The Relation between Capital Structure, Interest Rate Sensitivity, and Market Value in the Property-Liability Insurance Industry

JOURNAL OF RISK AND INSURANCE, Vol. 62 No. 4, December 1995

Posted: 26 May 1998

See all articles by Kim B. Staking

Kim B. Staking

Colorado State University - School of Business; National Academy of Social Insurance

David F. Babbel

University of Pennsylvania - The Wharton School - Finance and Insurance Departments; CRA International

Abstract

The choice of financial structure is appropriately viewed as a complex, multidimensional decision by insurer management. Specific attention is given to traditional theories regarding capital structure, including the tradeoff between the tax benefits and increasing probability of incurring the cost of financial distress associated with leverage, and the tradeoff between protecting franchise or charter value and expropriating value through increasing exposure to interest rate risk. Within this framework, the relation between leverage, interest rate sensitivity and firm value is investigated in the property-liability insurance industry. Equity value, as gauged by Tobin's q, is determined to be related to an insurer's choice of financial structure. It is shown that the market value of equity at first grows but then later declines as leverage increases. Interest rate risk has the opposite effect. Equity value first declines with interest rate risk, but then rises at high levels of interest rate risk. These results are consistent with the prediction that financial institutions will expend scarce resources to control risk in order to protect franchise value and may indeed be signaling the existence of these valuable intangibles via these actions.

JEL Classification: G22

Suggested Citation

Staking, Kim B. and Babbel, David F., The Relation between Capital Structure, Interest Rate Sensitivity, and Market Value in the Property-Liability Insurance Industry. JOURNAL OF RISK AND INSURANCE, Vol. 62 No. 4, December 1995, Available at SSRN: https://ssrn.com/abstract=6955

Kim B. Staking (Contact Author)

Colorado State University - School of Business ( email )

Fort Collins, CO 80523
United States

National Academy of Social Insurance ( email )

1776 Massachusetts Avenue, NW
Suite 615
Washington, DC 20036-1904
United States

David F. Babbel

University of Pennsylvania - The Wharton School - Finance and Insurance Departments ( email )

215 Wakefield Road
Bryn Mawr, PA 19010
United States
610-527-1839 (Phone)

CRA International ( email )

John Hancock Tower
200 Clarendon Street, T-33
Boston, MA 02116-5092
United States
610-527-1839 (Phone)

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