrequent trading when estimating betas for PL insurers. NTUICF, 10/DEC/2010

  38. Conclusions (2/2) • (3) The cost of equity capital varies significantly by line of insurance. • (4) Financial distress factor is significant in estimating the cost of equity for property-liability insurers. NTUICF, 10/DEC/2010

  39. Thank For Your Attention NTUICF, 10/DEC/2010

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