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Implied Cost of Equity Capital in the U.S. Insurance Industry

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    This study derives and evaluates estimates of the equity risk premium inferred from the stock prices and analysts’ earnings forecasts of U.S. insurance companies. During most of the sample period, April 1983 through September 2012, the quarterly median implied equity risk premium (IERP) of U.S. insurers was relatively stable, fluctuating mildly around an average value of 5.5%. However, during the financial crisis of 2007-2009, the median IERP reached unprecedented levels, exceeding 15% in the first quarter of 2009. Following the financial crisis, the IERP declined substantially but it remained at historically high levels, exceeding 9% on average. In spite of significant differences in operations and financial profile, the median IERP of Life and Health insurers was similar to that of Property and Casualty insurers during most of the sample period. However, during the financial crisis the median IERP of Life and Health insurers was substantially larger than that of Property and Casualty insurers, consistent with the higher sensitivity of Life and Health insurers to fluctuations in financial markets. The differences in the IERP across the insurance sub-industries remained substantial after the crisis, indicating a structural change in the pricing of Life and Health insurers. Consistent with investors demanding relatively high rates of return in periods of poor economic performance or high uncertainty, the IERP is positively related to the credit spread, term spread, and inflation, and negatively related to the 10-year Treasury yield. The relations with firm-specific risk factors are similarly consistent with expectations: the IERP is positively related to market beta, and negatively related to size and the equity-to-assets ratio. These risk factor sensitivities are generally higher for Life and Health insurers as well as during the financial crisis. Finally, consistent with the strong correlations between the IERP and the macro and firm-specific risk factors, the IERP performs well in predicting subsequent excess stock returns. One implication of the results is that the current trend in accounting regulation to eliminate accounting differences across insurance operations may not be desirable.

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    Article provided by EY Global FS Institute in its journal Journal of Financial Perspectives.

    Volume (Year): 1 (2013)
    Issue (Month): 1 ()
    Pages: 87-103

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    Handle: RePEc:ris:jofipe:0008
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