The Impact of Firm Franchise Value on Asset Allocation: An Analysis of Property-Liability Insurance Firms

____________________________ The authors gratefully acknowledge financial support from the College of Business Administration at the University of Rhode Island. We would like to thank Tian Xiao at NAIC for useful comments and Xuanjuan Chen, doctoral student at University of Rhode Island, for computational assistance. We also thank participants at the 2003 Western Risk and Insurance Conference. All errors are sole responsibility of the authors. Abstract This study considers risk taking incentives, intangible assets and firm leverage in one unified framework. We propose a model considering the deadweight cost of losing a fraction of intangible assets, commonly known as franchise value in insurance industry, when firm's tangible assets decline. The model shows that firms' risk taking incentives vary when they have different levels of franchise value. Firms with high franchise value are more risk-averse and thereby would prefer a lower level of risk. However, as leverage increases, some firms might increase the risk exposure to take advantage of the limited liability option. Our empirical results, using a sample of property and liability insurance firms, support the above predictions. Specifically, we identify a negative relationship between the amount of franchise value and the level of firms' asset investment risk. The results hold after controlling for insurance company group affiliation, ownership structure, and operating risk. In addition, we also present evidence that firms' risk aversion declines as leverage increases.