Price Regulation, Market Exit, and Financial Leverage of Canadian Property-Liability Insurers

Strauss, Jason (2007): Price Regulation, Market Exit, and Financial Leverage of Canadian Property-Liability Insurers.

Abstract

This paper investigates strategic brinksmanship between regulated property-liability insurance firms and their regulators. Prior research suggests that firms increase their financial leverage, and thus their probability of bankruptcy and expected bankruptcy costs, in order to mitigate the severity of binding price ceilings. Although financial leverage can be altered by changing capital structure, it can also be altered by increasing other liabilities, as analyzed in this paper. This paper uses an instrumental variable for price regulation with a maximum-likelihood Heckman estimation method over panel data for Canadian property-liability insurers to extract the impact that price regulation has on the financial leverage of insurers as well as the probability of bankruptcy, the non-selection probability.

• Item Type: MPRA Paper
• Language: English
• Keywords: Price Regulation, Insurance, Financial Leverage, Capital Structure, Bankruptcy
• Subjects: G - Financial Economics > G2 - Financial Institutions and Services > G22 - Insurance ; Insurance Companies ; Actuarial Studies; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; G - Financial Economics > G3 - Corporate Finance and Governance > G33 - Bankruptcy ; Liquidation

References

Bajtelsmit, V. L. and Bouzouita, R., 1998, 'Market Structure and Performance in Private Passenger Automobile Insurance,' Journal of Risk and Insurance, 65 (3), 503-514.

Bankruptcy and Insolvency Act of Canada, mimeograph, accessed on the Department of Justice, Canada’s website: http://laws.justice.gc.ca/en/showtdm/cs/B-3, accessed July 23, 2007.

Barros, P. P., 1996, 'Competition Effects of Price Liberalization in Insurance,' Journal of Industrial Economics, 44 (3), 267-287.

Booth, et al, 1999, ‘Modern Actuarial Theory and Practice,’ New York, Chapman & Hall/CRC.

Bradley, M., G.A., Jarrell, and E.H. Kim, 1984, ‘On the Existence of an Optimal Capital Structure: Theory and Evidence,’ The Journal of Finance, 39 (3), 857-880.

Cagle, J. A. B. and Harrington, S. E., 1995, 'Insurance Supply with Capacity Constraints and Endogenous Insolvency Risk,' Journal of Risk and Uncertainty, 11 (3), 219-232.

Choi, B. P. and Weiss, M. A., 2005, 'An Empirical Investigation of Market Structure, Efficiency, and Performance in Property-Liability Insurance,' Journal of Risk and Insurance, 72 (4), 635-673.

Choi, S., Hardigree, D. and Thistle, P. D., 2002, 'The Property/Liability Insurance Cycle: A Comparison of Alternative Models,' Southern Economic Journal, 68 (3), 530-548.

Cummins, J. D. and Lamm-Tennant, J., 1994, 'Capital Structure and the Cost of Equity Capital in the Property-Liability Insurance Industry,' Insurance: Mathematics and Economics, 15 (2-3), 187-201.

Cummins, J.D. and Danzon, P.M, 1997, 'Price, Financial Quality, and Capital Flows in Insurance Markets,' Journal of Financial Intermediation, 6, 3-38.

Cummins, J.D. and Mahul, O., 2003, 'Optimal Insurance with Divergent Beliefs about Insurer Total Default Risk,' The Journal of Risk and Uncertainty, 27 (2), pp.121-138.

Dasgupta, S. and V. Nanda, 1993, ‘Bargaining and Brinkmanship—Capital Structure Choice by Regulated Firms,’ International Journal of Industrial Organization, 11 (4), 475-497.

Dionne, G. (editor), 2000, 'Handbook of Insurance,' Boston/ Dordrecht, London, Kluwer Academic Publishers.

Doherty, N. A. 1981, 'The Measurement of Output and Economies of Scale in Property-Liability Insurance,' Journal of Risk and Insurance, 48 (3), 390-402.

Doherty, N.A., and Schlesinger, H, 1990, 'Rational Insurance Purchasing: Consideration of Contract Nonperformance,' The Quarterly Journal of Economics, 2, 243-253.

Gron, A., 1994, 'Capacity Constraints and Cycles in Property-Casualty Insurance Markets,' RAND Journal of Economics, 25 (1), 110-127.

