||The simultaneous equations model of capital structure, derivatives and credit rating for UK insurers
||Institute of International Business
Simultaneous equations model
The credit rating levels can have significant impact on insurers’ capital decision-making. In this paper, I investigate the relationship of rating levels and capital decision-making variables, leverage and derivative use for UK life insurers. Thus I construct the three equations, rating, leverage and derivative use equation, and utilize the simultaneous equations model to run 2SLS to eliminate the endogeneity problem and try to see the true impact for those variables.
In the rating equation, I find that highly leveraged firms will have lower rating like previous literatures, while firms with high derivative use will get higher rating which suggests derivative can reduce the risk firms have. On the other hand, on leverage equation, higher rating firms are found to have higher leverage. Finally, in derivative use equation, higher rating firms are more likely to utilize derivative to prevent rating downgrade, while highly leveraged firms are reported to use less derivative.
Chapter1. Introduction 1
Chapter2. Literature Review and Hypothesis 5
2.1 Credit rating and leverage 5
2.1.1 The effect of credit rating on leverage 5
2.1.2 The effect of leverage on credit rating 6
2.2 Credit rating and derivative use 7
2.2.1 The effect of credit rating on derivative use 7
2.2.2 The effect of derivative use on credit rating 8
2.3 leverage and derivative use 9
2.3.1 The effect of leverage on derivative use 9
2.3.2 The effect of derivative use on leverage 10
Chapter3. The Methodology and Framework 11
3.1 Methodology 11
3.2 Data 12
3.3 Dependent variable 12
3.4 Control variable 13
Chapter4. Empirical Results 21
4.1 Description Statistics 21
4.2 Multivariate Results 23
4.2.1 Results for rating equation 23
4.2.2 Results for leverage equation 27
4.2.3 Results for derivative use equation 29
Chapter5. Conclusion 31
Adams, M., P. Hardwick, and H. Zou, 2008, Reinsurance and Corporate Taxation in the United Kingdom Life Insurance Industry, Journal of Banking and Finance, 32:101-115.
Adams, M. 1996, The Reinsurance Decision in Life Insurance Firms: An Empirical Test of the Risk-Bearing Hypothesis, Accounting and Finance, 36: 15-30.
Altman, E.; Avery, R.; Elsenbeis, R., and Sinkey, J. 1981 "The Application of Statistical Classification Methods to Bond Quality Ratings" in Application of Classification Techniques In Business, Banking, and Finance. JAI Press. Ameer , Rashid and Mat Isa, Rosiatimah and Abdullah , Azrul, 2010, A survey on usage of derivatives and their effect on cost of equity capital / Dr Rashid Ameer , Dr Rosiatimah Mat Isa , Azrul Abdullah. Technical Report. Institute of Research, Development and Commercialization ,University Teknologi MARA. (Submitted)
Ashbaugh-Skaife, H., Collins, D. W., &LaFond, R. 2006. The effects of corporate governance on firms' credit ratings. Journal of Accounting and Economics, 42(1/2): 203-243.
Beaver, W.H., M.L. McAnally and C.H. Stinson, 1997, 'The Information Content of Earnings and Prices: A Simultaneous Equations Approach, Journal of Accounting and Economics, Vol. 23, pp. 53-81.
Belkaouj, Ahmed, 1983. Industrial Bonds and the Rating Process. QuarumBooks.
Bradley, M., G. Jarrell, and E. H. Kim, 1984, On the Existence of an Optimal Capital Structure: Theory and Evidence, Journal of Finance, 39: 857-877.
Chen, Y., I. S. Hamwi, and T. Hudson, 2001, The Effect of Ceded Reinsurance on Solvency of Primary Insurers, International Advances in Economic Research, 7: 65-82.
Cole, C. R., and K. A.McCullough, 2006, A Reexamination of the Corporate Demand for Reinsurance, Journal of Risk and Insurance, 73: 169-192. Colquitt, L. L. and Hoyt, R. E. 1997. Determinants of corporate hedging behavior: evidence from the life insurance industry. Journal of Risk and Insurance, 64, 649–71. Corporate Criteria: Analytical Methodology, 2008, Standard & Poor’s. Retrieved 27-Jun-2009,
Cummins, J. D., Phillips, R. D. and Smith, S. D. 1997. Corporate hedging in the insurance industry: the use of financial derivatives by US insurers. North American Actuarial Journal, 1, 13–40.
