Capital Allocation and the Pricing of Financially Intermediated Risks: An Empirical Investigation
51 Pages Posted: 28 Jun 2006
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: Suggested Citation