1. Efficiency and the Internal Capital Markets in the U. S
Efficiency and the Internal Capital Markets in the U.S. Property-Liability Insurance Industry
Ji Yun Lim
Temple University
18th APRIA Annual Conference
Moscow State University, Russia

2. Motivation
Questioning the influence of the internal capital markets (ICM) on insurer's efficiency
Powell, Sommer, and Eckles (2008)
Positive relationship between the investment decision of affiliated insurers and internal capital transfers in the U.S. P-L insurance industry is found
Internal capital markets are being utilized to transfer capital to affiliates with the best perceived investment opportunities
Most of the internal capital market studies are focused on the existence of the active internal capital markets and their activities
Many studies about efficiency in insurance industry examine the relationship of efficiency to the organizational form, corporate governance, and market structure
Few studies regarding the relationship between the utilization of internal capital markets and the firm's efficiency

3. Objective Assumption Objective of this study
Internal capital market activity exists in the U.S. P-L insurers
Objective of this study
To determine whether utilizing the internal capital market is beneficial for the U.S. P-L insurers to operate efficiently and ultimately maximize firm value
Why the U.S. property-liability insurance industry?
Insurers are required to report the transactions among affiliates
Insurer groups are prevalent
Grouping structure creates an active internal capital market within the group, letting the holding company allocate capital among affiliated insurers

4. Literature Review – ICM
Many studies question whether or not the internal capital market is active and whether it is efficient if it is proven to be active
Mixed results among prior studies regarding the internal capital markets
Shin and Stulz (1998) and Rajan, Servaes, and Zingales (2000)
Transferring capital to and from affiliates could create an additional layer of information asymmetry between insurer and policyholders and shareholders
Internal capital market activity is not an economically significant factor in the investment strategy for conglomerate firms
Scharfstein and Stein (2000)
Internal capital markets may be less efficient than external capital markets
It may lead to value destroying cross-subsidization among divisions
Stein (1997)
Incentives to establish internal capital markets may be the greatest among firms that are narrowly focused and whose assets present difficulty in valuation

5. Literature Review - ICM
Some empirical studies have found support for the hypothesis that ICMs are active and play a meaningful role in the operations of financial intermediaries
Gertner, Scharfstein and Stein (1994)
Conglomeration may improve financial efficiency by creating internal capital markets
It is easier to efficiently redeploy the assets of poorly performing projects
Internal capital markets are less affected by capital market frictions
Khanna and Tice (2001)
Active and significant internal capital markets in discount retailing industry, focused industry without high levels of information asymmetry
Campello (2002)
Internal capital markets tend to play an efficiency-enhancing role in large bank holding companies

6. Literature Review - Efficiency
The main stream of efficiency studies in insurance industry has been organizational form, corporate governance and mergers and acquisitions
Cummins, Weiss and Zi (1999)
Stock and mutual are operating on separate production and cost frontiers
Stock cost frontier dominates the mutual cost frontier for the majority of both stock and mutual firms
Cummins, Tennyson and Weiss (1999)
Acquired firms achieve greater efficiency gains than firms that have not been involved in mergers or acquisition in the life insurance industry
Use DEA and the Malmquist methodology

7. Literature Review - Efficiency
Cummins and Xie (2008)
Mergers and acquisitions in P-L insurance were value-enhancing
Acquiring firms achieve more revenue efficiency gains than non-acquiring firms and target firms experience greater cost and allocative efficiency growth than non-targets
Choi and Weiss (2005)
Examine the relationship between the market structure and revenue and cost efficiency in P-L insurance industry
Cost-efficient firms charge lower prices and earn higher profits
Prices and profits are found to be higher for revenue-efficient firms

8. Hypothesis
Efficiency scores of the U.S. P-L insurers are related to the internal capital transactions
If transferring capital via internal capital markets facilitates insurer to minimize costs conditional on output levels produced and input prices, the relation of cost efficiency to the internal capital markets would be statistically significant
Two-stage DEA approach
Estimate the insurers' cost efficiency using data envelopment analysis (DEA)
Regress the efficiency scores on the proxy for internal capital market activity

9. Methodology - 1st stage: DEA
Two primary frontier efficiency methodologies
Stochastic frontier analysis (SFA)
Data envelopment analysis (DEA)
In this study, the DEA method will be used because DEA is non-parametric, thus avoiding misspecification of functional form or the probability distributions assumed for the error terms
The proxy measures for the quantity and price follow the definitions in Cummins and Weiss (2012)
Insurers provide three principal services
Risk-pooling and risk-bearing
Real financial services relating to insured losses
Financial intermediation

