CAPITAL STRUCTURE AND THE COST OF EQUITY CAPITAL IN THE PROPERTY-LIABILITY INSURANCE INDUSTRY

Financial pricing models are now widely used in insurance pricing and price regulation. However, most practical applications of these models have not taken into account either the effects of firm capital struct ure or the differences in financial risk across lines of insurance. Th e objective of this paper of this paper is to provide a first step tow ards remedying these deficiencies by providing theoretical and empiric al evidence on the effects of capital structure and line of business r isk on the cost of equity capital in property-liability insurance. A t heoretical model is developed that expresses the cost of capital as a function of both insurance leverage (the ratio of policy reserves to a ssets) and financial leverage (the ratio of financial debt to assets). The model is tested using data on traded stock property-liability ins urers over the period 1980-1989. The results indicate that the cost of equity capital is sensitive to both insurance and financial leverage and that the cost of equity is higher for firms writing long-tail comm ercial lines such as general liability and workers' compensation. Thus , both leverage and line of business specialization should be taken in to account in using the cost of equity capital in pricing property-lia bility insurance.