1 Which Firm Gets Burned? Rachel J. Huang Larry Y. Tzeng Kili C. Wang

2 The main purpose of our paper We intend to examine the theory of De Meza and Webb (2001) directly. Risk Probability Market InsuranceSelf-Protection

3 Asymmetric information: theory Hidden Information –Adverse selection Hidden Action –Moral hazard Both of them predict that the higher the coverage, the higher the probability of risk.

4 Empirical evidence Many papers didn ’ t find the evidence of adverse selection or moral hazard. For example, –Auto insurance: Chiappori and Salanie (1997, 2000), Dionne, Gourieroux and Vanasse (2001) –Life insurance: Cawley and Philipson (1999) –Health insurance: Cardon and Hendel (2001)

5 Some papers even found that … A negative correlation between the coverage of the insurance and the occurrence of the risk –Finkelstein and McGarry (2003): long- term care insurance –Gronqvist (2004): dental care insurance

6 Another theory: advantageous selection De Meza and Webb (2001) –hidden risk preference –A separating equilibrium: Timid individuals purchase market insurance as well as make an effort to reduce the loss probability, whereas bold individuals neither purchase market insurance nor make an effort to reduce the loss probability.

7 Make sure the negative correlation is not reflecting the underwriting ability … Risk Probability Market InsuranceSelf-Protection + (+) (-) (+) - -

8 Our data set Target: Commercial Fire Insurance Through the Fire Department, we hand-collect the data: –market insurance –self protection activities –records of fire accidents –other relevant variables on which insurance companies usually collect data to underwrite commercial fire insurance Observations: 2,592.

9 Are firms risk aversion? Most of the literatures focus on individual insurance. Risk attitude of a firm: –The classic finance literature: risk neutral –Recent studies: The value function of a firm could be concave due to –bankruptcy costs (Greenwald and Stiglitz, 1990; Stiglitz, 2002) –taxes (Eeckhoudt, Gollier, Schlesinger, 1997) Thus, a risk-neutral firm will behave as if it is risk averse.

10 Why not from insurance companies? Drawbacks to the data obtained from insurance companies: –Insurance companies do not have information on the non-insured. –Insurance companies may not have information on individuals ’ self protection activities.

11 Self-protection variables The proxy must satisfy two criteria: –A non-market risk reduction activity to reduce the probability of a loss. –This activity to reduce risk is unobservable to insurers. Two proxy variables: –the operations of self-defense fire organizations –the qualified operation of fire safety equipment

12 Summary statistics 42.47% of the firms purchase commercial fire insurance. 5.79% of the firms face a fire accidence in the last year. 74.6% of firms have self-defense fire organization operated in the last half year 75.3% of firms have qualified operation of fire safety equipment in the last half year

13 Summary statistics: business type Class-A places

14 Summary statistics: Location

15 Empirical Methodology and Results Empirical Methodology and Results

16 Conditional dependency test Gourieroux, Monfort, Renault, and Trognon (1987) Probit regressions: Estimated residuals:

17 W statistic If is significant, we reject H0:

18 Conditional correlation coefficient We predict that Risk Probability Market InsuranceSelf-Protection

19 Table 3 Items Panel A: Self-Defense Fire Organization as a Proxy for Self-Protection Market insurance vs. Loss occurrence *** *** Self-protection vs. Loss occurrence *** ** Self-protection vs. Market insurance *** *** Panel B: Qualified Operation of Fire Safety Equipment as a Proxy for Self- Protection Market insurance vs. Loss occurrence *** *** Self-protection vs. Loss occurrence *** *** Self-protection vs. Market insurance *** ***

20 4. Conclusion (1/2) Our paper contributes to the literature by providing more direct evidence to support the existence of the advantageous selection theory derived by De Meza and Webb (2001). We simultaneously examine the pair-wise correlations among the purchase of market insurance, the efforts made to engage in self-protection, and the occurrence of accidents.

21 4. Conclusion (2/2) We find that –(1) firms that purchase market insurance have a greater tendency to make an effort to engage in self protection; –(2) firms that make an effort to engage in self protection are less likely to suffer a fire accident; –(3) firms with commercial fire insurance have a lower chance of suffering a fire accident than those without such insurance.

Thank you