10. Methodology - 1st stage: DEA Outputs
Three principal services
Output Proxy
Lines of business
Quantity
Price
Risk pooling and risk bearing
Present value of real losses incurred
The difference of premiums earned and the present value of losses incurred
divided by the present value of losses incurred
Personal short-tail losses,
Personal long-tail losses,
Commercial short-tail losses,
Commercial long-tail losses
“Real” insurance services
Financial intermediation
Average invested assets of a firm
Expected rate of return on the insurer’s assets
Because lines of business offered by P-L insurers have different risk characteristics and payout schedules, four separate output measures will be utilized; the present values of personal lines short-tail losses, personal lines long-tail losses, commercial lines short-tail losses, and commercial lines long-tail losses. Cash flow patterns are estimated from the data in Schedule P using the Taylor separation method (Taylor, 2000) and discounted by using U.S. Treasury yield curves.
Since losses incurred differ from the expected loss estimates used in calculating the premiums for the coverage year, there are potential “errors in variables” problem in the measurement of output prices. Thus, smoothing methodology by Cummins and Xie (2008) of moving extreme values to specific percentiles in a systematic way will be adopted to get less noisy efficiency estimates.
The average of the beginning and end-of-year invested assets are used to measure the quantity of the financial intermediation output for P-L insurers. The price of intermediation outputs is measured by the expected rate of return on the insurer's assets. The expected return on bonds and notes is defined as the ratio of actual investment income (minus dividends on stocks) to insurer holdings of debt instruments. For stocks, the expected return is calculated based as 30-day Treasury bill rate plus the long-term average market risk premium on large company stocks (Cummins and Weiss, 2012). The expected portfolio rate of return for each insurer is the average of the debt and equity returns, weighted by the proportion of the portfolio invested in debt securities and stocks.
Classified based on the Schedule P of the NAIC P-L regulatory annual statement
Data from the Federal Reserve Economic Database (FRED) (Federal Reserve Bank of St. Louis)

11. Methodology - 1st stage: DEA Inputs
Category
Quantity
Price
Administrative labor
Sum of expenses associated with home office labor:
salaries + payroll taxes
+ employee relations and welfare
Real national average weekly wage rate for property–liability insurers (SIC code 6331)
Agent labor
Net commissions + brokerage fees + allowances for agents
Average weekly wage rate for insurance agents (SIC 6411)
Business services and materials
Sum of all non-labor expenses
Average weekly wage rate for business services (SIC 7300)
Financial equity capital
Average of the beginning and end-of-year equity capital
Average 90-day Treasury bill rate in year t + the long-term average market risk premium on large company stocks
Policyholder-supplied debt capital
Loss reserves
+ unearned premiums reserves
Total investment income minus expected investment income from equity divided by average debt capital
Insurance inputs are classified into four categories; administrative labor, agent labor, materials and business services including physical capital, and financial equity capital. Because detailed information on input quantities is not publicly available, the quantity of physical inputs can be derived by dividing the relevant insurer expense item by a corresponding price index, wage rate, or other type of deflator.
The quantity for administrative labor is the current dollar expenditures on salaries, payroll taxes and employee benefits. The quantity for agent labor is the current dollar expenditures on commissions, brokerage, and agents allowances. The proxies for prices of those labors are the U.S. Department of Labor real national average weekly wage rate for property-liability insurers and for insurance agents, respectively.
The financial equity capital input is measured by the real value of the average of the beginning and end-of year capital. The best proxy for its price is the market return of equity capital; however, many insurers are not publicly held. Thus, the size adjusted capital asset pricing model utilized in prior insurance efficiency research is employed. The cost of equity capital is calculated as the 30-day Treasury bill rate, plus the long-term average market risk premium on large company stocks, plus the long-term average size premium, implicitly assuming equity portfolios with market betas of 1.0 (Cummins and Xie, 2008).

12. Methodology - 2nd stage: Regression
Efficiency scores from the 1st stage are regressed on
Internal capital market activity in the group
ICM Reinsurance
ICM Surplus
Capital transactions other than internal capital market activity
External Reinsurance
Other Surplus
Firm characteristics
Size
Proportion of personal long tail, personal short tail, commercial long tail, commercial short tail line of business

13. Key Variables
ICM Reinsurance* : the ratio of net ceded reinsurance among affiliates divided by net premiums written
External Reinsurance : the ratio of net ceded reinsurance to and from non-affiliates divided by net premiums written
ICM Surplus** : the sum of four types of the internal capital transactions divided by net premiums written
Shareholder dividends paid to affiliates
Capital contributions
Guarantees made on behalf of affiliates
Capital exchanged when one affiliate purchases, sells or exchanges an asset from another
Other Surplus : the total surplus minus ICM Surplus divided by net premiums written
*The Underwriting and Investment Exhibit Part 2B - Premiums Written in the NAIC P-L regulatory annual statements
**The Schedule Y-Part 2 Summary of the Insurer's Transactions with any Affiliates in the NAIC P-L regulatory annual statement

14. Data Main source of data is the NAIC annual statements
Sample period of 2003–2010
Decision making units used in DEA are defined as groups consisting of at least two affiliates
The data needed for DEA estimation is summed up by group code
Excluded insurers with
Zero or negative net worth, premiums, or inputs
Less than $1.5 million in assets

15. The final sample accounts for approximately 84% of total property-liability insurance industry assets

17. Summary Conclusion In the future work
Groups cede more reinsurance within affiliates than they assume are expected to have higher cost efficiency than those do not
Internal capital transactions except internal reinsurance have no influence on the cost efficiency of insurers
In the future work
Revenue and profit efficiencies
Two-stage least square regression using the rank of efficiency scores as an instrument (Weiss and Choi, 2008)

18. Thank you