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Derivatives and corporate risk management: participation and volume decisions in the insurance industry

  • J. David Cummins
  • Richard D. Phillips
  • Stephen D. Smith

In this paper we formulate and test a number of hypotheses regarding insurer participation and volume decisions in derivatives markets. Several specific hypotheses are supported by our analysis. We find evidence consistent with the idea that insurers are motivated to use financial derivatives to hedge the costs of financial distress, interest rate, liquidity, and exchange rate risks. We also find some evidence that insurers use these instruments to hedge embedded options and manage their tax bills. We also find evidence of significant economies of scale in the use of derivatives. Interestingly, we often find that the predetermined variables we employ display opposite signs in the participation and volume regressions. We argue that this result is broadly consistent with the hypothesis that there is also a per unit premium associated with hedging and that, conditional on having risk exposures large enough to warrant participation, firms with a larger appetite for risk will be less willing than average to pay this marginal cost.

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Paper provided by Federal Reserve Bank of Atlanta in its series FRB Atlanta Working Paper No. with number 97-12.

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Date of creation: 1997
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Handle: RePEc:fip:fedawp:97-12
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  1. Brewer III, Elijah & Minton, Bernadette A. & Moser, James T., 2000. "Interest-rate derivatives and bank lending," Journal of Banking & Finance, Elsevier, vol. 24(3), pages 353-379, March.
  2. DeMarzo, Peter M & Duffie, Darrell, 1995. "Corporate Incentives for Hedging and Hedge Accounting," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 743-71.
  3. J. David Cummins & Richard D. Phillips & Stephen D. Smith, 1996. "Corporate hedging in the insurance industry: the use of financial derivatives by U.S. insurers," Working Paper 96-19, Federal Reserve Bank of Atlanta.
  4. David F. Babbel & Anthony M. Santomero, 1997. "Risk Management by Insurers: An Analysis of the Process," Center for Financial Institutions Working Papers 96-16, Wharton School Center for Financial Institutions, University of Pennsylvania.
  5. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. " Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, vol. 48(5), pages 1629-58, December.
  6. J. David Cummins & Mary A. Weiss, 1991. "The structure, conduct, and regulation of the property-liability insurance industry," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, vol. 35, pages 117-164.
  7. Stulz, ReneM., 1990. "Managerial discretion and optimal financing policies," Journal of Financial Economics, Elsevier, vol. 26(1), pages 3-27, July.
  8. Brewer, Elijah, III & Jackson, William E, III & Moser, James T, 1996. "Alligators in the Swamp: The Impact of Derivatives on the Financial Performance of Depository Institutions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(3), pages 482-97, August.
  9. J. David Cummins & Scott E. Harrington & Robert Klein, 1995. "nsolvency Experience, Risk-Based Capital, and Prompt Corrective Action in Property-Liability Insurance," Center for Financial Institutions Working Papers 95-06, Wharton School Center for Financial Institutions, University of Pennsylvania.
  10. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
  11. Venkatachalam, Mohan, 1996. "Value-relevance of banks' derivatives disclosures," Journal of Accounting and Economics, Elsevier, vol. 22(1-3), pages 327-355, October.
  12. René M. Stulz, 1996. "Rethinking Risk Management," Journal of Applied Corporate Finance, Morgan Stanley, vol. 9(3), pages 8-25.
  13. Latha Shanker, 1996. "Derivatives usage and interest rate risk of large banking firms," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 16(4), pages 459-474, 06.
  14. Catherine Schrand & Haluk Unal, 1998. "Hedging and Coordinated Risk Management: Evidence from Thrift Conversions," Journal of Finance, American Finance Association, vol. 53(3), pages 979-1013, 06.
  15. Mayers, David & Smith, Clifford W, Jr, 1988. "Ownership Structure across Lines of Property-Casualty Insurance," Journal of Law and Economics, University of Chicago Press, vol. 31(2), pages 351-78, October.
  16. Cummins, J. David & Grace, Elizabeth, 1994. "Tax management and investment strategies of property-liability insurers," Journal of Banking & Finance, Elsevier, vol. 18(1), pages 43-72, January.
  17. Tufano, Peter, 1996. " Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry," Journal of Finance, American Finance Association, vol. 51(4), pages 1097-1137, September.
  18. Gregor Andrade & Steven N. Kaplan, 1998. "How Costly is Financial (Not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed," Journal of Finance, American Finance Association, vol. 53(5), pages 1443-1493, October.
  19. Smith, Clifford W. & Stulz, René M., 1985. "The Determinants of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(04), pages 391-405, December.
  20. Jeffery W. Gunther & Thomas F. Seims, 1995. "The likelihood and extent of bank participation in derivatives activities," Financial Industry Studies Working Paper 95-1, Federal Reserve Bank of Dallas.
  21. Cummins, J. David & Harrington, Scott E. & Klein, Robert, 1995. "Insolvency experience, risk-based capital, and prompt corrective action in property-liability insurance," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 511-527, June.
  22. Mian, Shehzad L., 1996. "Evidence on Corporate Hedging Policy," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(03), pages 419-439, September.
  23. David Cummins, J. & Sommer, David W., 1996. "Capital and risk in property-liability insurance markets," Journal of Banking & Finance, Elsevier, vol. 20(6), pages 1069-1092, July.
  24. Mayers, David & Smith, Clifford W, Jr, 1990. "On the Corporate Demand for Insurance: Evidence from the Reinsurance Market," The Journal of Business, University of Chicago Press, vol. 63(1), pages 19-40, January.
  25. Cragg, John G, 1971. "Some Statistical Models for Limited Dependent Variables with Application to the Demand for Durable Goods," Econometrica, Econometric Society, vol. 39(5), pages 829-44, September.
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