Daykin, C. D., T. Pentik¨ainen, andM. Pesonen, 1994, Practical Risk Theory for Actuaries,1st edition (London: Chapman & Hall).
Doherty, N. A., 2000. Integrated Risk Management: Techniques and Strategies for Managing Corporate Risk. New York, NY: McGraw-Hill Professional Publishing.
Frank, M. Z., and V. K. Goyal, 2009, Capital Structure Decisions: Which Factors Are Reliably Important? Financial Management, Spring: 1-37.
Frank, M. Z., and V. K. Goyal, 2009, Capital Structure Decisions: Which Factors AreReliably Important? Financial Management, Spring: 1-37.
Graham, J. R., 1996, Debt and the Marginal Tax Rate, Journal of Financial Economics, 41:41-73.
Graham, John R., and Campbell R. Harvey, 2001, The theory and practice of corporate finance: Evidence from the field, Journal of Financial Economics 60, 187–243.
Graham, J. R., and D. A. Rogers, 2002, Do FirmsHedge in Response to Tax Incentives?Journal of Finance, 57: 815-839.
Graham, J. R., and C. W. Smith Jr., 1999, Tax Incentives to Hedge,Journal of Finance,54: 2241-2262. Harrington, S. E., and P. M. Danzon, 1994, Price Cutting in Liability Insurance Markets, Journal of Business, 67: 511-538.
Hoerger, T. J., F. A. Sloan, and M. Hassan, 1990, Loss Volatility, Bankruptcy, and theDemand for Reinsurance, Journal of Risk and Uncertainty, 3: 221-245. Kahane, Y., C. S. Tapiero, and L. Jacques, 1986, Concepts and Trends in the Study ofInsurer’s Solvency, in: J. D. Cummins and R. A. Derrig, eds., Financial Models ofInsurer Solvency (Norwell, MA.: Kluwer Academic Publishers).
Kisgen, D. J., 2009, “Do Firms Target Credit Ratings or Leverage Levels?” Journal of Financial and Quantitative Analysis, forthcoming.
Lin, C., and S. D. Smith, 2007, Hedging, Financing and Investment Decisions: A Simultaneous Equations Framework, Financial Review, 42: 191-209.
Mayers, D. and C. W.Smith. 1981. Contractual Provisions, Organizational Structure, and Conflict Control in Insurance Markets. Journal of Business 54 (July): 407-434.
News Article: Best's News Publications & Press Releases, 2012, A.M. Best
Company, Inc. Retrieved 12-Jun-2012
src=14&altnum=&refnum=65494656775346556648 Pottier, S. W. and Sommer, D. W., 1999, Property-Liability Insurer Financial Strength Ratings: Differences Across Rating Agencies,Journal of Risk and Insurance, 66, 621–642
Powell, L. S., and D.W. Sommer, 2007, Internal Versus External Capital Markets in the Insurance Industry: The Role of Reinsurance, Journal of Financial Services Research,31: 173-188. Sommer, D. W., 1996, The Impact of Firm Risk on Property-Liability Insurance Prices, Journal of Risk and Insurance, 63: 501-514. Shiu, Y., 2011. Reinsurance and Capital Structure: Evidence from the United Kindom Non-life Insurance Industry. Journal of Risk & Insurance, 78: 475-494
Shortridge, R. T., and S.M. Avila, 2004, The Impact of Institutional Ownership on theReinsurance Decision, Risk Management and Insurance Review, 7: 93-106.
Smith CW, Stulz RM, 1985,The Determinants of Firms’ Hedging Policies. Journal of Finance Quant. Anal., 20(4): 391-405.
Titman, S., and R.Wessels, 1988, The Determinants of Capital Structure Choice, Journal of Finance, 43: 1-19.
Warner, J. B., 1977, Bankruptcy Costs: Some Evidence, Journal of Finance, 32: 337-347. Yi, B., Lin J. and Chen, 2008, Does derivative use help reduce the cost of debt?,Review of Business Research.,8: p196-204
Ziebart, D. A., & Reiter, S., 1992. Bond ratings, bond yields and financial information.Contemporary Accounting Research, 9 (2): 252-282.