Capital Allocation and the Pricing of Financially Intermediated Risks: An Empirical Investigation

51 Pages Posted: 28 Jun 2006

See all articles by Richard D. Phillips

Richard D. Phillips

Georgia State University - Risk Management & Insurance Department

J David Cummins

Temple University - Risk Management & Insurance & Actuarial Science

Yijia Lin

University of Nebraska at Lincoln - Department of Finance

Date Written: June 21, 2006

Abstract

Under perfect market conditions, standard capital budgeting theory predicts that the discount rates on projects should reflect only non-diversifiable risk and be constant across firms. However, theoretical research by Froot and Stein (1998), among others, suggests that when firms invest in non-hedgeable assets under conditions where capital is costly, project pricing should reflect the covariability of the project with the firm's existing portfolio, even if this covariability represents non-systematic risk. They argue that their theory is especially applicable to financial institutions pricing intermediated risks. Theoretical research also suggests that the prices of intermediated risks will reflect the capital strain that such risks place on the intermediary and hence reflect implicit allocations of capital to the intermediary's business lines (Myers and Read 2001, Zanjani 2002). We test these theoretical predictions by analyzing the prices of insurance risks for U.S. property-liability insurers over the period 1997-2004. Specifically, we regress insurance price variables on capital allocations by line, measures of insurer insolvency risk, and other risk and control variables. The results provide strong support for theoretical predictions that prices of intermediated risks vary across firms to reflect insolvency risk, marginal capital allocations, and non-systematic covariability.

Keywords: Capital allocation, Insurance, Prices

JEL Classification: G2, G22, G12, G31

Suggested Citation

Phillips, Richard D. and Cummins, J. David and Lin, Yijia, Capital Allocation and the Pricing of Financially Intermediated Risks: An Empirical Investigation (June 21, 2006). Available at SSRN: https://ssrn.com/abstract=911613 or http://dx.doi.org/10.2139/ssrn.911613

Richard D. Phillips (Contact Author)

Georgia State University - Risk Management & Insurance Department ( email )

P.O. Box 4036
Atlanta, GA 30303
United States
404-413-7009 (Phone)

HOME PAGE: http://robinson.gsu.edu/profile/richard-d-phillips/

J. David Cummins

Temple University - Risk Management & Insurance & Actuarial Science ( email )

Fox School of Business and Management
1801 Liacouras Walk.
Philadelphia, PA 19122
United States
215-204-8468 (Phone)
215-204-4712 (Fax)

Yijia Lin

University of Nebraska at Lincoln - Department of Finance ( email )

Lincoln, NE 68588-0490
United States

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
321
Abstract Views
2,006
Rank
172,208
PlumX Metrics