Gron, A., 1994, 'Evidence of Capacity Constraints in Insurance Markets,' Journal of Law and Economics, 37 (2), 349-377.

Hagerman, R., and Ratchford, B., 1978, ‘Some Determinants of Allowed Rates of Return on Equity to Electric Utilities,’ The Bell Journal of Economics, 9 (1), 46-55.

Harrington, S. E. and Danzon, P. M., 1994, 'Price Cutting in Liability Insurance Markets,' Journal of Business, 67 (4), 511-538.

Harrington, S. E., 1987, 'A Note on the Impact of Auto Insurance Rate Regulation,' Review of Economics and Statistics, 69 (1), 166-170.

Harrington, S. E., 1990, 'The Relationship between Voluntary and Involuntary Market Rates and Rate Regulation in Automobile Insurance,' Journal of Risk and Insurance, 57 (1), 9-27.

Harrington, S. E., 1992, 'Presidential Address: Rate Suppression,' Journal of Risk and Insurance, 59 (2), 185-202.

Harrington, S., 1984, 'The Impact of Rate Regulation on Prices and Underwriting Results in the Property-Liability Insurance Industry: A Survey,' Journal of Risk and Insurance, 51 (4), 577-623.

Insurance Act of Alberta, mimeograph, accessed on the Queen’s Printer website: http://www.qp.gov.ab.ca/documents/Acts/I03.cfm?frm_isbn=0779723252, accessed July 22, 2007.

Insurance Companies Act of Canada, mimeograph, accessed on the Department of Justice, Canada’s website: http://laws.justice.gc.ca/en/I-11.8/index.html, accessed July 23, 2007.

Joskow, P. L., 1973, 'Cartels, Competition and Regulation in the Property-Liability Insurance Industry,' Bell Journal of Economics, 4 (2), 375-427.

Kaas, et al, 2001, 'Modern Actuarial Risk Theory,' Dordrecht, The Netherlands, Kluwer Academic Publishers.

Kim, W., Mayers, D. and Smith, C. W., Jr., 1996, 'On the Choice of Insurance Distribution Systems,' Journal of Risk and Insurance, 63 (2), 207-227.

Klein, R.W., R.D., Phillips, and W. Shiu, 2002, ‘The Capital Structure of Firms Subject to Price Regulation: Evidence from the Insurance Industry,’ Journal of Financial Research, (21) 79-100.

Mas-Colell, A., et al., 1995, ‘Microeconomic Theory,’ New York, Oxford University Press. MSA Research Inc., accessed July 16, 2007: http://www.msaresearch.com/.

Owen, B.M., and R. Braeutigam, 1978, ‘The Regulation Game: Strategic Use of the Administrative Process,’ Cambridge, Mass., Ballinger Publishing Company.

Phillips, R.D., and J.D. Cummins and F. Allen, 1998, ‘Financial Pricing of Insurance in the Multiple-Line Insurance Company,’ The Journal of Risk and Insurance, 65(4), 597-636.

Property and Casualty Companies Borrowing Regulations (1992). http://www.canlii.org/ca/regu/sor92-281/part280861.html. Accessed 29 February 2008.

Rees, et al, 1999, 'Regulation of Insurance Markets,' The Geneva Papers on Risk and Insurance Theory, 24, 55-68.

Spiegel, Y. and D. Spulber, 1994, ‘The Capital Structure of a Regulated Firm,’ Rand Journal of Economics, 25 (3), 424-440.

Taggart, R.A. Jr., 1981, ‘Rate of Return Regulation and Utility Capital Structure Decisions,’ Journal of Finance,’ 36 (2), 383-393.

The Facility Association, accessed July 16, 2007: http://www.facilityassociation.com/.

Willes and Willes, 2001, ‘Contemporary Canadian Business Law, Principles and Cases, Sixth Edition,’ McGraw-Hill Ryerson Limited, Toronto.

Winter, R. A., 1988, 'The Liability Crisis and the Dynamics of Competitive Insurance Markets,' Yale Journal on Regulation, 5 (2), 455-499.

Winter, R. A., 1991, 'Solvency Regulation and the Property-Liability 'Insurance Cycle.',' Economic Inquiry, 29 (3), 458-471.

Winter, R.A., 1994, ‘The Dynamics of Competitive Insurance Markets,’ Journal of Financial Intermediation 3(4), 379-415.